The Van Tharp Institute

March 15, 2006 — Issue #262

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In this Issue:

Back-to-Back

Systems Development and Mutual Funds / Exchange Traded Funds Workshop

Feature Article

Interview with Systems Expert, Ken Long, Part Two, By Van K. Tharp, Ph.D.

Trading Education

People Don't Trade the Markets, They Trade Their Beliefs about the Markets.

Trading Tip

What Research and Reason Say About Short Selling, by D. R. Barton, Jr.

Free

Millionaire Mind Events by Harv Eker

Listening In Why is the ANTI MARTINGALE strategy considered superior?
Special Reports Reports by Van Tharp: Self Sabotage, Changing Markets

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April 1-3, 2006 Raleigh, NC


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April 5-7, 2006 Raleigh, NC

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Feature

An Interview with Ken Long

By Van K. Tharp, Ph.D.

Part Two

Through this series of interviews with Ken Long it is my objective to highlight important points about trading system development.

Last week in Part One we discussed the importance of defining what you want from your system before you design it, in addition to the importance of knowing who you are as a trader and your objectives.

We also began a discussion on decision making. So let’s continue…V.T.

You did a lot of thinking about the input you would need for decision-making.  In the case of the game (trading simulation 'marble' game), you were looking at 1) the drawdowns (with respect to 20%); 2) how your group was performing with respect to the other groups; and 3) if there were any statistical anomalies that you needed to consider. Are these general to most systems?

The game was set up with the following payoffs: real money penalties for drawdowns, and those penalties were assessed after every 10 turns.  The final input was that the group with the most money at the end got the big reward.  We knew we needed to make decisions based on drawdowns to adjust our risk levels and to consider changing strategies after each review period depending on how our performance compared to the other groups.  Knowing that these decisions were coming, we were able to review the data we would need to make informed decisions and to rehearse these decisions under the different conditions we might face.  This analysis, performed while not under stress, made it very easy for us to react when the decision points came.  

So, one decision you must make is when to evaluate your system and against what criteria?

A real world example for a trading system might be a trader who decides to check his actual trading performance every month against the calculated system expectancy, and determine the statistical significance of the variation.  He might decide that any result greater than one or two standard deviations is a signal to stop trading and recalibrate the system or reconfirm the validity of the trading model and its underlying assumptions.  If the actual expectancy is close to the predicted expectancy, then the trader knows he’s on target.  In modern manufacturing systems this concept is called “Statistical Process Control.”  It lets the system controller know when the production machines are drifting out of tolerance and degrading the quality of the output to the point where the line is stopped and the machines are retooled.  Dr. Edward Deming is the real pioneer in this area, and I can strongly recommend Mary Walton’s fine book, The Deming Management Method for a great discussion of the role of sampling and statistics in systems design and management.  

Is there any more to that?

Basically, a good decision making system must identify who the decision makers are, what level of decision making they are authorized to make, and under what conditions they can make them.  Delegation of responsibility and authority in a system leverages the power of your available personnel, decreases response time, and keeps your senior leaders free to make the decisions that only they can make.  An organization that has thought this through avoids the constricting effects of rapid growth that can overwhelm an over-centralized decision system.  My rule of thumb is to figure out how we handle 10 times the maximum volume we think is reasonable. 

But a lot of decision-making is automatic, especially for good traders.  How does that fit in?

It’s a general problem of the information age, which provides us with a wide range of automated decision support systems that can compile massive amounts of data, analyze and process it, and present us with decision packages for action based on criteria that we can specify.  I use a lot of these.  However, the key to making them work is to make sure that you understand the underlying business model and system logic.  When you do things automatically by computer, you need to understand what the computer is calculating and filtering.  For example, I won’t use power tools until I know how they work and I have mastered their use in simulations.

If someone has done all the preparation work that you outlined in your system design workshop, and has chosen indicators that provide the right signals for making trading decisions, then the right thing to do is to rely on the signals to make your decisions.  However, periodic calibration of the system is still necessary to confirm that you have chosen the correct signals and that your actions are correct.  If you have not done that work though, it may be the case that you simply picked up the latest hot indicator and are using it regardless of how appropriate it may be for your trading system.  If it fails to work as advertised, you are likely to dump it for the next hot idea that comes along.  Then you’re not a system’s trader, you are only reacting to advertising.

So what we’re really talking about is the periodic review from the ten tasks of trading.

Exactly.  You can reliably operate a trading system by paying attention to a few key indicators, as long as you are faithfully conducting the periodic servicing that represents recalibration.  That systems performance check is your insurance that the system design is still appropriate for the markets you are in.

And, you have to have something built into the decision-making so that you know when your system is broke.  For example, with the periodic review, you must know what kind of markets we’ve had and how you’d expect your system to perform in those markets.  You are only going to make changes when something is wrong.

Your goal is to design a synchronized system that can be monitored with a few simple signals. But, I caution traders again to fully understand what those signals represent and to take personal responsibility for the results they get.  After all, it’s your choice to use a signal or a system you don’t understand, but the results and the responsibility are yours alone. 

Next week in part three of this interview we pick up with an example of mental rehearsal, which is part of my Ten Tasks of Trading, and discuss the importance of comparing your systems’ results with your goals and objectives throughout the process. 

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

 

Trading Education

Van Tharp's  Peak Performance Home Study Course

People do not trade the market. They trade their beliefs about the market. 

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  • Bring more discipline to your trading.

  • Learn self-confidence, overcome fear and eliminate self-sabotage.

These are just a few of the benefits of the Peak Performance Home Study Program.

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Trading Tip 

Trading Tip

 What Research and Reason Say About Short Selling

Short Selling  (Part III)

by D. R. Barton, Jr.

In the past couple of weeks in Part I and Part II, we have looked at the semi-mysterious and oft maligned world of short selling.  We’ve debunked myths that short selling is unpatriotic, immoral and fattening.  (Okay, I didn’t say anything about short selling and waistline size.  But I’m sure it’s been blamed for that too…)

Today, let’s look at two more common misconceptions about short selling. One, that short selling drives the stock market down and, two, that short selling presents the trader with “unlimited risk.”

Short selling does not drive the market down.  A famous study by NYSE Economist Edwin Meeker after the 1929 crash showed conclusively that short selling had a negligible effect on that famous drop in price.  In November of 1929, 1 out of 10,000 shares sold was sold short.  By 1931 that number had still only risen to 1 out of 170 shares – less than one percent of all transactions.  The fact that 1 out of 170 shares traded was a short sale did not drive the market down!  The main source of panic selling during the great crash was large institutions unloading big of blocks of stocks.  The second source of panic selling was shares that had been bought on 10 to 1 margin during the mania that preceded the crash and had to be unloaded as the market plummeted.

Short selling does not have “unlimited risk”.  The myth of unlimited risk was obviously championed by people who were trying to discourage short selling.  It has it roots in the notion that a stock “theoretically” can go up forever with no stopping point, while price can “only” decline to zero.

In practice, the notion that a stock trade or investment has unlimited risk is absurd.  How can any financial transaction in a very liquid market have unlimited risk?  The only way you can have “unlimited risk” is if you never close out your trade.  Readers of Van’s material (and mine) understand that we, as traders and investors, are responsible for our own results.  We also understand stop losses and setting limits on how much we’re willing to risk (or lose) in any one trade or investment.  Don’t be duped by crazy notions like “unlimited risk.”  They are perpetuated by folks who have a vested interest in keeping you from shorting their stock.

Next week, we'll look at some tools and tactics that can be used to help you be more productive in your short selling.  Until then,

Great Trading!

 

D. R. Barton, Jr. is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching, and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

 

Free

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As you probably already know, I do not make recommendations very often. However over the last three years, since speaking at a Harv Eker event, I have had numerous clients become involved with Harv’s teachings and I continue to hear great reviews time and time again. Therefore, if my clients find his work beneficial and continue to get value, then I am happy to let more of you know about it.  Click on the link below if you'd like to learn more about Harv's upcoming events and free teleconference coming next Tuesday, March 21st  —Van

Learn More....

 

Listening In...  

ANTI MARTINGALE 
Author: oz 
Date: 02-27-06 10:30

I have read everywhere that traders should use an anti martingale betting strategy. But no one has explained why it is superior. What makes betting more when you're winning good? Also, what are the benefits of a fixed fraction betting strategy (which is supposed to be martingale?


Reply To This Message 


Re: ANTI MARTINGALE 
Author: nazzdack


With the anti-martingale, you shouldn't go bankrupt when you add-on to winners AND scale-back when you're losing. With the martingale, you can be destroyed if a trend doesn't reverse soon enough. Each "method" has merits and drawbacks. Ultimately, you can't let small losses become huge losses. The anti-martingale should give you a larger margin of safety. Streaks and trends "happen" in the market. Knowing and believing that, you can expect to be wiped out eventually if you adhere too rigidly to martingale-type trading. You can also expect to hit it big sometime if you get onboard a monster-trend and keep adding on to it and getting out close enough to the final price extreme. Do what you feel comfortable doing.


Reply To This Message 


Re: ANTI MARTINGALE 
Author: level7 

Just to add to nazzdack's comments.

IMO, anti-martingale (AMG) is superior because of risk reward ratio as well. The longer the streak, the more unlikely it is to occur in an absolute probability sense. You want to ensure that on longer streaks you actually win more than one unit for betting an (absolute, not relative sense) riskier bet. - which is all a true MG system can give. With proper stop losses, your risk/ratio is relatively less for the final bet than in a martingale where it is still a risk of one. For example on a 3 repeat streak, your risk (doubling each time) is now potential 8 gain for 1 risked (assuming stop of 1).

Further on a bad streak for anti-martingale you will lose an arithmetic amount whereas on a good streak you will win an exponential amount. Thereby you have a win due to the difference in these two curves in a 50/50 system. In a MG you will lose and gain 1 unit, until a very long streak hits you because of your drawdown.

Does that make sense?


Reply To This Message 


Re: ANTI MARTINGALE 
Author: Terry

Hi Oz,

The antimartingale betting strategy is superior because it allows you to take advantage of your winning streaks with maximum gain. Taking a fixed fractional approach (which is antimartingale...not martingale), will allow you to best exploit whatever "positive expectancy" you have.

Terry 

Participate on Van's Trading Forum, a place for traders and investors to share ideas and learn from each other. For more on the above posts, look for the title, "ANTI MARTINGALE."

Special Reports By Van Tharp

Click below to read page one of each report, or to order. 

Self  Sabotage - Two Reports of Self Sabotage

Does Your System Still Work in Changing Markets?

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Copyright 2006 the International Institute of Trading Mastery, Inc.

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Quote of the Week


The Ides of March is the first day of the Roman New Year. It also marks the first day of spring in the Roman calendar. 

On this day in history, Julius Caesar was warned by soothsayers to "beware of the Ides of March". He was stabbed by Marcus Brutus on the Ides of March in 44 BC.

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It is designed to teach you the important principles of proper position sizing. 

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Did You Know...

Van Tharp is featured among Jack Schwager's original Market Wizards. 

The Market Wizards books are cited by top traders as essential reading. 

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