Friday, August 28, 2009

The Components of Trading Well

By Van K. Tharp, Ph.D.

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This article is an excerpt from Part 1 Working on Yourself: The Critical Component That Makes It All Work, from the book, Super Trader: Make Consistent Profits in Good and Bad Markets

I’m a neuro-linguistic programming (NLP) modeler and a coach for traders. As an NLP modeler, I encounter a number of people who excel in something, determine what they do in common, and then determine what beliefs, mental strategies, and mental states are required to perform each task. Once I have this information, I can teach those tasks to others and expect to get similar results. My job as a coach is to find talented people and make sure they learn and follow the fundamentals.

I remember doing a workshop with the Market Wizards Ed Seykota and Tom Basso around 1990. All three of us agreed that trading consists of three parts: personal psychology, money management (which I subsequently renamed position sizing (TM) in my book Trade Your Way ...), and system development. We also agreed that trading psychology contributes about 60% to success and position sizing contributes another 30%, which leaves about 10% for system development. Furthermore, most traders ignore the first two areas and don’t really have a trading system. That’s why 90% of them fail.

Over the years I’ve done extensive modeling in all three areas, and I now disagree slightly with our conclusions in 1990. First, I would argue that trading psychology accounts for 100% of success. Why? This conclusion is based on two findings. First, people generally are programmed to do everything the wrong way. They have internal biases that seem to lead them to do the exact opposite of what is required for success. For example, if you are the most important factor in your trading, you should spend the most time working on yourself, but the majority of people totally ignore the “you” factor in their success. Read over the checklists in this part that deal with good trading. If you’ve worked extensively in all the areas listed, you are probably very successful and are certainly a rarity.

Second, every task I model requires that I find the beliefs, mental states, and mental strategies that are involved. All three ingredients are purely psychological, and so it’s hard not to conclude that everything is psychological.

I now think that there are five components to trading well:

1. The trading process. The things you need to do on a day-to-day basis to be a good trader.

2. The wealth process. Exploring your relationship with money and why you do or do not have enough to trade with. For example, most people believe that they win the money game by having the most toys and that they can have it all right now if their monthly payments are low enough. This means that they save zero dollars and are over their heads in debt. If this is you, it also means that you don’t have enough money to trade.

3. Developing and maintaining a business plan to guide your trading. Trading is as much a business as is any other area. The entry requirements are much easier because all you have to do is deposit money in an account, sign a few forms, and start trading. However, the entry requirements for successful trading require that you master all the areas listed here. That requires a lot of commitment, which most people do not have. Instead, they want trading to be easy, fast, and very profitable.

4. Developing a system. People often consider their system to be the magic secret for picking the right stocks or commodities. In reality, entry into the market is one of the least important aspects of good trading. The keys to a moneymaking system are elements such as determining your objectives and the way you exit a position.

5. Position sizing to meet your objectives. We’ve discovered through our simulation games that 100 people at the end of a set of 50 trades will have 100 different equities. (They all get the same 100 trade results). This extreme variability of performance can be attributed to only two factors: how much they risked on each trade (i.e., position sizing) and the personal psychology that determined their position sizing decision.

Based on the five components of trading well, rate yourself by asking the following questions:

How well have I mastered the discipline of trading well each day? Do I do a daily self-analysis or a daily mental rehearsal to begin each day? If not, why not? (I will give you a lot of ideas about how to improve in this area throughout the Super Trader book).

Do I really have enough money for trading to make sense? If you do not, you probably need to work on yourself and the wealth process.

Do I have a working business plan to guide my trading? If you don’t, you are not alone. We estimate that only about 5% of traders have a written business plan. Then again, perhaps you’ve heard that only about 5% to 10% of all traders are really successful. Super Trader will guide you toward developing this kind of working document.

Do I have a set of objectives thoroughly written out to guide my trading? Most people don’t. How can you develop a system to meet your objectives without having objectives?

How much attention have I paid to the “how much” factor: position sizing? Do I have a plan for position sizing my system to meet my objectives? It is through position sizing that you either meet or fail to meet your objectives.

How much time do I spend working on myself? You have to overcome your psychological issues and develop the discipline necessary to carry out the processes described above, which are necessary for success.

Most of the items described here could be the topic for an entire book. However, my intention was to give you an overview of what is required for successful trading, and my job as a coach is to find talented people and coach them on following the fundamentals I’ve described them here.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study Program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at the Van Tharp Institute