Tuesday, July 31, 2012

Developing Your Own Profitable Trading Path

Some years back, I used to follow a particular market analyst very closely. He was rather unorthodox in his approach and wrote richly detailed predictions with so much historical perspective and meticulous analysis that I was convinced he understood what the market was doing and where it was going.

Recently, his company sent out a ridiculously low-priced trial subscription offer for his newsletter, so I decided to sign up and see what he was saying these days. He’s been bearish since the late 1990s, and it turns out he’s still pretty bearish. In fact, he just presented a long-term stock market log scale chart that looked something like this:

Years ago, I would have looked at a chart like this one and believe that the red arrow was going to happen. All those pages of analysis, historical research and a track record of correctly calling major turning points clearly proved that this guy knew! All I needed to do was think about how big and how short I could get so that I could simply sit back and enjoy the long ride down.

When I consider now that I used to think and trade like that, I actually shake my head and shudder a little. It amazes me how lucky I was that I never lost significant amounts of money doing things that way.

Still, when I first saw the above chart last month, the old feelings came flooding back. I felt the excitement I used to feel and thought about the huge gain I could reap from such a large move. But this time, I immediately started asking myself some questions.

1. Is the chart true? Is the drop going to happen?

I don’t know. Before understanding Tharp Think principles, I used to believe that good traders had to know where the market was going in order to trade well. Now, I believe that I don’t know what the market will do, and I don’t care that I don’t know. In fact, not knowing can be quite liberating. Why? Because the market could go down, or sideways, or up some more. The market is going to do what it’s going to do, and it’s not my job to figure that out. My job is to be ready with systems so that I can trade whatever type of market shows up (Byron Katie writes at length about the “don’t know” mind, but that’s another article in itself).

2. Could it happen?

I have my own big picture written out now, and a significant move down in the coming years fits with that picture, but I don’t try to predict the degree or the timing of that drop. All I can say is that such a drop wouldn’t surprise me. I’m not willing to risk money on it, because I also wouldn’t be surprised if the market moved up a bit more or sideways for a long time. Central banks have more monetary engineering strategies left to try to buoy the markets, and some might actually work for a while.

3. Is a long-term short the best way to trade such a move?

I used to think so, but now that I have a number of trading systems at hand and a better understanding of my objectives, abilities and limitations, LEAP puts or a massive short would definitely not be the best way for me to trade such a move. I believe I could earn a lot more and risk a lot less by trading shorter-term systems. After all, there would still be plenty of strong up days, weeks and months during the years over which the move would play out. Take a look at the DJIA chart from 1930 to 1932—down >80% in that period. Within that decline, however, were numerous rallies of 10%-40%. I’d like to benefit from bear market volatility in both directions rather than watch (sweat) a long-term short position expand and contract with lots of fluctuations.

After asking myself these questions, I came to the realization that I found the analyst’s predictions interesting, and that was all. They aren't particularly useful to me anymore.

Traders Evolve, Trading Evolves

I’ve noticed a number of other changes in my thinking in recent months as well.

Late last year, Van requested that I rework my business plan. I began the process by applying one of recently-deceased Stephen Covey’s seven habits — “to start with the end in mind.”

First, I revisited and revised my long-term objectives, which I really hadn’t looked at in a few years, even though a number of my personal circumstances had changed. To that end, I built a multi-year cash-flow model of my trading business and personal financial situation. After developing a long list of assumptions and calculations for the model, I discovered that financial freedom wasn’t some distant possibility, but something that was actually achievable—and long before I’d thought it would be. That was more than heartening; it was thoroughly invigorating. Just thinking about it now gets my heart going.

Second, I built my objectives for the rest of 2012 in line with my longer-term objectives.

Third, I rewrote a good chunk of my business plan. What’s come out of that process has proved very interesting, and I'm looking forward to trading in a very different manner for the rest of this year. Before, my focus was on trading often and minimizing mistakes. Now, it will be on flawless execution—on trading when and how the system rules dictate so that each system generates the results it “should” generate. To help with this new focus, my business plan now reflects the following:

The number of trading systems I intend to actively trade at any one time is way down—by more than half. Before, I was interested in taking lots of trades from lots of systems, but now, I’m more interested in taking a few trades and executing those trades flawlessly to achieve the expectancy of each system.

Also, the systems are different in nature. One of the day trading systems would have seemed quite boring to me before; it has what I would have judged to be a low expectancy and a low win rate. What it also has, however, is consistency and lots of setups. Those factors give it a decent SQN score and a high expectunity. Understanding the importance and power of position sizing strategies has dramatically changed how I think about trading systems and what kinds of systems I want to trade from now on.

I’ve also invested much more time in the position sizing strategies themselves. Given my objectives for the rest of the year, I created an independent position sizing strategy for each system. Why? Because each system has very different performance characteristics, but they all need to help me reach my business goals. Each position sizing strategy will help each trading system accomplish that in different ways.

What Happens Now?

What happens when the predictions of an analyst you used to follow become nothing more than interesting to you, and you attempt flawless execution with effective position sizing strategies for a few systems? In all honesty, I don’t know yet, but I’ll share that with you sometime soon.

About the Author: RJ Hixson is a devoted husband and active father. At the Van Tharp Institute, he researches and develops new products and services that will help traders trade better. Among myriad aspirations, he dreams of moving dirt around his yard with a Bobcat and going for a sail on an America’s Cup yacht. He can be contacted Dr Van Tharp Institute of Trading Mastery.