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Thread: Conquering Trading Biases: Q&A with Dr. Van Tharp

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    Default Conquering Trading Biases: Q&A with Dr. Van Tharp

    By Active Trader Staff

    2007, Reprinted with permission of Active Trader magazine (www.activetradermag.com)

    While many traders waste time chasing elusive perfect entry techniques, one trading coach points out that trading success is about accepting market realities, knowing yourself and implementing a money management plan that keeps the odds on your side.

    Van K. Tharp. Ph.D., is a well-known trading coach and consultant. He is president of the International Institute of Trading Mastery (www.iitm.com) in Cary, N.C., and author of Trade Your Way to Financial Freedom (1999, McGraw-Hill) and Financial Freedom Through Electronic Day Trading, due to be released this fall.

    He recently spoke with Active Trader about the psychological biases that prevent traders from succeeding in the markets, and what traders can do to combat negative habits.

    AT: What are some of the most common weaknesses you see in traders?

    VT: Ive designed a test to help people determine their weaknesses. There are 10 measured areas that fall into three categories: psychology and discipline; understanding systems and expectancy; and money management, which I now call Position Sizing.

    I think you could safely say that everyone who wants to succeed as a trader must master those three areas. However, all of them fall under psychology because we are all human beings, not robots. Psychology impacts everything.

    One reason psychology is so important is that we all have certain biases that help us deal with processing the vast amount of information to which we are exposed everyday as traders. These
    biases help in decision-making, but they tend to lead us astray. If you naturally follow those biases and most people do then you will have a very hard time learning what you need to learn to be successful. And incidentally, most of the information available to help traders caters to our biases.

    AT: What are some examples of these biases?

    VT: There are four that actually cover the common weaknesses almost all traders have.

    First, we all need to be right. Were taught in the school system that anything less than 70 percent is failure. As a result, we want to be right at least 70 percent of the time in the markets. But when you have this bias, the result is that you wont take losses. Youll think the losing trade youre holding might turn around and become a winner, so you wont take the loss. Eventually the loss becomes huge so you have to take it or you turn into a long-term investor.

    The flipside of having this bias is that you want to take profits right away. Why? If you take profits right away, your trades have no chance of turning into losers and you get to be right.

    But this flies in the face of the golden rule of trading: Cut your losses short and let your profits run. By needing to be right you end up doing the opposite, cutting profits short and letting losses run.

    Second, we want to be in control, which means, in trading, we want to control the markets. The only thing most people can control about the markets is when they get into a trade. Consequently, most people focus all of their effort on predicting the market and picking the right stocks.

    But I think most of this effort is wasted. Profits come from exits, not picking the right stocks. If you cut losses and let profits run, you can be a phenomenal success and it will have little to do with what stocks you pick.

    Third, people dont understand the nature of streaks. Arandom sequence tends to have very long streaks in it longer than most people would think. But since we dont expect them, we tend to risk more after a few losses and risk less after a few wins. But the best way to trade and make money is to always risk more when you are ahead.

    Last, people seem to think they know what theyre doing and none of this the issues Im talking about now applies to them. They dont take responsibility for their results and they blame others for what happens to them. When you do that, you will never learn from your mistakes. Instead, youll continually repeat them. And if you risk a constant percent of your equity, youll be doing just that.

    I think that if people could master, really master, those four concepts, theyd become good traders. The problem is that theyre not as easy to master as they appear to be.

    AT: What do you consider the hall - marks, psychological or otherwise, of a good trader?

    VT: I teach people that there are seven key principles you must master to be a good trader.

    The first is what I was just talking about you must take total responsibility for what happens to you.
    Whatever your results, you must believe that you somehow produced them. This means that when things go bad you can start to learn from your mistakes. It also means that most of your effort will be in the area of understanding yourself, not understanding the markets.

    Second, you must treat your trading like a business. You must know who you are, what your mission is as a trader and have objectives that fit your mission. Once you have those things in hand, you can
    then design a game plan that will help you succeed.

    Third, you must understand that whenever you enter a trade you must have some point at which you will get out in order to preserve your capital. I call this your initial risk level, or R for short. If you dont have an exit point when you enter a trade, then you are not a professional and you have very little chance of long-term success.

    Fourth, you must strive to make profits that are multiples of R. For example, if your profits are generally 10R, then you can be wrong 70 percent of the time and still make tremendous profits. For example, seven 1R losses and three 10R gains would give you a total profit of 23R. Thats superb. When you do this, you will have a positive expectancy system.

    Fifth, you must understand a what a low-risk idea really is: a trading approach with a positive expectancy, but traded at an appropriate size to allow for the worst possible outcome in the short run so that you can realize the expectancy over time.

    Sixth, you must master Position Sizing, which is the part of your system that answers the question, How much? throughout the course of the trade. It is the key to meeting your objectives and it is the most overlooked aspect of trading, with the exception of psychology.

    Finally, you must continually work on yourself, because your trading results are much more a result of you and what you do than any other factor. I have a Peak Performance Course for traders that addresses many of these issues like discipline, the 10 tasks of successful trading, self-sabotage, smart decision making, etc.

    AT: Do you think trading skills can ultimately be taught or does a basic aptitude for the profession play a bigger part in determining success?

    VT: Its hard for me to imagine anyone who masters those seven principles not being a success. But few people can do it. First, most people are not ready for principle No. 1, and unless you master that one, you have little chance of success, in my opinion.

    Also, its very hard to understand some of the other principles unless you have good mathematical skills. For example, concepts like expectancy, which comes from principles No. 3 and No. 4, are very difficult to understand if you dont have good mathematical stills. And math skills are critical for mastering Position Sizing.

    I give a simple 1 1⁄2-hour talk in which I teach the essentials of expectancy and position sizing. However, Ive had people listen to that talk, think it was brilliant and still not get the concept. Then they want to take our most advanced seminars before they master the fundamentals. That never works, but thats the way most people want to go.

    I also think commitment is critically important to be a good trader. If you have commitment you can overcome major obstacles. If you dont have it, nothing can help you.

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    AT: If you could only communicate one principle, rule or guideline to increase the odds of trading profitably, what would it be?

    VT: The one thats hardest to learn taking responsibility for whatever happens to you. When youve mastered that, then you are in total charge of your life. Until youve mastered that, youre a helpless victim. But as Ive said, few people want to claim their power. They want know-how, but they dont want self-mastery.

    AT: Do you feel a systematic trading approach is vital to success?

    VT: Yes and no. We have programs designed to teach people to be professional traders. In that program, I require them to develop a systematic game plan that will make at least 50 percent per year with very few drawdowns. Thats actually quite easy to do when youve mastered the seven principles, as long as you are not trading too much money say, $5 million or less.

    Initially, it must be very mechanical. But later, when people have proven they can trade mechanically, I think they become much better by learning how to break the rules.

    AT: How important is money management in your overall philosophy?

    VT: I believe its the key to meeting your objectives in the market. What I now call Position Sizing is the part of your system that controls how much you trade throughout the course of a trade.

    In my workshops we play a simple game that involves randomly drawing marbles out of bag and replacing them. Lets say 60 percent of them are winners and 40 percent of them are losers thats not a bad system. People start out with $100,000 and they decided how much to risk on each marble draw.

    After about 50 draws from the bag, with everyone in the room getting the same marble draws, well generally have as many different account levels as there are people in the room, with the exception of the people who go bankrupt. There are only two factors involved in that game Position Sizing and psychology.

    I now have a five-part computer game that allows people to master Position Sizing. It starts out with a simple system like the one described and it progresses through five increasingly more complex areas to help people master Position Sizing.

    AT: What is the core money-management concept or technique you teach?

    VT: Risk a percentage of your equity. And for stock traders, I think 1 percent is high one-half percent might be a better starting point.

    AT: How would you rank the following aspects of trading in terms of importance: entry rules, exit rules, money management/risk control, psychology and capitalization?

    VT: Well, psychology is definitely No. 1 because we are human beings and everything we do from money management to entry rules requires us to use our brains.

    Someone once told me that psychology wasnt important to his firm because they were totally computerized. That firm later went out of business because his partner didnt take a particular trade because they had so many losses in that particular item. That trade would have been the trade of the year and saved their business. The partner didnt take the trade because of his psychology and that one incident cost them the business.

    Money management/risk control would be No. 2. By this I mean Position Sizing as Ive described it and defining what multiple of your risk level you use on each trade. This is fundamental. Without it, no trader can succeed.

    Capitalization is No. 3 because without adequate capital you cannot practice adequate Position Sizing. Your risk will always be too big and you may eventually blow out.

    Exit rules are No. 4. Exit rules are what allow you to cut your losses short and let your profits run.

    Entry rules are the least important. They are where most people put their emphasis because they believe that prediction and finding the right stock are so important. Pick some stocks that have the power for a big move and youll be fine if you have the other principles mastered.

    AT: Have you found there is a particular kind (or general category) of trading strategy or approach that successful traders tend to use?

    VT: No, everyone is different. The key to success is to find something that fits you. Thats really the holy grail of trading. However, if you dont know who you are, then how can you find something that fits you?

    AT: What are the most common pitfalls for beginning traders?

    VT: They ask the wrong questions, such as: What should I buy and what is the market going to do? The seven principles I outlined earlier have little to do with these questions. Unfortunately, the beginning trader has trouble moving beyond them.

    AT: How can traders reinforce good habits and break bad ones?

    VT: I designed a model for good trading that incorporates 10 tasks. Three of them are designed to reinforce good habits and break bad ones.

    The first task is self-analysis. Your trading performance is a function of you, so you must spend time every day analyzing yourself.

    The second key task is mental rehearsal. You must decide what could happen today to cause you to break your rules. Mentally rehearse how you will deal with those situations, so when and if they come up, your response to them will be automatic.

    The third key task is a daily debriefing. At the end of the day, ask yourself, Did I follow my rules? If you did, then pat yourself on the back even if you lost money. If you didnt, then you need to figure out why and use the mental rehearsal step to correct the mistakes in the future.

    And heres the most important aspect of the daily debriefing if you dont have any rules to guide you, then you are really in trouble and you shouldnt be trading.

    **Position Sizing is a trademark of Position Sizing Technologies Inc.

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