TRADE YOUR WAYTO FINANCIAL FREEDOMVAN K. THARPForeword by David Mob& Sr.Acknowledgements xviixiiiPreface xxiPART ONETHE MOST IMPORTANT FACTORIN YOUR SUCCESS: YOU!The Legend of the Holy Grail 3The Holy Grail Metaphor 6What’s Really Important to TradingModeling Market Geniuses 11Summary 149chapter 2Judgmental Biases: Why Mastering the Markets Is So Difficultfor Most People 17Biases That Affect Trading System Development 2 0Biases That Affect How You Test Trading Systems 3 5Biases That Affect How You Trade Your System 3 8Summary 41Chapter 3-Setting Your Objectives 45Designing Objectives Is a Major Part of Your System Work47
Tom Basso on ObjectivesSetting Your Own ObjectivesChapter 6Understanding Expectancy and Other Keysto Trading Success 130The Six Keys to Investment Success 1304857PART TWO:CONCEPTUALIZATION OF YOUR SYSTEMChapter 4Steps to Developing a System611. Take an Inventory 612. Develop an Open Mind and Gather Market Information 633. Determine Your Objectives 664. Determine Your Time Frame for Trading 665. Determine the Best Historical Moves in That Time Frame andNotice What Those Moves Have in Common 696. What’s the Concept behind Those Moves and How Can YouObjectively Measure Your Concept? 707. Add Your Stops and Transaction Costs 728. Add Your Profit-Exits and Determine Your Expectancy 739. Look for Huge Reward Trades 7410. Optimize with Position Sizing 7611. Determine How You Can Improve Your System 7712. Worst-Case Scenari-Mental Planning 78Chapter 5The Snow Fight Metaphor 133Looking at Expectancy under a Magnifying Glass 137Expectancy and R Multiples 143Expectancy Applied to the Market 148Using Expectancy to Evaluate Different Systems 152A Review of How to Use Expectancy 158PART THREE:UNDERSTANDING THE KEY PARTSOF YOUR SYSTEMChapter 7-Using Setups 165The Four Phases of Entry 167Setups for Stalking the Market 172Filters versus Setups 179Setups Used by Well-Known Systemshnmary of Setups 196184Selecting a Concept That Works 81Trend Following 82Fundamental Analysis 86Seasonal Tendencies 91Spreading 99Arbitrage 103Neural Networks 110There’s am Order to the UniverseSummary of Key Points 126Chapter 8Entry or Market Timing 198120Trying to Beat Random Entry 200Common Entry Techniques 202Designing Your Own Entry Signal 220An Evaluation of Entry Used in Some Common Systems 224Sunmary 2 2 9
chapterChapter 9Know When to Fold ‘Em: How to Protect Your Capital233What Your Stop Does 2 3 5Using a Stop That Makes Sense 2 4 3Summary: Preserving Capital 248Stops Used by Common Systems 249Appendix I: Recommended Readings 325Appendix II: Key Words Defined 328How to Take Profits 254Index 337Purpose behind Profit-Taking Exits 2 5 5Just Using Your Stop and a Profit ObjectiveSimplicity and Multiple Exits 2 6 4What to Avoid 265Summary 266Exits Used by Common Systems 266263Chauter 11The Opportunity and Cost Factors 270Several Approaches to Take 2 7 0Factoring in Opportunity 273Summary 278Conclusion! 314APPENDICESChapter 10The Cost of Trading Opportunity13275Chapter 12What Do You Mean Position Sizing? I Only Have 10,000in My Account! 280Position-Sizing Strategies 284Model 1: One Unit per Fixed Amount of Money 2 8 6Model 2: Equal Value Units for Stock Traders 2 9 0Model 3: The Percent Risk Model 2 9 2Model 4: The Percent Volatility Model 2 9 6The Models Summarized 298Examples of the Impact of Position SizingSummary 306Position Sizing Used by Other Systems300307
FOREWORDThe title of Chapter 1 of this book is: “The Legend of the HolyGrail.” “The Holy Grail” is a phrase you often hear in some tradingand investment circles. Most people believe that it refers to somemysterious trading system out there that is going to make themmillions with little or no risk. It’s not that at all.But before I tell you about the Holy Grail, let me tell you a little about who I am and why Dr. Tharp asked me to write theForeword to his book. I started managing other peoples’ money in1992 and in just 5 years those assets have grown from about 3 million to about 50 million. That has happened partially because myhedge fund has compounded by better than 40 percent per year, netto investors, over the last 5 years. We were up 61 percent net toinvestors in 1996 and 53 percent net to investors in 1997. Since I metDr. Tharp, my net worth has grown many times over, and I dobelieve that it comes from adopting many of the Holy Grail secretscontained in this book. I think that Dr. Tharp understands andteaches those,secrets better than anyone else I have ever met. Letme tell you why:When I was a young boy, I remember dreaming that I wouldbecome a millionaire by the time I reached 25 years of age. I reachedthat goal through real estate development in 1981, but only brieflyand then it all came tumbling down around me. I was devastated,but I picked myself up and started again. My next attempt at realsuccess was in the investment field.Yet I almost had a similar type of crash in my fortunes. Iremember the day clearly. I was sitting in my office in Naples,Florida, in late 1992. It was a typical south Florida autumn day. Iwas watching the palm trees sway in the breeze outside my window, wondering why my trading had become more difficult sinceI began managing money for others. I wasn’t about to crash at thexiii
time, but I had the same sort of feeling in my gut that I had hadbefore my first crash.My interests in investing began in 1967, when I would makeregular trips to the local public library to devour every book I couldfind on investing. I’d also study biographies of successful businesspeople. I certainly wish I had been aware of Dr. Tharp’s modeling work back then, because it would have saved me so muchtime and so many heartaches.In 1969, at the age of 13, I talked my reluctant parents intoopening a brokerage account for me at the local Merrill Lynch officein Toledo, Ohio. The conditions of the account: I had to fund theaccount myself from lawn mowing and odd jobs, and every tradehad to be confirmed by my mother since it was a Unified Gift toMinors Act account. Once open, my father would occasionally giveme a little money to put into the account, as long as I didn’t tell mymom.As I looked out the window, I realized how fortunate I was. Inow lived in a tropical climate. I had probably again achieved mychildhood dream of success doing something I loved to do.Twenty-two years had gone by since I made my first trade; onlynow I was doing it successfully. Yet, somehow, I was now beginning to find trading difficult.That nervous feeling helped me open up to whole new levelsof success-way beyond those of my first childhood dreams. Thatfeeling was the key to what was going on, and the key to my success, but I didn’t know what that key was- not yet at least.A few days later, I notice a magazine ad about Dr. Van Tharp.I had read about him in Jack Schwager’s book Market Wizards, so Idecided to give him a call. That call was the start of a close professional and personal relationship that would end up affecting mylife, my family, and even my business interests and associates. Ialready understood many of the secrets contained in this book.However, through my association with Dr. Tharp, I now understood the ultimate aspect of the Holy Grail secret-the part that Dr.Tharp so eloquently describes in Chapter 1.The Holy Grail is not what you would expect it to be. It issomething that is different for each person. It’s a hidden secret thatyou have to discover for ydurself, but it is obvious once it is realized.I must admit that when I first learned what Dr. Tharp wasgoing to write about in this book, I was concerned. He was givingaway too many of our secrets! However, I’m not concerned anymore because I now realize that those secrets are so personal. MyHoly Grail is not the same as your Holy Grail. In addition, many ofyou will just let those secrets pass by you, so I urge you to be careful. Read this book carefully. Indeed, pay particular attention to:. Understanding the psychological biases against goodsystem development (Chapter 2). Setting objectives for what you are trying to accomplish(Chapter 3). Understanding expectancy and R multiples(Chapters 6 through 10). Realizing that the golden rule of trading is created by howyou get out of the markets, not by picking some magicstock (Chapters 9 and 10). Understanding the importance of position sizing(Chapter 12)And pay special attention to the meaning of the Holy Grail asdescribed in Chapter 1. Until you’ve mastered yourself, you’llalways struggle with the market. I wish all of you could integratethat meaning into your being and then truly apply it to your trading.The material that Dr. Tharp presents in this book, in his MarketMastery newsletter, in his home-study courses, and in his seminarswill change your life if you are open to them. I urge you to take thefirst step today and open yourself up to the material found in thisbook. Enjoy the journey It’s a great one!David Mobley, Sr.Naples, FloridaFebruary 2998
ACKNOWLEDGMENTSThis book is a product of 15 years of thinking about markets, studying hundreds of great traders and investors, and coaching manymore to greatness by helping them apply some of the principlesyou’ll find in this book. If this book helps hundreds more, even if Inever meet you, it will have been worth the effort.During those 15 years, numerous people have helped shapethe thinking that has gone into this book. I can only acknowledge afew of those people by name. However, everyone who contributedin any way has my deepest thanks and appreciation.I’d like to acknowledge Ed Seykota for showing me very earlyon the importance of simplicity and creative money management.Ed has presented at three of my early seminars, and I’m deeplyindebted to his wisdom.Tom Basso has been a great contributor to my thinking and mylife. Tom was a guest speaker at more than a dozen of my seminarsand several of our professional trader schools. Tom has also contributed several sections to this book. Thank you, Tom.Ray Kelly was one of my earliest clients. I’ve watched himevolve from a tough floor trader-whose favorite saying used to be“My way or the highway!“-into someone who would freely givehis time to inner-city high school kids just to convince them to startto take responsibility for their lives. Ray is one of the best traders Iknow and a great teacher as well. He’s presented at many of myseminars and has written the arbitrage section of this book.Chuck LeBeau helped me make the link from the famoustrader’s axiom-“Cut your losses short and let your profits run”to the importance of exits. Think about it. Cutting losses short is allabout aborting losses--exits. Letting profits run is all about exitsas well. The entire axiom is all about exits. Chuck’s persistence indriving home this point has been very valuable to me. Chuck isxvii
xviiinow a guest speaker at my advanced systems seminar and has alsocontributed a section to this book on fundamental analysis.I would also like to acknowledge a very special person in mylife--David Mobley, Sr. I’ve probably done more consulting withDavid than any other trader. I’ve also worked with most of his family. I’ve watched them all grow tremendously over the last 6 yearssince we’ve been close, but especially David. Thus, it is with greatpleasure that I asked David to write the Foreword to this book.David’s company, Maricopa, was one of our first graduating companies.Kevin Thomas, Jerry Toepke, and Louis Mendelsohn all contributed great sections to the concepts chapter (Chapter 5). Theirwork is very insightful and helpful I deeply appreciate your contributions.I’d also like to acknowledge our first graduates-WebsterManagement. Three key people at Webster met at my school forprofessional traders. They have achieved tremendous success byunderstanding the key components necessary for investment andtrading success xpectancyand money management. I’d particularly like to acknowledge the contributions to my thinking fromPaul Emery, Rob Friedl, Parker Sroufe, and Paul Rusnock.Chuck Branscomb has been a great model for me of how toadopt these principles. When he first came to my seminars, hethought he had a great system-when he really had no system atall, just some entry signals. He’s attended all my system seminars(except for one held in London) and most of the other seminars.I’ve watched him evolve into a very knowledgeable systems trader.He’s also a great example of how solid “intuition” about the market evolves out of solid systems trading. Chuck is the editor of ournewsletter, Market Mastery, and several excerpts from Chuck’swork were put into this book. In addition, Chuck helped tremendously in generating some of the graphics in this book.John Humphreys is the senior developer of Athena MoneyManagement software used in this book. John has incorporated allmy suggestions about money management into the software to thepoint where one can now begin to see the millions of possibilitiesthat exist in money management, which I call “position sizing”throughout this book. I knew position sizing was critical when theAc!aomledgmentsxixproject started, but now that I can actually see the results of usingthe software I know that its importance is beyond anything that Ihad imagined.I’d like to thank everyone in my supertrader program. Severalof them-William Curtiss and Rolf Sigrist-who continuallybounce their great, creative ideas off me, have helped shape mythinking tremendously through their education process. I’d alsolike to thank Loyd Massey and Frank Gallucci for their tremendoussuggestions in reviewing the manuscript. I’d also like to thankBruce Feingold, Sir Mark Thomson, Dennis Ullom, Willard(“Buddy”) Harper, Andreas Pfister, Corky Dobbs, and JimHetherington for the tremendous insights I’ve gained from working with them.Some very special teachers in my life deserve a special mention. These include Connierae Andreas, Deepak Chopra, RobertDilts, Todd Epstein, John Grinder, Tad James, Robert Kivosaki,John Overdurf, James Sloman, Enid Vien, and Wyatt Woo&mall.Your contribution to my personal evolution has been tremendous.I’d like to thank my editors at McGraw-Hill for their wonderful help. Stephen Isaacs miraculously appeared when I needed apublisher and John Morriss was very helpful throughout the production process.Lastly, but not least, I’d like to thank my staff at I.I.T.M., Inc.for their support in completing this book. Cathy Hasty has been agreat help in laying out the book and with the graphics. AnnetteFrench has always “been there” to assist me with whatever wasnecessary.My deepest thanks go to all of you and to the many peoplewho also contributed, but were too numerous to mention.
PREFACEA number of my clients have asked me not to include certain sections in this book, with the admonishment of “You’re giving awaytoo much.” Yet my job is to coach traders and investors to achievepeak performance. Every available tool is important in attemptingto do that, because so much misinformation is available in the literature that the average person will constantly be led astrayMost of the misinformation is not deliberate. People want tobe led astray. They constantly ask the wrong questions, and thoseselling information get rewarded by giving them the answers theywant. For example:. What’s the market going to do now?. What should I buy now?. I own XYZ stock. Do you think it’s going to go up? (If yousay no, then they’ll ask someone else until they find aperson who agrees with their opinion.). Tell me how I can get into the market and be “right” mostof the time.In April 1997, I did a Z-day seminar in Germany. Toward the end ofthe seminar, I gave the participants the choice of doing an exercisedealing with self-sabotage (which all of them needed) or asking mequestions. They took a vote on what to do. Guess what the firstquestion asked of me was? “Dr. Tharp, what’s your opinion aboutwhat the U.S. stock market will do for the rest of 1997?” This wasdespite my best efforts over the past two days to explain to themwhy such questions were unimportant.When people move beyond questions of “what” to buy intoquestions about “how,” they still ask the wrong questions. Now thequestion becomes something like:What criteria should I use to enter the market in order to be rightmost of the time?ui
xxiiPrefaceThere is a large industry available to give you the answer to suchquestions. Hot investment books are filled with entry strategiesthat the authors claim to be 80 percent reliable or to have thepromise of big gains. A picture tends to be worth a thousand words,so each strategy is accompanied by a graph in which the marketjust took off. Such “best-case” pictures can sway a lot of people andsell a lot of books.At an investment conference in 1995, a well-known speaker onthe futures markets talked about his high-probability entry signals.The room was packed as he carefully explained what to do. Towardthe end of the talk, one person raised his hand and asked, “How doyou exit the market?” His response, albeit facetiously, was, “Youwant to know all my secrets, don’t you?”At another conference about a year later, the keynote speakergave an hour talk before 600 people on high-probability entry techniques. Everyone listened eagerly at every word. Nothing was saidabout exits except that one should keep a tight stop and pay closeattention to money management. After the talk, this particularspeaker sold 10,000 worth of books in about a half-hour period,because people were so excited that such high-probability entrytechniques were the answer.At the same conference, another speaker talked about moneymanagement-the key factor in determining one’s profits. Thirtypeople listened to the talk, and about four of them purchased abook having to do with that particular topic.People gravitate toward the things that don’t work. It’shuman nature. You’ll learn why this occurs and what to do about itin this book.Such stories could be told about conference after conference.Everyone will flock to a talk on high-probability entry signals, andless than 1 percent will learn anything significant. However, talksfeaturing the most important keys to making real money will havefew people in attendance.Even the software products dealing with the markets havethe same biases built into them. These products typically areloaded with indicators that can help you perfectly understandwhy markets did what they did in the past. Why wouldn’t they?Those indicators are formed from the same past data about whichthey are predicting prices. If you could do that with future prices,Prefacexxiiithe software would be wonderful. However, the reality is that youcannot predict prices in this manner. But it does sell a lot of software.I have over 15 years of experience as a coach for traders. Ihave worked with some of the top traders and investors in theworld and have completed thousands of psychological evaluations on all sorts of traders and investors. As a result of my background and experience, I have filled this book with the kind ofinformation that will help you really improve your performance asa trader or investor.During that research period, many of my own beliefs aboutthe market have been shattered. I expect many of your most“sacred” beliefs about trading or the market (or perhaps even yourbeliefs about yourself) will be shattered before you finish this book.The reason is that you can learn the real “secrets” to the marketonly if you pay attention to what really works. If your attention iselsewhere, you are not likely to find any secrets. However, thisbook simply contains my beliefs and opinions. Explore its contentswith an open mind and you will take a giant leap forward in yourability to make money consistently.I have divided this book into three primary parts: Part One isabout self-discovery and moving yourself to a point where it’s possible for you to do market research. I’ve included a chapter on theessence of successful trading, a chapter on judgmental heuri
TO FINANCIAL FREEDOM VAN K. THARP Foreword by David Mob& Sr. xiii Acknowledgements xvii Preface xxi PART ONE THE MOST IMPORTANT FACTOR IN YOUR SUCCESS: YOU! The Legend of the Holy Grail3 The Holy Grail Metaphor 6 What’s Really Important to Trading 9 Modeling Market Geniuses 11 Summary 14 chapter 2 Judgmental Biases: Why Mastering the Markets .