An Interview with Van K. Tharp, Ph.D.
In the unique arena of professional trading coaches and consultants, Trading Psychology Expert,
Most people are not successful when it comes to trading. Why?
I can answer that question on a number of levels. At the most basic level, people must trade by processing information. Unfortunately, we’re not very efficient information processors. We have a lot of biases that enter into trading decisions. I’ve documented 25 of them in my home study program. However, I think most of those biases can be summarized by realizing that trading/investing are very simple processes and we human beings try to make it into something much more complex. Those biases are all about adding complexity to the world.
Is it really that simple?
Consider the trading rules that work: 1) follow the trend; 2) let your profits run; 3) cut your losses short; and 4) manage your money (i.e. risk) so you can stay in the game. If you design something around following those rules, you’ll make a lot of money. But when a great trader says, “That’s what I do,” the average person responds, “Yes, but tell me what your real secret is.” This all about Trading Psychology.
The markets are not random in that we have very large abnormal price moves. On a normal distribution curve, these amount to abnormally large tails. For example, in the past, we have seen a one-day move of 500 points in the Dow Jones and a very short-term move of crude oil from the mid-teens to the $40 level and back to the mid-teens. We might expect those moves by chance, perhaps once in a 1000 years, but not several times in a decade. But we’ve seen those moves in the last decade. Consequently, what most traders need to do to be successful is to participate in those moves in some way and not lose too much money when we’re wrong. Unfortunately, we have all sorts of biases in our thinking which keep us from doing so.
What are some of those biases?
First, we have a bias to understand things such as “Why is the market acting like it is?” Most traders make money with systems that are right less than fifty percent of the time. What makes them money is that they make a lot more, on average, than they lose. Executing a system based on probabilities doesn’t require an understanding of how the market works, it requires position sizing strategies. smNevertheless, people want to treat the world as if they could predict and understand everything. As a result, they tend to seek patterns where none exist and to invent the existence of unjustified, causal relationships. Traders don’t want to trade probabilities. Yet trading is a probability and money management game.
Another bias that most people have is called the law of small numbers. This means that we don’t need a lot of information in order to find the patterns or causal relationships that produce our understanding—it only takes a few examples. People also have a bias in that we tend to imagine that what we see or expect to see is typical of what can and will occur. Thus, if you observe a pattern in the market, you expect it to occur. If you develop some concept about the market, you will look for data to support that concept in the market, and you will probably find it whether it exists or not.
Add to those another bias called the conservatism bias. This means that once we find a pattern or causal relationship, we tend to ignore contradictory evidence no matter how pervasive it is. There are many more biases. Hopefully, you get the picture. We tend to create a reality that’s much more complex than what really works. We try to add complexity rather than employ sound money management.
There is one more important bias, called the ego bias. The ego bias amounts to the fact that most of us make the following statement: “Yes, I understand that most people have these biases, but none of them apply to me.”
Are there any biases around risk management?
Yes, there are several. The most notable is called the gambler’s fallacy. People tend to assume that after a string of losses, a win is much more likely and vice versa. Thus, after a losing streak they are likely to risk a lot because they believe a win is more likely. Or after a winning streak they are likely to bet less because they believe a loss will occur soon. However, in reality a win or loss depends upon the probabilities levels in your type of trading, not what has happened in the past. Professional gamblers know that you bet small during a string of losses and bet big during a winning streak. This is the reason most professional traders use some sort of money management in which they risk a percentage of equity. Your equity increases during a winning streak and decreases during a losing streak.
Most good traders would agree that risking less than 1% of equity in a trade (where 1% is the amount you would lose if your stop loss was hit) is a prudent risk. Risking between 1% and 3% gets into the gun-slinging range. Risking any more than 3% is usually financial suicide, and the average trader commits financial suicide all the time without knowing it.
Your definition of 1% risk is important!
Most people don’t understand risk at all—including a lot of professionals. Risk often is equated with the probability of losing. Thus, for some people, futures trading is considered to be risky. Others equate risk with the amount invested or with margin. But that’s not it at all. Risk is the amount of money you are willing to lose if you are wrong about the market. When you define risk that way it changes a lot.
Let me give you an example. An equity trader might say, “I risk 10% on each trade.” For him, that might mean that if he has $100,000 he wouldn’t invest more than 10% in each stock or $10,000. That’s not the same thing. According to his definition, he could only buy 50 shares of a $200 stock. But let’s say that he bought a stock at $200 and that he would admit to being wrong if his stock dropped to $198 and sell it—that’s a $2 stop. If he is willing to risk 10% of equity it means that he could buy 5000 shares of the stock. Those 5000 shares would cost him a million dollars and no brokerage house would allow him to buy that much with a $100,000 account. Risk must be thought of as the percent of equity you are willing to lose on a trade if you are wrong. And when you do it that way, anything over 3% is extremely risky, especially if you have 10 to 15 positions on at one time.
What’s really interesting is that once you understand risk and portfolio management, you can design a trading system with almost any level of performance. For example, you can design a system to trade for clients that would make about 30% per year with only 10% drawdowns. On the other hand, if you want to trade your own account and be a little more risky, you can design a system that will produce a triple digit rate of return-as long as you have enough money to do so and are willing to tolerate tremendous drawdowns.
I have written a text book on this subjuct as there are so many possible strategies that one can devise to manage their capital. I coined the term Position Sizing to describe it because the term money managment and or risk management means so many different things to people. My book is called The Definitive Guide to Position Sizing Strategies.sm
Van, you describe yourself a modeler. What is a modeler?
I’ve had a lot of training in NeuroLinguistic Programming (NLP), and I consider NLP to be the science of modeling. That means if you can find several people who do something well, then you can determine how they do it. You need several people because if you try to model one person you tend to find that person’s idiosyncrasies rather than what makes that person a super-performer. For example, I know one “Market Wizard” caliber trader who has actually hired people to model him. However, they’ve all failed because they were only trying to model one person and that just doesn’t work. They’d just find out what he thinks he’s doing and that’s not it at all. Most of what he thinks is important are his idiosyncrasies.
What is a coach for traders?
A coach is someone who takes raw talent and brings out top performance. People sometimes forget that trading is human performance—measurable human performance. Changes in equity reflect the performance of the trader much more than what happens in the market. A good trader can make money in the long run no matter what the market is doing. In contrast, a poor trader is unlikely to make money, regardless of what the market is doing.
A coach is someone who attracts talented people and then teaches them the fundamentals of good performance. At the Yankees spring training camp, Casey Stengle, who coached such baseball greats as Mickey Mantle and Roger Marris, used to hold up a baseball to his entire staff and begin the season with the statement, “This is a baseball.” Even the best players need to be reminded of the fundamentals occasionally.
But just what are the fundamentals of trading?
To me, trading fundamentals include the ten tasks of trading. Traders need to be reminded of that and to eliminate any self-sabotage that keeps them from following those tasks. That’s what I do and I am very effective at doing it.
Van, what is a low-risk idea?
A low-risk idea is a trading strategy or concept with a long-term positive expectancy for profit, which allows for the worst possible result in the short term. It still allows the trader to remain in the game to obtain the long-term rewards.
Why did you decide to do modeling and coaching with traders, Van?
My mission in life is to help people understand how they think and how they can change their lives and this planet by changing their thinking. Traditional occupations do not do that. If I can influence just one more person by creating great models, I’m eager to do so. People need to realize that they can wish upon a star and get their wish. What they really want is happiness. Happiness does not come from wealth or money or achievement. People get happiness from deep down inside of themselves. And they realize they have it by giving it away. I guess that’s what I’m about—giving away happiness. I sell financial success, but what I’m attempting to do is give away happiness in the process.
You said there were other levels at which we could talk about why people lose in the markets?
Yes, at another level, people get exactly what they want out of the markets. Most people are afraid of either success or failure (or both). As a result, they tend to resist change and continue to follow their natural biases and lose in the markets. When you get rid of the fear, you tend to get rid of the biases.
I guess the classic question is “Can a losing trader transform himself?”
I believe that if one person can do something, then you can model it and teach it to others. And we’ve developed all sorts of trading models that work. In fact, we’ve had great success teaching the models to other traders.
Yet transformation is only something that winners do. I’ve found over the years that most of the people who come to me are above-average traders and investors. In fact, when my clients have tried to talk others into using my service, they don’t want it. I can remember one client telling a friend that if my course didn’t help him (both his life and his trading) that he (my client) would pay for it. The friend still refused to buy it. Eventually, the friend lost so much money that he no longer trades. Yet he never called me. I hear stories like that all the time. The best way to describe the phenomenon is to say that losers don’t want to transform themselves.
What role does discipline play?
Discipline to me means being able to control one’s mental state where mental state is like the emotional context that one brings to a task. Every task has some state of mind that’s important for optimal performance. For example, in answering these questions I’d describe my state as being relaxed, confident and focused. I just let the answers flow. If I were in any other state, I think it would be a lot harder to come up with the answers.
Well, the same thing holds for trading—there’s some optimal state that is necessary for carrying out each of the tasks of trading. Overall, you need a background state of confidence, of knowing that you’ll make money in the long run. If you don’t have that context, then trading is quite difficult. And, each trading task requires a different sort of state.
Can you give us an example?
The first task of trading, self-analysis, requires that you be introspective, dissociated, objective, curious, and willing to trust messages that come from your unconscious mind. If you don’t have a mental state like that, then it’s hard to do self-analysis properly. And the same goes for any of the other nine tasks that are important to successful trading.
Can one change their mental state?
Yes. We teach about 15 methods for changing one’s state. One that everyone reading this interview can use immediately has to do with what we do with our bodies. Our posture, our breathing, and the muscle tension in our bodies all have a profound affect on our mental state. There’s a profound statement credited to the native American Indians: “Before you judge someone, walk a mile in their moccasins.” So try it; only imitate their walk rather than actually wear their shoes. Try on four or five different walks.
That also leads to a profound way of changing yourself when you are not in a resourceful state. Change what you are doing with your body. Change your posture! Notice your posture and change it. Notice the muscle tension in your body (especially your face) and change it. And notice your breathing. Sometimes when people panic, for example, they completely stop breathing. That’s not very useful, so change your breathing.
What are mental strategies?
Essentially, mental strategies refer to another of the three ingredients of success. It refers to the sequencing of our thoughts—most of which is unconscious. For example, most people make decisions based upon specific details of their mental images. Traders usually have a mental image of a trade that works. If the image is in the correct location and has a sharp figure-to-ground distinction (e.g., the last bar stands out), then people get a strong feeling to act. Now, that’s not the same for everyone, but it’s the most common pattern. Everything else we do in terms of manipulating the environment or changing our own thinking is just to set up an image like that which causes us to act.
Are there different mental strategies for different types of trading?
What other kinds of strategies are there?
What’s the difference between system development and trading?
System development is different than trading. For a beginner, it’s learning how to trade. For a seasoned trader or investor, it is ongoing research. But in either case, it is different from the actual tasks of trading.
I have continually asked top traders how they learned to trade and there are a lot of commonalities. As a result, I have incorporated many aspects of systems development into my work. It started with the material in How to Develop a Winning Trading System that Fits You workshops and has evolved into detailed information about position sizing and expectancy. Jack Schwager says in his New Market Wizardsthat the most important characteristic that all market wizards have is that they’ve adopted a trading system to fit their personality. Well, that’s the concept that I’ve seen work over and over again, and it’s what I’ve built my system development work upon.
What can you share with us about system development?
First, there are a number of trading psychology issues involved in system development. That topic covers a lot of ground. It’s too much to cover in this interview, but I’ve written a newsletter on the topic: Psychological Issues in Trading System Development and it’s only $19.95.
Second, trading systems tend to have various components. Those components include selecting the market, the entry, the initial stop, the exit, and the money management overlay. Everyone concentrates upon entry, which is the least important component. In fact, technical analysis, which is popular among investors and traders, focuses primarily upon market timing, which implies entry. I’ve conduced a study in which you can use a coin flip for entry and still make money if you use the other components effectively.
Incidentally, the most important part of the equation is the position sizing overlay that I’ve already talked about. Yet, if you bought a software package to develop a trading system, you could not apply any of these position sizing stategies. Isn’t that interesting? All of the software packages give people what they want and thus focus on the least important areas of system development—how to use various indicators for entry.
What about a trading business plan? What role does that play in trading success?
I think the statistics indicate that 90 to 95% of all new businesses fail and the reason they fail is that they do not plan adequately. Most fail because they lack an adequate business plan. Well, trading is just like a business. Traders need more than just a system—they need a business plan. And that business plan should include several systems that generate low-risk trading ideas, a psychological management plan, a money management plan, and a worst case contingency plan.
The psychological management plan has to do with managing oneself. Trading is human performance and the main determiner of the performance is the trader. For example, most people spend all their time analyzing the market and trying to predict what is going on, which has very little to do with successful trading. As a result, I recommend that people develop a full psychological management plan. This involves analyzing themselves regularly and spending time on anything that would improve their own performance. This would include such things as proper diet, regular exercise, regular relaxation or meditation, goals, planning, and avoiding anything that would get one’s life out of balance, etc. This kind of mental rehearsal will go a long way toward improving performance.
But perhaps the worst case contingency planning is even more important. It amounts to brainstorming about what could go wrong. That doesn’t mean that I’m advocating that one expect disasters, just that one plan for them so that it’s easy to weather the storm. Once you’ve brainstormed what could go wrong, then I recommend that your plan include three or four ways of dealing with each potential disaster.
Once I got a phone call from Tom Basso wondering what I had called about the previous day. He said, “We had a disaster yesterday, and I wasn’t able to answer the phone.” I said that I hoped everything was okay and Tom responded, “It was a planned disaster.” They had planned and run-through dress rehearsal of a disaster in which all of their computers and phone systems were down. Thus, they were assuming that they had to run the office on Tom’s home computer and home phone line. Could they do it? What would the problems be? And how would they overcome problems they hadn’t predicted? I think every trader should do that kind of planning.
Do you advocate a mechanical approach to trading for most people?
But I also think that discretionary trading can be terrific once someone has had a mental clearing and knows what he or she is doing.
What other component is important to trading and investing?
For example, people once believed that the earth was flat and that everything in the universe revolved around the earth. People’s lives were shaped by that belief. We then believed in Newtonian physics where everything was mechanical and lawful and most of the universe was thought to be outside of us. And today we’ve moved into quantum physics in which everything is relative and the observer has an effect on the observation because he is part of it. The laws of physics (which are really just beliefs) shape our concepts, inventions, and progress. Probably at a level beyond all of that (of course, this is a belief) is that once you give up all of your beliefs, you have an experience of the universe as it really is—which tends to be a very profound spiritual experience, the kind that some of my clients have after an emotional clearing.
Beliefs are one of the ingredients of success. They tend to form a hierarchy with spiritual beliefs and self-concept beliefs being the most significant. I’ve written extensively on this topic in my home study program. Most significantly, I have developed my advanced workshop, Peak Performance 202, to maximize a person’s understanding of belief systems and how they affect not only our trading and performance but our daily lives. It’s powerful material.