by Van K. Tharp, Ph.D. International Institute of Trading Mastery
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I'd like to take some time this week and review a few Tharp Think basics. If you're an experienced trader or long-time reader of this newsletter, you should view this material as an important reminder, even if you have seen it before.
From a big picture standpoint, I believe we entered a secular bear market back in 2000. Secular bear markets historically last on average about 15-20 years, so we still have quite a ways to go with this one. Being in a secular bear market doesn’t mean that prices decline for 15-20 years; however, it does mean that the price-to-earnings ratio for the stock market tends to decline into the single digits by the end of the cycle. In between, there are multiple down market phases and bear market rallies. Rallies in bear markets can be some of the most dramatic around—look at what the markets have returned on a percentage basis since March 2009. The current bull market rally, however, may be nearing an end soon so the simple steps below take on some importance.
1. Invest with the current trend of the market.
Before you enter the market in any way, you need to know what the market is doing. Is it going up or down? You should avoid having a major long position in the stock market unless you can safely say that the market is going up. But how do you determine that?
First, look at what the S&P500 index is doing. This index is a composite of the 500 largest companies in America. To determine how well it is doing, compare the close of the market today, with the average price of the market over the last 200 days. The latter is called a 200-day moving average. You can easily create a free chart of the S&P with a 200-day moving average on any number of web sites with charts.
When the stock price is above the 200-day moving average, the market generally goes up about 12.6% each year. When the stock price is below the 200-day moving average, the market generally goes down by 1.6% each year. Isn't it better to have that moving average on your side? At the moment, we have the average on our side—but maybe not for long.
If you were hurt in the 2008-2009 bear market, go back and look at that S&P 200-day moving average. It helps to be out of the market when prices go beneath it.
If you want to know what I think the markets are doing, read my Market Update in this newsletter at the beginning of every month.
2. Never enter a position in the market without knowing where you will get out.
Most people enter a position with the idea of holding onto it for a long time. The investment industry heavily promotes "buy and hold" as the best strategy for investors to follow. I believe buy and hold is a strategy for disaster in a secular bear market.
If you do want to enter long-term positions right now and don’t know where to get out, I recommend using a 25% trailing stop as a bare minimum. A 25% trailing stop is big enough to allow you to catch a good trend move up, but most importantly, it gets you out before a major drop hurts your account.
3. Never expose more than 1% of your portfolio in any given position.
Suppose you start out with $25,000. Based on this rule, we would not risk more than 1% of that or $250 on each position. If we like MSFT right now at $25, but want to get out if it drops $2, we would be able to buy 125 shares. Our total risk for the position is $250 and our risk per share is $2, so we divide $250 by $2 to get 125 shares.
Let's look at a second example. Suppose you want to buy XOM at $80 per share, and you use the 25% trailing stop rule I mentioned above. 25% of $80 is $20, so you are willing to risk $20 per share—this means you will set your stop order at $60. Your portfolio, again, is worth $25,000 and you will risk only 1% on this position. If you divide 1% of equity ($250) by your risk per unit ($20), you can buy 12 shares. The actual number is 12.5; however, you must round down to the nearest whole number as buying half a share is not an option.
In our first example, our risk per share was $2 and we could purchase 125 shares. In our second example, our risk per share was $20, so we could purchase only 12 shares. In each case, however, we limited our exposure to the market by the same small amount. If we are wrong about the stock price moving up, we only lose 1% of our portfolio or $250 per position.
If you risk more than 1% of your equity per position, you take on a higher risk of burning through your equity. Stay safe to live long enough in the markets so you can learn and improve.
4. Continually observe yourself and notice your patterns, habits and emotions. Self-awareness is the key to improvement.
I once asked one of the world's greatest traders, "What's your secret to handling your emotions and psychological problems?" His response surprised me at the time. He said, "I just notice that I'm emotional and then I continue to trade the system."
Most people allow their emotions to control them. They get caught up in those emotions and don't even realize what is happening. The great trader, in contrast, stays aware of those emotions as they occur. Awareness is the key to any personal change process and is essential if you want to improve. People who are unaware of their emotions and thoughts are victims of their own repetitive patterns. They are psychological robots.
Become aware of what goes on inside of your head. Keep a diary of your trades and record what you are feeling and thinking as you enter, manage and exit your trades. Look for habitual thoughts, emotions or actions in your diary that might indicate self-destructive patterns.
5. Take responsibility for everything that happens to you.
One of the problems in down markets is that people found lots of other people or things to blame. For example, in 2009, people blamed the market fall on, among others sub-prime mortgage lenders, derivatives dealers, Lehman Brothers or Bear Stearns or Goldman, the Fed, TARP and on and on. People blamed their broker or mutual fund manager or analysts. People who blame someone else or anything external always repeat their mistakes and avoid personal responsibility.
Some years back, an investor sued a large mutual fund because his account went down 90%. This person received an account statement every month and watched his account drop bit by bit. Only when his account was down 90%, though, did he decide to finally take action—by initiating a lawsuit. But who was really to blame for his losses? The investor! He risked too much of his portfolio on one investment and he didn't have a predetermined exit point. He probably never had any idea that he made those mistakes, so he has likely made them again and will likely do so in the future.
No matter what happens to you, you must be completely accountable for your results. That’s the only way you can learn from the markets.
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.
Click here to learn more about Van Tharp at the International Institute of Trading Mastery.