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TRADE YOUR WAY TO FINANCIAL FREEDOM

McGraw-Hill

Chapter One

We have only to follow the hero's path, and where we had thought to find an abomination, we shall find a god. And where we had thought to slay another, we shall slay ourselves. Where we had thought to travel outward, we will come to the center of our own existence. And where we had thought to be done, we will be with all the world.

Joseph Campbell, The Power of Myth (page 51)

Let me tell you a secret about the market. You can make big money by buying breakouts that go beyond a normal day's range of price movement. These are called volatility breakouts. One trader is famous for making millions with volatility breakouts. You can do it too! You can make a bundle! Here's how you do it.

First, you take yesterday's price range. If there's a gap between yesterday and the day before, then add the gap into the range. That's called the true range. Now, take 40 percent of yesterday's true range, and bracket today's opening price by that amount. The upper value is your buy signal, and the lower value is your sell signal (that is, for selling short). If either value is hit, get into the market, and you'll have an 80 percent chance of making money. And over the long run, you'll make big money.

Did that particular pitch sound interesting to you? Well, it has attracted thousands of speculators and investors alike. And while there's some truth to the pitch—it can be a basis for making big money in the market—it's certainly not a magic secret to success. Many people could go broke following that advice because it's only part of a sound methodology. For example, it does not tell you

• How to protect your capital if the market goes against you

• How or when to take your profits

• How much to buy or sell when you get a signal

• What markets the method is designed for and if it works in all markets

• When the method works and when it fails miserably

Most importantly, you must ask yourself, when you put all of those pieces together, does the method fit you? Is it something you'd be able to trade? Does it fit your investment objectives? Does it fit your personality? Can you tolerate the drawdowns or the losing streaks it might generate? Does the system meet your criteria for feeling comfortable trading it, and what are those criteria?

This book is intended to help traders and investors make more money by learning more about themselves and then designing a methodology to fit their own personality and objectives. It is intended for both traders and investors because both of them attempt to make money in the markets. The trader tends to have a more neutral approach—being willing to both buy and sell short. The investor, in contrast, is looking for an investment that can be purchased and held over a longer period of time. Both of them are looking for a magic system to guide their decision making—the so-called Holy Grail system.

The journey into finding the profits available in the markets usually starts another way. In fact, the typical investor or trader, in preparing to trade, goes through an evolutionary process. At first he gets hooked on the idea of making a lot of money. Perhaps some broker gives him a pitch about how much money he can make playing the market. I've heard a radio advertisement in North Carolina that goes something like this:

Do you know where real money is made year after year? It's all in the agricultural sector—people have to eat. And when you consider the weather we've been having lately, there's likely to be a shortage. And that means higher prices. And for just a small investment of $5,000, you can control a lot of grain. You'll make a small fortune if grain moves just a few pennies in your favor. Of course, there are risks in this sort of recommendation. People can and do lose money. But if I'm right about what I'm saying, just think how much money you can make!

(I've heard similar pitches for various other commodities and, these days, even for currency trading.)

Once the trader has committed his initial $5,000, he's hooked. Even if he loses it all—and in most cases he will—he'll still retain the belief that he can make big money playing the markets. "Didn't Hillary Clinton turn $1,000 into $100,000? If she can do it, then I certainly can do it." As a result, our investor will spend a great deal of time trying to find someone to tell him what to buy and sell in his quest to determine the hot prospect.

I don't know many people who have made money consistently following other people's advice. There are exceptions, but they are very rare. In time, the people who have followed other people's advice and have consequently lost their capital get discouraged and drop out of the picture.

Another pitch that really seems to get people is the newsletter pitch. That typically goes something like this: "If you had followed our guru's advice, you would have made 320 percent on XYZ, 220 percent on GEF, and 93 percent on DEC. And it's not too late. You can get our guru's picks for each of the next 12 months for only $1,000." As you'll learn from both the expectancy chapter and the position sizing chapter, one could easily have gone broke following such a guru's advice because we know nothing about his or her downside or even the expectancy of his or her system.

I once heard this pitch from an options trading guru: "If you had followed my advice on every trade last year, you would have turned $10,000 into $40,000." Now does that sound impressive? It does to most people, but what he really meant was if you had risked $10,000 on every trade recommendation made, then at the end of the year, you would have been up by $40,000. In other words, if your risk per trade was 1R (where R is short for risk), then you would have been up by 4R at the end of the year. Believe me when I say that 99 percent of the trading systems you'll probably develop will give you better performance than this one. Nevertheless, people fork out the $1,000 for the guru's advice because the pitch suggests a 400 percent return rather than a 4R return. That is, they do until they decide that perhaps they should ask a better question.

A few people miraculously move onto the next phase, which is "Tell me how to do it." Suddenly, they go on a wild search for the magic methodology that will make them a lot of money. This is what some people call the "search for the Holy Grail." During the search, our trader is looking for anything that will provide her with the secrets to unlocking the universe of untold riches. Typically, people in this phase go to lots of seminars in which they learn about various methods such as this one:

Now this is my chair pattern. It consists of at least six bars in a congestion range followed by a seventh bar that seems to break out of the congestion. Notice how it looks like a chair facing to the left? See what happens on this chart after a chair pattern occurred—the market just zoomed up. And here's another example. It's that easy. And here's a chart showing how much profit I made with the chair pattern over the last 10 years. Look at that: $92,000 profit each year from just a $10,000 investment.

Somehow, when these investors actually try to use the chair system, that $10,000 investment turns into large losses. (You'll learn the reasons for these losses later in this book.) Such setbacks notwithstanding, these investors simply go looking for yet another system. And they continue in this losing cycle until they are finally broke or they learn the real meaning behind the Holy Grail metaphor.

THE HOLY GRAIL METAPHOR

In trading circles, one frequently hears: "She's searching for the Holy Grail." Typically this means that she's searching for the magic secrets of the market that will make her rich—the secret rules that underlie all markets. But are there such secrets? Yes, there are! And when you really understand the Holy Grail metaphor, you will understand the secrets of making money in the market.

Several books such as Malcolm Goodwin's Holy Grail deal with the topic of the Holy Grail metaphor. Beyond the Grail romances themselves, the metaphor has been used extensively throughout history, and most Westerners instantly recognize something described as a "Grail quest" as very significant. Scholars have used the term to mean all types of things, from blood feuds to searches for everlasting youth. Some scholars consider a "Grail quest" to be a search for perfectionism, enlightenment, unity, or even direct communion with God. The investor's "search for the Holy Grail" has been framed within the context of those other quests.

Most investors believe that there is some magic order to the markets. They believe that a few people know about it and that those few are making vast fortunes from the market. These believers are constantly trying to discover the secrets so that they too can become wealthy. Such secrets exist. But few people know where to find them because they are where one would least expect the secrets to be.

As you complete more and more of this book, you'll really understand the secrets of making money in the markets. And as those secrets are revealed to you, you'll begin to understand the real meaning of a "Grail quest."

According to one interesting Grail account, there is an ongoing war in heaven between God and Satan. The Grail has been placed in the middle of the conflict by neutral angels. Thus, it exists in the midst of a spiritual path between pairs of opposites (such as profits and losses). Over time this territory of concern has become a waste-land. Joseph Campbell says that the wasteland symbolizes the inauthentic life that most of us lead. Most of us typically do what other people do, following the crowd and doing as we're told. Thus, the wasteland represents our lack of courage to lead our own life. Finding the Holy Grail represents finding the means to escape the wasteland—which means leading our own life and thereby attaining the ultimate potential of the human psyche.

Investors who follow the crowd might make money during long trends, but overall they'll probably lose, while the investors who are thinking and acting independently will usually make money. What's holding back the crowd followers? They ask others for advice (including their neighbors) rather than thinking independently and designing a method that fits them. Most investors have a strong desire to be right about every trade, and so they find some hot entry technique that gives them a feeling of control over the market. For example, you can require that the market totally do your bidding before you enter it. Yet real money is made through intelligent exits because they allow the trader to cut losses short and let profits run. Making intelligent exits requires that the trader be totally in tune with what the market is doing. In summary, people make money in the markets by finding themselves, achieving their potential, and getting in tune with the market.

There are probably hundreds of thousands of trading systems that work. But most people, when given such a system, will not follow it. Why not? Because the system doesn't fit them. One of the secrets of successful trading is finding a trading system that fits you. In fact, Jack Schwager, after interviewing enough "market wizards" to write two books, concluded that the most important characteristic of all good traders was that they had found a system or methodology that was right for them. So part of the secret of the Holy Grail quest is in following your own unique way—and thus finding something that really fits you. But there is still a lot more to the Holy Grail metaphor.

Life starts out in the neutral position between profits and losses—it neither fears losses nor desires profits. Life just is, and that's represented by the Grail. However, as a human being develops self-awareness, fear and greed also arise. But when you get rid of the greed (and the fear that comes from lacking), you reach a special unity with everything. And that's where great traders and investors emerge.

Joseph Campbell, the late, great scholar and leading expert on myths, says:

Suppose the grass were to say, "Well, for Pete's sake, what's the use if you keep getting cut down this way?" Instead, it keeps on growing. That's the sense of the energy at the center. That's the meaning of the image of the Grail, of the inexhaustible fountain of the source. The source doesn't care what happens once it gives into being.

One of the Grail legends starts out with a short poem that states: "Every act has both good and evil results." Thus every act in life has both positive and negative consequences—profits and losses, so to speak. The best we can do is to accept both while leaning toward the light.

Think about what that means for you as an investor or trader. You're playing a game of life. Sometimes you win and sometimes you lose, so there are both positive and negative consequences. To accept both the positive and the negative, you need to find that special place inside of you in which you can just be. From that vantage point, wins and losses are equally a part of trading. That metaphor, to me, is the real secret of the Holy Grail.

If you haven't found that place in yourself, then it's very hard to accept losses. And if you cannot accept the negative consequences, you'll never succeed as a trader. Good traders usually make money on less than half their trades. If you can't accept losses, then you are not likely to want to get out of a position when you know you are wrong. Small losses are more likely to turn into giant ones. More importantly, if you cannot accept that losses will occur, then you cannot accept a good trading system that will make a lot of money in the long run but might lose money 60 percent of the time.

WHAT'S REALLY IMPORTANT TO TRADING

Almost every successful investor that I have encountered has realized the lesson of the Holy Grail metaphor—that success in the markets comes from internal control. This is a radical change for most investors. Internal control is not that difficult to achieve, but it is difficult for most people to realize how important it is. For example, most investors believe that markets are living entities that create victims. If you believe that statement, then it is true for you. But markets do not create victims; investors turn themselves into victims. Each trader controls his or her own destiny. No trader will find success without understanding this important principle at least subconsciously.

Let's look at some facts:

• Most successful market professionals achieve success by controlling risk. Controlling risk goes against our natural tendencies. Risk control requires tremendous internal control.

• Most successful speculators have success rates of 35 to 50 percent. They are not successful because they predict prices well. They are successful because the size of their profitable trades far exceeds the size of their losses. This requires tremendous internal control.

• Most successful conservative investors are contrarians. They do what everyone else is afraid to do. They buy when everyone else is afraid, and they sell when everyone else is greedy. They have patience and are willing to wait for the right opportunity. This also requires internal control.

Investment success requires internal control more than any other factor. This is the first step toward trading success. People who dedicate themselves toward developing that control are the ones who will ultimately succeed.

Let's explore internal control, the key to trading success, from another perspective. When I've had discussions about what's important to trading, three areas typically come up: psychology, money management (that is, position sizing), and system development. Most people emphasize system development and deemphasize the other two topics. More sophisticated people suggest that all three aspects are important but that psychology is the most important (about 60 percent), position sizing is the next most important (about 30 percent), and system development is the least important (about 10 percent). This is illustrated in Figure 1.1. These people would argue that internal control would fall only into the psychological sector.

A good trader once told me that his personal psychology did not enter into his trading at all because everything he did was automated. I responded, "That's interesting, but what if you decide not to take one of your signals?" He responded, "That would never happen!" About six years later this trader went out of business as a professional trader because his partner did not take a trade. That trade would have made them very profitable for the year because it was a huge winner, but they'd had so many losses in that particular area that his partner decided not to take it.

(Continues...)

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Excerpted from TRADE YOUR WAY TO FINANCIAL FREEDOM by VAN K. THARP Copyright © 2007 by Lake Lucerne Limited Partnership. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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