Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Big Number Benefits from Trading ETFs and Large Caps by Ken Long
• Trading Education Learn Five Swing Trading Systems in October
• Trading Tip Y2K: S&P 500-Style By D. R. Barton, Jr.
• Podcast Michael Covel Interviews Van Tharp
• Matrix Contest New Contest Has Begun

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Article

Big Number Benefits from Trading ETFs and Large Caps

by Dr. Ken Long

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Sometimes I think we try to give ourselves too much credit and too much blame for our trading results. There is no doubt that we are responsible for our results in the macro sense, and that it is a healthy philosophical and psychological mind-state to be responsible for results. 

It is clear to me that the positive edge for many robust systems is small but persistent and relies on having a large number of opportunities to have a realistic level of confidence in realizing the expected, average return.  On the other hand, with fewer opportunities, the more the variance of individual trade results influences final results. 

This is why casinos prefer to have a million people wagering $1 rather than 1 person wagering $1 million. They can’t predict the outcome of a single event, but the larger the number of chances, then the more likely the expected return for their games will come through. 

How do large numbers relate to trading?  Actually, in many ways but for a moment, let’s focus on just one aspect — decisions and results.  If the market is really a complex adaptive system and our judgment is only a small part of the contributing factors that actually generate results, then we are likely to overestimate how much our decision-making contributes to performance. 

This is only true concerning systems which have been designed, tested, prototyped and rehearsed and in which an appropriate role for human discretion has been designed.  Quite different than seat-of-the-pants trading, a well-developed system might have a win rate of only 55%. If you had five losing trades in a row with such a system, you might be tempted to question your own performance and decide you are in a losing streak.  In fact, all you have seen is a string of five losing trades that should be statistically expected as part of a large number of opportunities. 

The right decision is to check your compliance with the system's rules and examine details of your execution. If you are within parameters, simply continue to take the entry signals as they occur rather than trying to reinvent yourself after a normal string of losses. 

By the same token, you might be tempted to think you were on a hot streak after five wins in a row and be tempted to change your rules or accept more risk. This would not be justified by the results, because five wins in a row would not be unusual for a system with a 55% win rate. 

Understanding your trading system and the types of results you can expect given a large number of opportunities will put you in a better position to interpret results and create meaning from data.  Now that we’ve laid that conceptual groundwork, what’s a good way to execute that concept — to ensure you have a large number of opportunities with meaningful results? 

Trading ETFs and Large Caps

I believe traders can find a large number of opportunities (and other substantial benefits) by focusing on systems that trade ETFs and large cap stocks.  Trading ETFs/large caps is not without its tradeoffs, but for a lot of traders, especially new ones, this approach can make a lot of sense.

First, however, you will have to give up dreams of riding the next small cap which, against all odds, rockets to the very top of the market food chain the way Microsoft did some time ago or as Google has done more recently.  Instead, you will find the following “big number” advantages by focusing on ETFs and the largest companies in the world: 
  
1. Very Narrow Bid-Ask Spreads:  This is the difference between what buyers are offering as their best buy price and what sellers are offering as their best sale price. By minimizing the slippage between the bid and the ask price, you will not be penalized as much as you might be on a thinly traded issue where the bid-ask spread can easily be 10 to 20 times wider. 
  
2. Liquidity: Because of the enormous size of their market capitalizations, it is very hard for big ETFs to go to zero very fast or for the biggest companies to go bankrupt overnight. It can happen of course, but remember that GM’s and Enron’s fall from grace played out over many months which gave agile traders many opportunities to either protect themselves from harm or to profit from their fall. 
  
3. Analyst Coverage: Because of the sheer size of the companies and the institutional interest in them, you can be sure that the major ETFs and large cap companies have plenty of analysts covering their every move. You can debate on the merits and quality of analyst coverage, but if you perceive your edge there, then you have many analysts to choose from. 
  
4. Institutional Money: Institutions must buy ETFs and large caps in order to get fully invested and meet the fiduciary requirements of their stated investment strategies.  Some of these institutions are so large that they must focus their buying and holding only big ETFs and large capitalization stocks.  You can be sure that there is always a buyer in size out there somewhere to act as a cushion of safety for you. 
  
5. Orderly Behavior: because of the sheer numbers of interested buyers and sellers, ETFs and large caps tend to trade in an orderly manner throughout the day and because they trade in tandem with the broader market to a large extent, you can effectively monitor positions with less concern over intraday volatility catching you by surprise. 
  
There are as many styles of trading as there are traders. Systems that trade ETFs and large cap stocks provide multiple big number benefits and they are one way that many traders, especially new ones, can begin mastering the craft of trading.

About the Author: Dr. Ken Long retired from the Army as a Lieutenant Colonel and teaches at the U.S. Army Staff College. He is a proud father of three, a husband, teacher, student, martial artist and active trader. Ken also instructs dynamic trading workshops for the Van Tharp Institute. Watch this video to hear two testimonials from students of Ken Long.

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Trading Tip

Y2K: S&P 500-Style

By D. R. Barton, Jr.

On Monday, August 25th, the S&P 500 cash index pushed through the 2000 price level for the first time in its history (hence the Y2K reference in the title).  It was not able to close above that level, though it’s giving it the old college try as I write this. (Editor’s Note: After DR submitted his article yesterday on Tuesday, August 26, the S&P 500 did close above 2000 for the first time ever.)

Hitting this significant millennial milestone got my quantitative analysis juices flowing.  The first question that came to mind probably occurred to a lot of other traders too, namely, “What typically happens after the S&P crosses a big round number milestone — is there a directional bias toward continued strength or is there a pullback first?”  The results surprised me a bit. Let me know if they surprise you as well…

New Centennial Prices: What Happens Next?

Let’s jump straight into the data.  In 1968, the S&P 500 cash index first crossed above 100.  Here is the data for that and that instance as well as the next 17 times the S&P 500 touched a new multiple of 100.

Buying at the close of the day of the first touch of a 100 multiple and selling at the close of the next trading day:

Winners: 13
Losers: 68%
Average Gain % / Average Loss % > 1.5

Those are pretty compelling numbers for making a one day trade, and it would have worked on Monday/Tuesday 8/25+26 as well.

More compelling from a probability perspective is what has happened in the 10 trading days following a touch of a 100 multiple:

Winners : 15
Losers : 4
% Winners: 79%
Average Gain % / Average Loss %: 1.1

The good folks over at paststat.com had the data up through the 1600 touch; I added in the remaining data pieces to arrive at these numbers.

S&P Y2K and Then?

The next steps in the market will be interesting.  We are in the last unofficial week of summer with Labor Day and the return to school (and to the trading desk) coming up for many.  This should bring more activity into the markets — we have had the two lowest volume days of the last several years this week, so look for more action as the number of market participants gets back to full strength.

With increased data, the piercing of the psychologically important 2000 price level should mean some follow through momentum to the upside for the S&P.  However, we have to bear in mind that the data set we have to work with is relatively small and that outside news flow could impact the market direction at any time.  In the absence of external market-moving events, the odds certainly favor some continued momentum. 

As added food for thought, the numbers three months after the first touch of a 100 price multiple are compelling as well: 78 percent of the time, the S&P was up three months after touching a centennial level.

As always, your thoughts and comments are always welcome — please send them to drbarton “at” vantharp.com.

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and in Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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Podcast

Michael Covel Interviews Van Tharp

Michael Covel interviews Van Tharp on his second visit to the Trend Following Radio show. Covel and Van Tharp discuss beliefs in the context of trading and investing; the moment of now, and the Navajo’s belief of a never-ending present; the belief examination paradigm; what “big money” means to Van Tharp; the idea of “trader jail”; fear of the unknown; the importance of sleep; and the difference between spirituality and religion.

Click here to listen.

Matrix Contest

Our Next Matrix Insight Contest has Begun!

We want to hear about the one most profound insight that you got from reading Van's newest book, Trading Beyond the Matrix, and how it has impacted your life.

We have updated some of the rules since the last contest, so please read them carefully before entering:

• Each essay should be around 1200 words.
• The ideal entries will focus more on a single transformative insight as opposed to “the whole book was transformational”.
• Dr. Tharp and the VTI team will pick the top 5 best entries from the submissions and our newsletter readers will vote to choose the top winner.
• The winner receives one free VTI foundation workshop; (*foundation workshops include the Peak Performance 101 workshop, How to Develop A Winning Trading System That Fits You, and the Blueprint for Trading Success workshop.)  The winner may choose one of these workshops (valued at $2,995) or substitute any single VTI product priced at $795 (or below) of your choice.
• Over the duration of the contest, we will choose our favorite entries and publish them in our weekly newsletter, Tharp’s Thoughts. All entries appearing in the newsletter will receive a $50 coupon (increased from $20) which can be used on any VTI product or service.

If you would like to enter, send an email with your essay to van@vantharp.com.

If you haven't purchased Trading Beyond the Matrix yet, click here.

For more information about the contest, click here.

Missed the last contest? Click here to see all of the submissions which were picked to run in Tharp's Thoughts as well as the winning entry by Cristina Sau.

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