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The Efficiency Trading System

By

Van K. Tharp, Ph.D.

Background

This system was created for someone with good market knowledge but not a lot of time.  It was designed for someone who can do a thorough analysis of the markets each weekend, who doesn�t need to spend much time on the markets.  This basically fits my position as a trader�s coach who has a little time to spend on trading.

Because many aspects of this system are discretionary, I�ve elected to present the portfolio monthly for the next 12 months to test it.  This portfolio is being tested purely for educational purposes and it should not constitute investment advice.

In 2001, I followed a similar portfolio in Market Mastery for a little over a year.  However, this was a long-only portfolio and part of my purpose was to show that you could find good long candidates in the heart of a bear market.  There were some great examples in 2001 such as Deluxe Checking (now a probable short for this portfolio) and Autozone.  However, by the end of the bear market, there was not a single stock with an efficiency rating above 10 and I abandoned the project.  Since this project will have both long and short stocks, we should not have any such problems.

My Key Beliefs Behind this System

1) Trend-following works, so buy what�s going up and sell what�s going down.

2) Smooth uptrends (or downtrends) are more likely to continue than any other and one can find these through an efficiency filter.

3) What�s simple will work.

4) Let the market tell you what to do.  If the market is mostly going up, then one should be mostly long.  If the market is mostly going down, one should be mostly short.  If the market is mixed, one should have a strong hedged position reflective of the overall market.

5) Have tight stops to begin with, but once a particular market proves itself, then let it run.  (i.e., start out with a tight stop of about 10% of the price and then substitute a 25% trailing stop when that is closer than the original 10% stop).

6) When you find a better idea, get out of the dogs (the losers).

How the System Works

Market Filter:

Each weekend I will do an efficiency analysis of the market.  I will determine the overall condition of the market by determining what percentage of the market shows a positive versus negative efficiency.  For example, right now the market is 54% positive and 46% negative.  This means my long and short positions should be equivalent (i.e., about 54% long and 46% short). 

Since I generally plan to only have 10 stocks in the portfolio I will use the percentage of stock above +10 efficiency and below -10 efficiency to help in the decision.  Right now there are 55 stocks above +10 (59%) and 38 stocks below -10 (41%).  As a result, the portfolio will have six long positions and four short positions.

Entry:

My long entries will be chosen from those stocks with efficiencies above 10.  I will look at all of these stocks, beginning with the highest, and find those who�s charts I think are the smoothest, but are not parabolic or into a major correction.  This will be a discretionary process.

The specific entry will be to look for a retracement (in the hourly bars) and then a recovery during the week after the screening (hopefully one will occur on a Monday) and buy as the stock starts to recover.

My short entries will be the inverse of the long entries.  However, I�m not concerned about parabolic stocks on the downside.  I am concerned about stocks in which the price is too low and gives us little price potential.  As a result, we will not short any stocks below $3 and be very careful about any stocks below $5.

Stops:

The initial entry will be a 10% stop.  Thus, if I buy a stock at $30, I will sell it if it drops below $27 or 10%.  This stop will not be moved as the price goes up.

The 10% stops will be replaced by a 25% trailing stop once we have a 3R gain.  For example, if the $30 stock moved to $39, then a 25% trailing stop would take over (that is, the stop would now be $29.75 (i.e., instead of $27).

This system will give us a lot of small losses and some huge gains which fits my personality.

Other Exits:

Whenever our end of the month analysis of the market suggests a change in the long/short allocation, we will exit out of our weakest stock (even if it is showing a profit).   For example, suppose that we start out buying six long positions and four short positions.  In one month, the market shows us that we should be 70% long, instead of 60%.  Under those conditions, we will exit our weakest short position and enter in a seventh long position.  Similarly, if the market suggests that we should have a larger short position, then we will simply exit the weakest long position.  This aspect of our strategy might mean exiting a position that is profitable or one that is slightly unprofitable.

Each weekend we will continue to do the efficiency scans.  When a new stock appears that seems to be a better long or short than any of our current active positions, we will again exit the weakest position on that side of the market.  Thus, if we find a great new long position, we will exit our weakest long position.   And, similarly, if we find a great new short position, we will exit our weakest short position.  This aspect of the system will also be discretionary.  We will certainly exit 1) a barely profitable position, 2) a slightly losing position, or 3) a position whose efficiency has worsened dramatically for a better looking stock.  However, we may not exit a strongly profitable position (even if it is weakest) to add a new position.

Position sizing:

We will risk 1% in each position.  Since our initial stop will be 10%, this will allow us to have ten total positions.  Ten total position is very easy to keep track of at any given time.

Portfolio

We will start with a  $20,000 portfolio because I believe that this system can be done with fairly small size.  That means that each position, initially will represent a $2000 investment with a $200 (10%) risk.

We�ll introduce the portfolio next week and update the portfolio on the third issue of the month each month.  This process is being done for educational purposes and it will be based upon our end of the month analysis (so we may have entered into positions several weeks earlier).  Should you decide to invest in any of the positions, please do your own due diligence and remember that the portfolio information will be two weeks old.  Furthermore, since I do actively trade similar systems, I may or may not have some of the recommended stocks.

About Van Tharp: Trading coach, and author Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

70% Off Tape Sets

Our end of fiscal year inventory counts revealed that we have a handful of discontinued Van Tharp home study materials in cassette tape format.

If you can still use cassette tape format you can buy these programs at a ridiculously low price! Limited supply available, first come first serve.

Note: Though the content has not changed, some manuals will have a different look than the rest of the product. Items are not used or damaged; however they are sold "as is" since we won't have cassettes available for future replacements. CDs may not be substituted for cassette tapes. No refunds will be offered.

Trading Tip 

Trading Tip

A Review of Market Models: Spreads & Pairs

by D. R. Barton, Jr.

Spread or pairs trading takes many forms, but all with basically the same promise.  The promise is for reduced risk because you are long one instrument and short another at the same time.  That problem is usually not realized, as we�ll see later in the article.

All of the different styles of trading spreads and pairs have a common characteristic:  they play one instrument versus another.  Here are just a few of the many possible examples for this type of trading:

�     Futures spreads:  This method looks to take advantage of historical price ratios.  The gold vs. silver spread is a common one.  Recently, gold versus crude oil has been popular.  In general, it's when the ratio between the commodity prices gets out of it historic norms, like when crude prices appreciated faster than gold last year.  In that case, people would  buy gold futures contracts and short crude oil contracts, expecting the ratio to return to the historic norms.  There are as many futures spreads as your imagination can conjure!

�     Seasonal futures spreads:  These spreads try to take advantage of seasonal tendencies.  An example would be going long a spring/summer unleaded gas contract and short a spring/summer heating oil contract.  More driving and less heating takes place in the summer, so if you looked at this spread over a long period of years, there is a positive correlation.  Again, there are many examples based on harvest cycles, freezing seasons, etc.

�     Stock takeover arbitrage pairs:  When one company announces the purchase of another, a purchase price is set.  However, the stock still trades under it�s own name and symbol until all of the legal wrangling is completed.  During this time, the ratio of two companies� stock prices should theoretically be fixed.  However, market and psychological factors allow the ratio to narrow and widen, and people then play the spread to again revert to the logical norm.

�     Highly correlated stock pairs:  In this type of trading, highly correlated stock pairs are selected.  Again, historical norms are developed (long and short-term)  and then the one side of the pair is bought and one side is sold short in expectation of a return to normalcy.  Typical pairs are SPY vs. QQQQ (though this has had a poor correlation lately) and semiconductor stocks like ALTR vs. XLNX.

Let�s debunk one myth this week, and then we�ll look at who�s looking at these different type of spreads next week.

First of all, let�s look at the look at the myth of lower risk.  From an absolute perspective, spread and pairs traders are right:  if you buy 1000 shares of ALTR and simultaneously short 1000 shares of XLNX, you will get a smaller absolute range of movement or volatility than if you were only trading one side of the pair.  The problem is, while you limit your absolute liability, you also limit your potential profit.  So, what almost everyone does is trade bigger size to make up for the lower volatility!  So practically speaking, most traders take the same amount risk trading spreads or pairs as when they are trading individual instruments.

Next week, we�ll look at the pros and cons of spread and pairs trading and take a look at who�s trading what.  Until then�

Great Trading!

D. R. Barton, Jr. is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching, and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

D.R. presents the IITM Swing Trading Workshop and Professional Tactics for Day Traders Workshop. Each workshop is only held once each year. 

Listening in...  

VAN THARP HAS A NEW BLOG

www.SmartTraderBlog.com

Blog Entry from: July 10, 2006

Fundamentals of Poker

I love playing poker and one of the reasons is that I think it's very much like trading. First, you have to assess your initial hand and bet it only if it is above average. Interestingly enough, most beginners play every hand and many people who think they are not beginners still play every hand.

Lets look at an example. I had a computer simulation run of 10 million hands of poker with 10 people playing to determine how likely any starting hand was of winning.

Incidentally, if you are a poker player and would like access to that data. I'm willing to share the cost of the simulation with about 10 people (i.e., about $75 each). If you are serious about poker, it's a no-brainer because very few people have access to this sort of data. I found a listing that claimed to be such a simulation in a book, but there was NOTHING accurate about their data. I think it was actually plucked from air. Contact me at info@iitm.com if you have interest in the data.

There are basically 169 different starting hands and I now have them ranked in order and I bet that's information that a whole lot of people don't have. Those hands include 13 pairs. The suited combinations such as AJ suited, and the unsuited combinations. The best hand, of course, is AA. But how many times do you think AA will win against 9 other players if nobody folds and all the cards are dealt. The book I read said 86% of the time, but it was way off -- way off.

Most novices like to play Ace plus anything. But if you are talking about unsuited combinations, then only the combinations AKu, AQu, AJu, and A10u fall within the first 50 hands. And only A8u and A9u fall within the next 25 hands. And if you are talking about something like A2 unsuited -- it doesn't even rank in the top 100 hands (out of 169). Yet people play it all the time. It sort of like what happens when some analyst makes a recommendation on television, most people want to buy that stock even though it's probably a dog. Well, A2 unsuited is definitely a dog of a poker hand.

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