Five Ways to Make Money in a Trading Business by Van K. Tharp, Ph.D.

van tharp bkA note to readers: While Dr. Tharp’s content is timeless, this article is from our newsletter archive and may contain outdated information, missing links or images.

There are several methods for growing your trading business, especially when capital isn’t a problem. At first glance, they might seem obvious, but I’ve found that most people still don’t think about them enough, let alone implement them. Here are five key ways to grow your trading business:

1. Develop new, improved trading systems. Each system can help you make more profits, especially if it isn’t correlated with the other systems. Continue to look for new systems that can become new profit centers for your trading research. Some of your systems may stop working in certain market conditions, so it’s always good to have more systems in the pipeline.

2. Find more markets in which to apply each system. Let’s say you develop a great system that works on the S&P 500 index. It gives you five trades a month and has an expectancy of 2R. This means that, on average, it can probably generate 10R each month. But what if the system also works on other major stock market indices with the same results? If you can add 10 more indices, you might be able to make 100R each month.

3. Add traders. Each trader can handle only so much work and so many markets effectively. Let’s say that a good trader can trade $50 million effectively. When the total goes above that level, however, the trader’s effectiveness seems to drop off. On the other hand, ten good traders may be able to handle $500 million effectively.

4. Make your traders more effective at what they’re doing. Let’s say a trading system generates an average return of 40% each year. You can measure the effectiveness of a trader by the number of mistakes he or she makes. For example, a typical trader may make 20% worth of mistakes each year on a 40% system. That kind of trader, at 80% effectiveness, would allow you to generate 32% from the system. But what if you could make the trader more effective? What would happen if you gave your traders effective coaching that could reduce their mistakes to 5% each year? That amounts to a 75% increase in effectiveness per trader per system per year. You can expand a trading business immensely through coaching that allows your traders to become more effective.

5. Optimize your position sizing strategies for your objectives. To do that, you must take each of the following steps:

  • Clearly determine what the objectives are for your business. Many people and many firms do not do this well, if at all.
  • Determine the R-multiple distribution generated by each of the systems you use.
  • Simulate different position sizing algorithms to determine which of the thousands of possible algorithms will meet your objectives most effectively.
  • Apply that algorithm to your systems.

For example, suppose you want to make 200% on capital allocated to a particular system. You have a system that generates an average of 70R each year. If you risk 1% of your allocated capital per trade, you may find that you can make 70% per year from the system. However, if you increase the position sizing risk to 3%, you may find that you can make the 200%. Of course, increasing the position sizing risk will increase the potential drawdowns. You need to be fully aware of the downside to such changes.

All these factors can be multiplicative. For example, suppose you have three traders, each trading two systems in three markets. Each system makes about 60R per year per market, but the traders are only 75% effective in trading them. This means that they make about 15R in mistakes per system per market per year.

Let’s look at what this generates for the company. If you multiply three traders times two systems times three markets times 45R, you’ll find that the company generates 810R each year. Let’s look at the various changes we could make and see what kind of effect they might have.

  • What if we added three more traders? We might be able to double the total return to 1,620R.
  • What if we added three more markets for each system? We might now increase the returns to 3,240R.
  • What if we added one more system per trader? We might now increase the return to 4,860R.
  • What would happen if you increased the efficiency of your traders to 90% (which we might have to do for them to handle the extra work)? We’d get an additional 20% profit, which would raise us to 5,832R.
  • What if we made our position sizing method more effective and increased our profits another 50%?

Of course, no trading business would be able to do all the things I’ve suggested at the same time, but what if you could do a few of them? What would be the impact on your bottom line? If you’re considering some of these changes, concentrate on trader efficiency and on more effective position sizing methods to meet your objectives.

*This article was excerpted from Van’s book Super Trader.*

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