Have You Experienced a Level I Transformation? 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 Tharp’s content is timeless, this article is from our newsletter archive and may contain outdated information, missing links or images.

Our mission at The Van Tharp Institute (VTI) is transformation through a financial metaphor.  Earlier in the year, I wrote a series of articles on the three different levels of transformation that we take people through. I thought I’d revisit the topic today to see if I could get additional feedback from our customers about a Level I transformation that you’ve experienced.

The first level we offer is transformation of the trading game—we take you from rules that assure that big money wins to rules that give the astute trader a huge edge.  These new rules consist of the Tharp Think concepts that I require all Super Traders to know and understand as the first part of their program.

We all play “games” in life. A game can be defined as any dynamic consisting of two or more players with a set of rules that generally define how the game is won or lost. I’m using the concept of the “trading game” to symbolize a big picture description of all the aspects of trading.

Level I:  Transformation of the Trading Game

I believe the financial markets are part of a huge game, and at the top level, where the rules get set, made, and changed, there is big money.  Because big money makes its own rules, it profits no matter what any individual trader does—they are so much bigger than that.  Big money controls the US government (notice who the Secretary of the Treasury usually is) and has created a two-party system in which people argue over everything except what is really going on.

Trading is not easy; however, it is easy to become a trader—you simply open a trading account. I have long said that if trading were easy, big money would make the entry requirements so steep that it would be impossible for an average person to trade.  Big money might do this through an education and exam system that would weed out most people.  Even today, brokers have to take a Series 7 exam; however, being able to pass this exam does not guarantee success in the market.

Big Money’s Rules

Generally, big money believes the more people playing the trading game, the easier it is for them to make money.  And, as I said before, big money has a set of rules for how it makes money, which has little to do with you making money. I’ve listed some of the rules created by big money here:

  • They profit on commissions, which they take whenever you make a trade, whether or not you make a profit.  In fact, the industry considers it unethical for a broker to take fees based on the profitability of his clients.
  • They make markets and get the bid/ask spread on every transaction.
  • They continually invent new products for you to buy, and they profit when you do so.
  • They get paid a fixed fee based upon the amount of assets that they are managing without respect to their performance.

They also get you to believe that you have to adhere to the following rule set for success in the market:

  • Selecting the right investment (i.e., picking the right stock) is everything.
  • When you find the right investment, buy it and hold it.
  • Spend a lot of time analyzing the market to find the right investment.
  • Listen to experts for advice, including newsletter writers, brokers, and the investment gurus on television.
  • The market will determine whether or not you make money.  You are at the mercy of the market in the short term, but if you hold on, you will prevail.
  • If you do lose money, it’s not your fault.  Find someone to blame and a good lawyer to help you sue them.
  • The market is efficient.
  • Asset allocation is very important (even though most people are not sure what that means).

The New Rules

The new rules are born out of the idea that trading is as much a profession as any other.  Most people spend years learning their craft, but anyone can start trading today.  Can you imagine walking into a hospital and saying, “I think I’ll try some brain surgery today.”?  It just won’t work.  Yet you can open an on-line brokerage account, transfer in $100,000 and, suddenly, you are a trader. Trading with no preparation, however, could be as fatal to your account as performing brain surgery would be for that unlucky patient in the hospital.

It takes significant time (several years) and a deep commitment to become a successful trader.  I hold a similar belief to author Malcolm Gladwell that the best people in every field usually excel because they have successfully practiced their craft for 10,000 hours.  That means they know enough about their field to produce success.  By working on your personal psychology (which is covered in the second level of transformation), I believe you learn how you produce your own trading results.

Here are some of the new rules that make up the first level of transformation:

  • You are totally responsible for your performance as a trader; therefore, you should devote significant time working on yourself in order to be successful.
  • It’s important to know your initial risk in a trade before you enter a position—this allows you to ensure that your trade has a favorable probability for a sufficient reward-to-risk ratio.  In other words, it will help you cut your losses short and let your profits run.
  • Calculate the R-multiples of all your trades; this allows you to think of a trading system by the distribution of R-multiples it generates.
  • Thinking in terms of R-multiples also gets you thinking in terms of the reward–to-risk ratio of each trade.
  • Measure the quality of a trading system by its SQN® score.  The SQN score tells you how easily you can meet your objectives through position sizing™ strategies.
  • Position sizing strategies help you meet your trading objectives.
  • There are as many objectives as there are traders.
  • You can easily develop a Holy Grail trading system for any one market type; however, it is impossible to develop a system that will perform well in all market types.
  • Your trading system must fit you.  In fact, trading a good SQN system that fits you is probably better than trading a great SQN system that doesn’t fit you.  Trying to trade a system that doesn’t fit you will likely cause you to make a lot of mistakes and see poor results—regardless of the system’s SQN score.
  • Great performance is a function of the market, your system, and you as shown in the diagram below.

stay aligned 2

  • A mistake is when you don’t follow your rules.  If you don’t have rules, everything you do is a mistake.
  • When they do have rules, most people have trouble trading above 70% efficiency (three mistakes every ten trades), simply because they haven’t worked on themselves.  Trading at 70% efficiency will destroy the results from a good trading system.
  • Within one market type, the mean and standard deviation of your system’s R-multiples will give you a good idea about the future performance of that system under those same market conditions.  In other words, trading is a process that can be statistically measured and described if you understand probability and sampling theory.
  • Winning is a function of planning, so write a business plan to guide your performance and keep working on that document as you evolve as a person and trader.

Can you see how the first set of rules can lead to disaster while the second set of rules are a major transformation and lead to success?

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