Protecting Yourself in Today’s Market, by Van K. Tharp, Ph.D.

Van's PhotoI think every trader should have to read a warning prior to plunging into the markets. The warning should not be something naïve such as “Future results may not reflect past performance.” No, the warning should be much stronger. It should be something like:

Warning! You are biologically and culturally wired to lose a lot of money in the market over your lifetime. While people can prevent this fate by taking the right actions — both psychologically and system-wise — most people will fail to heed this warning!

I wish I didn’t have to write such advice but if this warning prevents a few disasters, it will have served its purpose. I know that most traders and investors, however, are disasters waiting to happen. Why? Let’s take a look at the two main ways most people play the markets.

1. Most people jump on the bandwagon when it seems hot and get off when it seems cold. This almost guarantees that they’ll lose money.

In Jack Schwager’s book on Futures Managed Trading: The Myths and Truths, Jack concludes that the average person who puts his money with a professional — even those putting their money with the best professionals — tend to lose money in the market. Why? Typically, that means that they put their money in when the manager reaches a new equity peak and withdraws the funds after a substantial drawdown, just before the start of a new trend toward a high equity peak. This tendency is also true of stock-based funds so many of them will lose money even in good times.

2. People who have not placed their money with professionals are typically following someone’s advice — usually with disastrous results.

People are drawn to advisors primarily to learn what to invest in and when. Those two things have little to do with the secrets of making money in the markets. Instead, the secrets have to do with the following:

  • Having reasonable objectives. Most investors have no idea what they want.
  • Knowing when to exit a position in order to keep your expectancy as high as possible!
  • Knowing how big of a position to trade to meet your objectives. This is all about your position sizing strategy and the ‘average’ trader or investor has no understanding of what a position sizing strategy is or how to come up with one.
  • Having the discipline to follow the first three secrets.

Avoiding Any Coming Disaster

I have no idea when the stock market will start to go up, turn down, or if it will keep going sideways. Neither do you, nor does anyone else. Plenty of people have developed many creative ways of predictions and they guess but in reality, no one truly knows.

So what can you do? The following three suggestions will help keep you safe regardless of what the market decides to do.

First, determine how much you are willing to lose (your risk or R) before you enter a position. A good rule of thumb is to never risk more than 1% of your capital on any one position.

This does not mean that you should divide up your capital into 100 pieces — each amounting to a 1% loss if you lost everything in each one. Instead, it refers to the maximum loss in a position that you would allow before you get out. Suppose you have a $100,000 account and you are willing to risk 1% or $1,000. If Apple were at $150 a share and you were to exit if it dropped by $5, you could buy 200 shares ($1,000 equity risk ÷ $5 loss per share = 200 shares). Buying 200 shares of AAPL will use $30,000 of your equity but to protect your capital, you will exit immediately if it declines $5 and you hit a $1,000 loss.

Second, you need to know when to get out of a position to preserve your profit.

Once you limit your losses to $1,000, you might want your average gain to be at least $3,000. Thus, your rule might be to allow a loss as much as 1% of equity as long as a gain of at least 3% of your equity is possible. Once you hit your 3% gain, you are willing to go for a lot more as long as you don’t give back too much profit. One way you could preserve most of your profit would be to use a 25% trailing stop. In other words, once you’ve made $3,000, you might be willing to give back 25% of that but no more ($750) for the opportunity to achieve even bigger profits. This is where you get out to protect your profit.

Let’s see how this example might apply to a position with a larger profit. Let’s say someone had 300 shares of a $200 stock which they had bought some time back when the stock was $50. Therefore, this trader now has a profit of $45,000. According to our 25% trailing rule, they can give back 25% of the price ($50 on the $200 stock price or $15,000 on the position) in order to allow the position to get bigger. If the account had started at $100,000 before the purchase and equity reached $145,000, then giving back $15,000 translates to about only a 10% drawdown in equity.

The rules I’ve given are just samples. Here are two other variations —

  • When you reach a profit target, you can sell out much of your stake in a particular position.
  • When you reach a profit target, you can allow for a retracement of some percentage of your total equity — perhaps 5 to 10%.
Whatever rules make you comfortable are fine – but – make sure you have some rules to protect your profit.

Third, have enough discipline to follow rules one and two.

If you don’t have this kind of discipline, then you need to practice the exercises in Volume 4 of my Peak Performance Home Study course. Those exercises will help you with mental rehearsals and other skills to make sure that your rules are second nature to you.If you practice these three keys, you can afford to stay in the stock market until we have a major correction. These are minimal practices of any speculative trader and if you don’t practice them, then you are risking the possibility of throwing your money away.

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