Stocks & Commodities V. 25:1 (50-53): Developing Discipline With Daily Debriefing by Van K. Tharp, Ph.D.

Stocks & Commodities V. 25:1 (50-53): Developing Discipline With Daily Debriefing by Van K. Tharp, Ph.D.

It is easy to design a system that will produce annual returns of 100% or more. Trading the system so you will get those returns is not so easy. Here’s why it’s easy to develop such a system, why it’s so difficult to get those returns, and how to fix the problem.

IN TERMS OF R-MULTIPLES

First, let’s start thinking about your trading results in terms of multiples of your initial risk (Rmultiples for short). A key of trading success is that you must have a predetermined exit before you enter into a trade that represents your worst-case risk. Let’s look at a few examples.

Suppose you decide to buy a stock at $25 and that you’ll sell it if it drops 10% to $22.50. Your risk is $2.50 per share in this case. Suppose you decide to risk $1,000 in this trade. That means you can buy 400 shares of stock (that is, divide your total risk of $1,000 by your per-share risk of $2.50 and you get 400 shares). You would be buying $10,000 worth of stocks (400 x $25), but your initial risk would only be $1,000.

Suppose you have a $100,000 portfolio. Your risk for that position would be just 1%. Further, if your risk was 10% of the value of the stock, you could buy 10 different positions, each with 1% risk, to be fully invested. Suppose you had 10 such positions, with the results you see in Figure 1.