'Trade Your Way to Financial Freedom' by Van K. Tharp

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NB: This review was first published on The Motley Fool discussion boards.

Important things first. The author has wisely kept his portrait to the inside back flap so you will be able to read this book in public without having to disguise the cover!

Not so good is the title. The book doesn't tell you how to trade successfully and doesn't set out to do so. What it does do though is raise the subjects required to devise a sensible trading strategy and present some ideas along the way. Tharp says, “My intention is to give you the tools and help you overcome your psychological biases so that you can develop a system that is right for you.”

Van Tharp isn't a professional trader himself, but describes himself as a 'coach for traders'. His training is in psychology and he is a student of Neuro-Linguistic Programming, believing that it is possible to model the characteristics of top traders and then teach the models to we lesser mortals. The book presents the aspects of three of his models, devised as the result of studying over 4,000 traders. Tharp was one of the interviewees in Schwager's 'Market Wizards' book.

The book is divided into three parts. The first part is entitled 'The Most Important Factor in Your Success: You!'. Tharp introduces the metaphor of the Holy Grail and uses it to show that the key to the market is in 'finding yourself' – having the internal control to follow a system that suits you. He discusses a number of judgmental biases which can affect trading system development, testing the system and then trading the system. Part 1 finishes with a chapter on setting the objectives for your trading system. Tharp recommends that at least 50% of the effort put into devising a system should be spent on defining the objectives. It is a pity, therefore, that this is possibly the weakest chapter in the book. A series of questions is presented along with the answers given by an already successful trader. There is definite merit in thinking long and hard about how you would answer these questions but I feel that guidance is required in interpreting your responses and then using them as parameters to your system design.

Part two is titled 'Conceptualization of Your System'. It starts out by describing 12 steps to be followed when devising a system, starting with an inventory of your strengths and weaknesses through the system development itself and ending with planning how to cope with catastrophe situations. The next chapter covers a number of common trading concepts, e.g. trend following, fundamental analysis (of commodities) and market cycles. The concept of expectancy is then discussed. Expectancy is essentially the average amount you can expect to make per dollar (it's an American book :) risked and depends on three factors: the percentage of times your trades win, the relative size of profits compared to losses and the cost of making trades. In addition to these, the number of opportunities that the system presents also affects the profitability of the system. This chapter is probably the most complex in the book, but it is well worth devoting the effort to understanding it.

Part three, 'Understanding the Key Parts of Your System' fills the second half of the book and is about the actual designing of your system. He discusses setups, entry techniques, taking losses & profits, opportunity & cost factors and position sizing. Each of these subjects gets its own chapter. For each subject, Tharp gives a discussion of the issue and a number of examples. In the section on stops, for instance, he covers dollar stops, percent retracement, volatility stops, dev-stops, channel breakout & moving-average stops, support and resistance stops, time stops, and discretionary & psychological stops. In addition for each subject he looks a six commonly used trading methods (three for stocks, three for futures) and how they tackle each area. The stock strategy selections are slightly 'interesting'; O'Neil's CANSLIM Model is fair enough, but the other two are Warren Buffett's 'Value' model and the Motley Fool's 'Foolish Four' approach (a variant of the 'Dogs of the Dow' strategy or the TMFUK 'Beat the Footsie')!

Tharp considers money management to be one of the most essential aspects to get right. He isn't exactly impressed by what most people consider to be money management so he even uses his own term for it, 'position sizing'. He says, “The purpose of position sizing is to tell you how many units… you are going to put on, given the size of your account. For example, a position sizing decision might be that you don't have enough money to put on any positions because the risk is too big”. To explain why he considers the subject so important, he presents the results of a study in which 40 graduate students “were asked to play 100 trials of a simple computer game in which they would win 60% of the time. They were each given $1,000 in play money and told to bet as much or as little as they wished on each of the plays”. Only 2 of the students managed to finish the game with more money than they started! This is definitely an area that it is essential to understand in order to properly control the risk of trading.

The book concludes with a very brief look at the system development subjects that haven't been covered. These include data, software, testing procedures, order execution and portfolio design.

Overall, I am finding the book to be very useful. It has made me question what I am doing and take a step back to reconsider many aspects of my trading. I can recognise that many of the traps I have fallen into have been the result of not having a strategy that I am fully comfortable with. Using the guidance from the book, I am starting to work on what I hope will be a strategy that I can successfully follow.

I would recommend the book to anyone seriously interested in developing a trading system.