Trade Your Way to Financial Freedom (2nd Edition)
Van K. Tharp
492 pages, $34.95
The title of this superb book is a bit deceptive. It suggests a target audience of aspiring traders seeking quick riches. In fact, “Trade Your Way to Financial Freedom” is a sober and sophisticated guide to methodically building winning trading systems. Far from appealing to novice traders, readers most likely to benefit from Tharp’s treatment will be veteran market professionals, especially analysts who practice systematic rather than discretionary investing methods.
Tharp’s central points on system design consist of several governing principles. First, the system must be suited to the trader’s personality, taking into account the individual’s distinctive appetite for risk and gain. Second, the strategy must have positive expectancy, which means the average trade must be profitable after a realistic allowance for transaction costs. Third, in the quest for positive expectancy, exit signals merit far greater attention than entry methods. Tharp thinks the misplaced stress on entry signals is the most common lapse in conventional system design. Indeed, with proper money management and superior exit tactics, Tharp says you can create a winning trading strategy using random entries.
A complementary point is that the system with the greatest expectancy is not necessarily the most profitable strategy. If a high-performance system trades only rarely, a system with lower expectancy that trades more frequently may be the better choice. Tharp calls this key consideration opportunity.
According to Tharp, the most important factor in winning system design is bet size. “The key to money making is having a system with a high positive expectancy and using a position-sizing model that will take advantage of that expectancy.” Tharp reinforces this point throughout the text: “What’s important is the how-much decision, not the investment selection decision.”
For position sizing, Tharp strongly advocates Anti-Martingale algorithms, which increase investment exposure as winnings grow. He analyzes four position-sizing models. Tharp faults two of the most commonly used methods because they fail to adjust bet size in line with growing profits. Tharp prefers the more sophisticated “percent risk” model and the “volatility percent” model. The former is widely known as “fixed fractional.” The latter, a type of risk-parity algorithm, is especially recommended for traders whose psychology favors tight stops.
If I have one lament about this compelling text it is the limited discussion of position-sizing. Tharp waits until the very end to analyze this key component of system design. The treatment of position-sizing occupies one of the shortest chapters in the book. Tharp himself notes he has “touched only on the surface of the topic.” The reader is urged to purchase a future Tharp title devoted specifically to position-sizing.
Based on the innovative insights, rich documentation, and fine prose skills of this discerning market analyst, I look forward to snapping up the new book as soon as it comes out.
Nelson Freeburg is editor of Formula Research, a financial letter that builds and tests quantitative timing models for stocks, bonds, and commodities. Formula Research serves systematic traders and institutional money managers in 27 countries.