PART 2
DEVELOPING A WORKING BUSINESS PLAN

Have a Plan for Your Trading/investing

What happens when someone gives you a tip or idea about the market? Do you get excited about it and want to act on it? Do you become skeptical and suddenly distrust the person who gave you the tip? In some cases you probably act, and in other cases you become skeptical, possibly depending on the source.

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Have a Plan for Your Trading

A better alternative is to notice whether acting on the tip fits into your business plan for trading. If it fits, you then do more evaluation in accordance with the criteria you use in your plan. If it does not fit, you simply discard it, saying, “That’s not something I know much about.”

The only correct response to a “hot tip” is to determine if you can integrate it into your business plan for trading. If it does fit and suggests that you do more evaluation, fine. That’s a proper response. An improper response is to go out and buy an exchange-traded fund (ETF) of Japanese stocks just because some guru recommended it.

This suggestion constitutes a test for your plan. Do you have a plan that helps you deal with “new surefire can’t lose” tips you’ve heard about? If you do not, perhaps it’s time you developed one. This means developing a thorough business plan to guide your trading.

Here’s a brief outline for what needs to be incorporated into your business plan. This outline is for individuals who are trading or investing for themselves; those of you who are running a trading business need something much more elaborate.

1. What’s your mission statement? What’s the real motivation behind your trading?

2. What are your goals and objectives? You cannot get from A to B easily unless you know where B is.

3. What are your trading and market beliefs? You cannot trade the market. You can only trade your beliefs about the market. As a result, it’s a good idea to identify those beliefs.

4. What is the big picture that affects the world markets, and do you have specific trading plans that fit that big picture?

5. What is your tactical trading strategy, and what is its expectancy? What setups do you use before entry? What is your timing signal for entry? What is your worst-case loss going to be, and how is it determined? How will you take profits? What is the expectancy of that methodology? We deal with this topic in Part 3 of this book.

6. What are your position sizing strategies (the part of your methodology that tells you “how much” throughout the course of a trade)? We deal with this topic in Part 4 of this book.

7. What are your typical psychological challenges and problems in following this plan? What is your plan for psychological management for dealing with these problems?

8. What are your daily procedures?

9. What is your education plan? How do you plan to improve yourself continuously?

10. What is your disaster plan? What can go wrong, and how will you deal with each item?

11. What is your planned income and budget for expenses? Are they realistic?

12. What other types of systems are important for you, and how will you plan for them? Examples are keeping your data accurate, explaining results to clients or family, conducting research, and keeping track of your trades and your accounting. These are all important.

13. How do you relate to business systems?

• As someone who just needs to be told what to do?

• As someone who is the system and becomes a perfectionist?

• As someone who develops systems so that others can do the work?

• As someone who invests in systems?

14. How do you prevent mistakes and avoid repeating them if they occur? This is the topic of Part 5 of this book.

Having a plan of this nature is so important that I rank it among my top requirements for traders. Perhaps it’s time you developed such a plan.

Having a Mission Statement behind Your Trading Is Critical to Your Success as a Trader

You probably have specific goals in your trading. If you don’t, I suggest that you develop some. Surely Part 1 of this book gave you some ideas. Once you have goals, you may need some discipline to help you meet them. As a trader, you need a mission statement to form the core of that discipline.

At one point some years back, I spent several days doing creative brainstorming on ways to take my company to the next level. Part of that process involved determining our mission statement. I’d always known our mission, but I’d never before put it down on paper. I also had not thought about expanding our business with respect to that mission. Developing and understanding your mission is a critical process and one you should go through for your trading. It also fits with the overall idea that you must understand who you are and who you want to be before developing a business because your business will develop out of your statement about who you want to be.

In that brainstorming session, I learned a process that will work for running any successful business. When I thought about it, it was obvious that it was a process that applies to trading. The first part of it is to create a mission statement for your trading business.

Here are a few examples of what that statement could be for you:

• Help others to prosperity by becoming a highly successful money management firm.

• Build a hedge fund with at least $250 million under management with the specific goal of helping doctors who don’t know how to invest or trade their money.

• Produce an infinite wealth stream (enough passive income to meet my expenses) within five years.

• Be a vehicle for me to grow moneywise and as a person.

• Fund a charitable foundation.

• Help others grow as traders by transforming themselves.

Second, you need to evaluate new projects with respect to the mission statement. When you have a mission statement, you can evaluate new projects (or new systems) constantly with respect to that statement by asking, “Is my objective in this project critical to the mission of the company?” People are always asking me to do this project or that project. For example, one trader, who was a sound engineer by training, said that when he came into town, we could start working on developing specific meditations for traders. Although his idea was a great one, it was very low on my list of mission-critical tasks that needed to be done in the near future. As a result, it didn’t happen. Without such a process in place, I’d probably spend most of my time doing noncritical tasks and thus not accomplishing what is important for the company to meet its goals.

Most traders treat their trading business like a hobby; in other words, they don’t treat it seriously. For example, some constantly look for new or better systems. Others trade discretionarily. Still others manage the money of a few friends or relatives without thinking of the consequences. These types of objectives need to be evaluated with respect to your trading mission statement to see how they fit.

Let’s make the assumption that you have a mission statement for your trading business to produce an infinite wealth stream for yourself within five years. Infinite wealth basically means that if you stopped working, including working at your trading business, you would have enough passive income (that is, your money working for you) to maintain your current lifestyle. You could accomplish this in two ways. First, you could accumulate enough money that if you invested it in T-bills or some other form of passive investment (I’d recommend a good hedge fund over T-bills because you can get a much better rate of return), you’d be infinitely wealthy. Second, you could automate your systems for trading so much that you could hire someone else to execute the trades for you.

Let’s take a look at some of the objectives we introduced to see if they fit with this mission statement.

Let’s Try This New System to See If It Works Better

If you have a system already that can help you achieve this goal, you probably are just wasting your time. For example, I’ve known people with systems that can easily net 100% or more each year who constantly jump on the next new system that comes along. However, if you don’t have a system that will meet your objectives, you need to evaluate both your current system and the new one in terms of R multiples, expectancy, opportunity, and the concepts involved to see if you have something that logically makes sense. For example, if you assume that you will risk 1% per trade, you have to net only about 8R per month (remember that R refers to your risk in each trade) to make 100% per year. Think about it. In most cases, someone else’s new system will not help you because that person has not evaluated it in these terms. It usually takes only a slight change in your thinking to net you great rates of returns. Thus, looking at a new system is probably a total waste of time in light of this mission statement.

I Want to Make Rule-Based Discretionary Trades Because I Think I Can Outperform a Mechanical System

This objective might fit within the mission of infinite wealth if your plan is to accumulate a certain amount of money and then invest it in various forms of passive income to produce infinite wealth. However, if you plan to produce infinite wealth through your own trading, this mission does not fit within the objectives because you will always be tied to your trading: You will always have to work if you make discretionary trades. In the second case, you should abandon the idea of discretionary trading.

I’ll Manage Money for a Few Friends and Relatives

This objective could be a total distraction from your mission or it could be a means to an end, depending on how you treat the practice of managing money. For example, are you going to do it for free or charge a fee? If you plan to charge a fee, that could help you meet a monetary target. However, are you prepared to deal with the psychology of the people for whom you are managing money? Do you have back office accounting procedures in place? Is the effort to deal with accounting and your clients worth the distraction to your trading? If the answer to any of these questions is no, this is not a mission-critical objective and should be abandoned on the spot.

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How Does Each Piece Fit the Big Picture?

If the project is mission critical, you need to allocate human and capital resources to it. Let’s make the assumption that your idea seems to be mission critical. Let’s say that your mission is to open a hedge fund with a target of at least $250 million under management and some friends are asking you to manage their money. To have large amounts of money under management, you need to produce above-average returns with very little risk. For example, a system that would help you achieve this mission would be one that would earn 15% to 25% each year with no more than one or two losing months a year. If you have that kind of system in place, accepting clients’ money probably would be useful. If you don’t have such a system in place, client money probably would be a major distraction.

Let’s say you have the system in place and decide to accept money. The next step is to determine the human and capital resources you need to allocate before undertaking the step of accepting client money. What else do you need to have in place before accepting client money? First, you have to have accounting systems in place. If you don’t, you need to (1) find someone to help you with your accounting and (2) put a system in place to report to clients. This amounts to allocating either human or capital resources to your objective.

Second, you need to have systems in place for dealing with client inquiries (including new clients). How will you market to clients? How will you deal with clients who want information about their accounts or about your trading? Again, since you have decided that accepting client money is mission critical, you need to allocate human and capital resources to putting these systems in place.

Next, you need a timeline for the project. If you decide that the project is mission critical and have allocated resources to it, you have to have a timeline for the completion of the project. Without a timeline, you could go on forever with the project.

Finally, you need a feedback and monitoring process for the project. This process will keep you on track and prevent you from wasting resources. When you allocate resources to a project that is mission critical for your trading business, you’ll need to have a way to monitor its progress. How will you know that resources are being spent properly? How will you know that progress is satisfactory? If someone else is involved, how will you know that that person is doing a good job? These are key tasks to perform if your trading business is to accomplish its mission.

What Are Your Goals and Objectives?

You cannot get from A to B easily unless you know the location of B. Most people don’t think too much about their objectives: what kinds of returns they want or what kinds of drawdowns they are willing to accept. However, you cannot develop any sort of trading system, at least one that you’ll be happy trading, without knowing these things. For example, you may decide that you want to make at least 20% and have a peak-to-trough drawdown of no more than 10%. That’s a reasonable objective, but it’s totally different from the objective of someone who wants to make as much money as possible and not worry about drawdowns at all. Those two objectives would have entirely different position sizing methods to get there.

Let me illustrate how many possible objectives you could have.

First, you might want to maximize your probability of achieving a certain goal. That goal could be anything from making a profit to making 1,000% or more.

Second, you might want to make sure that you don’t have a drawdown of a certain size from your peak equity. That drawdown could be anything from, say, 2% to 100%.

Third, you might want to minimize your probability of losing a certain percentage of your starting equity at the beginning of the year. For example, you might be willing to have a large peak-to-trough drawdown, but you might want to minimize the chances of losing more than a small amount of your starting equity. That could be 1% up to, say, 75%.

Fourth, you might want to achieve the highest possible equity at the end of the year and maximize your chances of achieving that goal.

Fifth, you might want to maximize the probability of having the greatest chance of meeting your goal and the smallest chance of experiencing your worst-case drawdown.

When you consider that it’s possible to put many numbers into these objectives, it is easy to see how each trader/investor can have different objectives. In fact, there are probably as many objectives as there are traders.

What are those objectives for you? Deciding on your objectives is about 50% of developing a trading system. Developing a system without an objective becomes an insane exercise, although many people do that.

Sometimes, I have traders play a game against other traders. After every 10 trades, the group that has the highest percentage gain wins $15, but groups that have a drawdown pay $1 per percentage point they are down and then another $2 for each percentage they are down over 20%. Thus, going bankrupt could cost them $180, plus a buyback fee. At the end, the group with the most equity wins everything in the pot—including any draw-down penalties.

Notice how this could create lots of potential objectives:

• Win the game at all costs and be willing to go bankrupt several times.

• Attempt to win the $15 at the end of each round.

• Make sure we never drop down as far as a 20% drawdown.

• Lose as little money as possible.

• Try to win the game but don’t draw down as much as 20% over 10 trades.

The interesting thing about this game is that when they start trading, it seems to be a zero-expectancy game. They can go long (80% losers but no really big losers) or short (80% winners but huge losers when they are wrong).

What everyone begins to understand by the end of the game is that even with a system they know very little about, it’s very important to (1) have clear objectives, (2) develop a position sizing strategy to meet those objectives, (3) know when to change the strategy because it is not working, and (4) understand how important the position sizing strategy is to guide their trading. For example, here is a typical comment from someone who recently played the game: “Even with a zero-expectancy system, we formulated clear objectives and accomplished those objectives with flying colors. My trading will never be the same because now I understand the importance of objectives and the power of position sizing strategies in meeting those objectives.”

Market Beliefs

When you trade, you probably think you trade the markets. However, you don’t trade the markets; instead, you trade your beliefs about the markets.

What do I mean when I say, “We only trade our beliefs about the markets”?

Let’s look at some statements and see what you believe about them:

• The market is a dangerous place in which to invest. (You are right.)

• The market is a safe place in which to invest. (You are right.)

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The Market Is a Dangerous Place

• Wall Street controls the markets, and it’s hard for the little guy. (You are right.)

• Market professionals have lots of limitations, which makes it easy for a little guy like me. (You are right.)

• You can easily make money in the markets. (You are right.)

• It’s hard to make money in the markets. (You are right.)

• You need to have lots of information before you can trade profitably. (You are right.)

Do you notice the theme? You are right about every one of these beliefs whether you said yes or no to any of them. If you don’t believe in any of these statements, what do you believe instead? You are right about that too! However, there is no real right or wrong answer. Some people will have the same beliefs and agree with you, and others won’t. Therefore, whatever your beliefs are about the markets, they will direct your thinking and your subsequent actions.

Let’s look at one concept that works: trend following. To be a good trend follower, you must start by identifying something that is in a trend. Once you’ve done that, you must jump on the trend, perhaps after a retracement. Note that I’ve made two statements about trend following. Both of those statements are beliefs; they are not necessarily true. They are simply my way of organizing reality for myself. A lot of people (that is, other trend followers) may share that reality, but it’s still based on a couple of beliefs.

You could have beliefs that would make it very difficult to be a trend follower:

• The stock just made a new high. How could I possibly buy a stock that has made a new high?

• Trend following works for some people, but when I get in at a new high, that’s likely to be the turning point in the market.

• Whenever I enter the market, it’s a signal to Wall Street to do the opposite of what I just did.

• Momentum trading doesn’t work; you have to buy value.

• The stock market doesn’t trend very well; it tends to be very choppy.

Note that these are all beliefs. Yet how could you be a trend follower if you believed any of these things? Are you beginning to see how beliefs shape your trading behavior?

Let’s look at another method that works: value trading. To be a value trader, you probably have to have one or more of the following beliefs:

• When I buy things that are undervalued and I am patient, I’ll see them move toward fair value, and I’ll make money.

• When I buy things that are undervalued, they eventually will become overvalued, and that’s when I should sell.

• Something is undervalued when … (fill in your definition).

• Something is overvalued when … (fill in your definition).

There are many successful value investors, but you probably couldn’t be a value trader if you believed that things must be moving rapidly in your favor for you to make money. Also, if you buy undervalued stocks, it can take forever to make a profit, but you want to make money each day.

My purpose in getting you to explore your beliefs about the market is to show the major influences on the way you trade. Write down your beliefs about the market and the way you should trade. You have not completed this exercise until you’ve written down 200 or more beliefs. If you find this difficult, try looking at charts and predicting what will happen next.

Your beliefs may fall into the following categories:

• What do I believe about the market?

• What do I believe about trading?

• What trading concepts do I believe work?

• What risk management principles work?

• How do the best traders trade?

• Who are some of the best traders, and what do they believe that I believe?

• What are the secrets to making money in the markets?

• What have I read lately about trading that resonates with me?

• When I try to predict what a stock will do from a chart, what concepts come up for me?

To give you a sample, here is a list of my beliefs, one from almost every category:

1. I believe we are in a secular bear market in which market valuations (price/earnings ratios) will go down to the single-digit range. However, crisis implies opportunity—if you understand how to take advantage of what’s going on in the market.

2. I believe that whenever you enter a trade, you must know the point at which you are willing to say “I was wrong about this trade” and get out. This is your stop loss point.

3. I like to trade stocks that are very efficient (that is, trending up or down with very little volatility).

4. Sometimes there are a lot of efficient stocks to select from, and sometimes one cannot find any.

5. When you get stopped out of a trade, make sure (if you can) that you don’t lose more than 1% of your equity in that trade.

6. The best traders trade by finding a niche that fits them and then becoming an expert in that niche.

7. One of the secrets to making money is to have well-thought-out objectives and then understand that you meet those objectives with position sizing strategies.

8. What have I read about trading lately that resonates with me? I just noticed a Warren Buffett quote: “Diversification is a substitute for not thinking.”

Each belief fits me. They may not fit you at all; however, I believe that you’ll have trouble as a trader/investor if you ignore some of those beliefs (that is, the second, fifth, sixth, and seventh). But that’s another story. Anyway, your job is to now write down 10 to 15 beliefs from each of the nine categories.

When you’ve finished the exercise, look over each belief and run it through the Belief Examination Paradigm:

• Who gave me the belief—where did it come from?

• What does this belief get me into? List at least five things.

• What does this belief get me out of? List at least five things.

• Is this belief useful, or is there a more useful belief?

• Does this belief limit me?

• How could I change it so that it is less limiting?

• If I can’t change it, is there a charge on the belief?

• If it’s appropriate, ask questions such as, “How do I define that?” and “How do I know?”

My work in modeling top traders suggests that if you are to do well, you must have a trading system that fits you. By writing down your beliefs, you are well on your way to developing a trading system that does that.

Understanding the Big Picture

I’ve been in business as a trading coach for over 25 years, and during that time I’ve seen many “trends” in investing. I’ve seen a commodities boom, a forex boom, an equities boom, a day-trading boom, and even a total disaster period in which there was a boom only in things that one might short. Because of these vastly different trading conditions, I think it is very important for people to be aware of the big picture. The big picture will tell you what’s going on and at least make you aware that what’s working now could end suddenly. In fact, it usually ends when you are most excited about it.

I would like my clients to be aware of and endure all market conditions rather than become casualties when bubbles burst. As a result, in Chapter 6 of the second edition of my book Trade Your Way to Financial Freedom, I presented six major factors that I believe influence the big picture:

Factor 1. The U.S. debt situation. The interest on the “official” debt of the U.S. government is now equal to the nation’s annual deficit. The debt situation is more interesting than one might think, and there are some serious questions you must ask yourself. Did you know that the Federal Reserve Bank of St. Louis has published a study saying that the United States is bankrupt?1

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Understanding the Big Picture

Factor 2. The secular bear market.2 The U.S. stock market has had secular cycles (long-term cycles that last 15 to 20 years) throughout its existence. These are not stock price cycles but cycles in the price/earnings (P/E) ratios of stock prices. A bear cycle started in 2000 and could last until 2020. Again, there are some serious issues here that you need to familiarize yourself with as a trader/investor.

Factor 3. The globalization of the economy. The fastest-growing economy in the world is now China, and India is making immense strides as well. China is consuming vast amounts of raw materials, and this has had some interesting economic effects on the world. As a trader/investor, there are some important questions you need to ask yourself about this factor. When the economy collapsed in 2008, everything collapsed.

Factor 4. The impact of mutual funds. To understand the potential impact of future events on the U.S. economy, it’s important to understand the role of mutual funds and the ways their managers think. Mutual funds certainly do not follow any of the principles of trading outlined in Trade Your Way to Financial Freedom and this book. You need to think about the impact of this and some of the things that are going to happen in the future. In 1982, when the great secular bull market started, there were only a few mutual funds. When it ended in 2000, there were more mutual funds than listed stocks. My prediction is that very few funds will be able to withstand the secular bear market with their philosophy of being 100% invested. Thus, when a new secular bull market starts, there again will be very few mutual funds. Perhaps this time they’ll be allowed to go to cash.

Factor 5. Changes in rules, regulations, and policies. Sometimes trader trends such as day trading are ended suddenly by changes in regulations that are designed to “protect” the investor.

Factor 6. Human beings tend to play a losing economic game. If you really understand this factor, your chances of long-term success in the market are greatly increased. But do you know that the big players have a different set of rules than you do? You cannot play by their rules, and if you trade the way they do, you are probably doomed. As a result, there are some serious questions you need to ask yourself. Most of the big players do not understand risk; they just think they do. That is why banks have rogue traders. It is why banks are leveraged 30 to 1 with debt instruments, which include subprime mortgage loans. One of Alan Greenspan’s comments after he left as chairman of the Federal Reserve was that he thought big financial companies would self-regulate in terms of risk. Big banks make their own rules about playing the game, and that allows them to win. However, they definitely don’t understand risk as I define it.

There are other major factors that are probably too long term to consider right now, but what about the long-term impact of global warming? Is the United States on the downside as an economic power? What happens when the U.S. dollar is dropped as the world’s reserve currency? When you think about these factors and keep tabs on them, you are not surprised when the stock market suddenly crashes or major reversals suddenly occur in whatever you are doing. Thus, it is very important to develop a business plan (as a trader) that takes into account some of these factors. I publish a monthly diagram that to me illustrates what is going on in the world. It comes out every month in my free weekly e-mail, Tharp’s Thoughts. Figure 2-1 shows the big picture as of May 28, 2010.

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Figure 2-1 The Van Tharp Institute Synopsis of the Big Picture in May 2010

Today, the entire world economic picture can be represented by 100 days of ETFs representing various aspects of the global economy. On May 28, the economy looked rather dismal. The top-performing areas are in green, average areas are in yellow, and the worst-performing areas are in brown and red.

And most of the top-performing areas are that way because of relative strength. For example, the interest rate sectors are mostly green, but they are strong only relative to the other areas. And this is at a time when many people think we are still in a bull market.

Notice that most of the countries of the world are either reddish (very bad) or brown (below average). The economy of the world, according to this, is not very healthy.

Do you think a regular look at the big picture in this manner would be useful? I certainly do. Doesn’t it give you a better picture of how to trade in the current conditions?

What it tells you is obvious: even though most professionals are invested, the market really is not that strong at all.

It’s important that you understand that my idea of the big picture could be entirely different from yours. For example, there are multiple ways to look at market types:

I look at the market from a 100-day perspective, but you might be an intraday trader, so only what the market is doing today is important for you.

I measure volatility relative to what it’s been over 50 years. You might be interested in volatility relative to the last 100 days.

Similarly, there are many ways to look at what is going on in the market:

I look at the relative performance of the trading vehicles in the world with respect to what their ETFs are doing. You might think ETFs are risky and don’t represent the world.

I look at secular market trends that could last 20 years. You might not care about such long-term cycles. You simply may want the market to be volatile enough to trade today.

What’s important is that you have a way to monitor what’s going on so that you’ll know when the big picture changes in the context of what’s important for the way you trade; what’s important, of course, depends on your beliefs.

What Are Your Tactical Trading Strategies?

Part 3 of this book discusses trading strategies in more detail, so I’m going to list only a few of the questions you should consider asking yourself here:

1. What are three noncorrelated strategies you can use that fit the big picture?

2. Do these three strategies cover the six major market types?

• Bear volatile

• Bear quiet

• Sideways volatile

• Sideways quiet

• Bull volatile

• Bull quiet

In other words, do you know how your system performs in each of these market types? Do you have all of them covered, or are there some markets that you’ll avoid trading?

3. What setups do you use before entry? Are they any more accurate than 50%?

4. What is your timing signal for entry?

5. How do you assess the reward-to-risk potential of the trade?

6. What is your worst-case loss going to be, and how is it determined?

7. How will you take profits?

8. What is the expectancy of that methodology? How good is the system? How easily will it be with this system to use position sizing strategies to achieve your goals?

You’ll need to keep up with the current market type, making sure you have a system that will perform well. If you do not have such a system, your only alternative is to stay out of the current market type.

How Will You Achieve Your Objectives through Position Sizing Strategies?

Using position sizing strategies to meet your objectives is an important part of your trading business plan. You need to have specific objectives. You have to understand that your system doesn’t achieve your objectives; your position sizing algorithm does that.

If you understand this concept, you are way ahead of many, if not most, professional traders: those who cannot practice position sizing methods. For example, most bank traders and even many company traders don’t know how much money they are trading. How could they practice position sizing strategies? Also, most portfolio managers must be fully invested, and so they can practice their position sizing strategies only by being overweight or underweight with certain stocks. In my opinion, that’s not a strong position sizing method.

You, fortunately, do not have any of these limitations, so it is essential for you to understand this topic thoroughly. Read Part 4 of this book, and then study The Definitive Guide to Position Sizing.3

Dealing with Your Challenges

Part 1 of this book involved assessing your strengths and challenges and developing a plan for dealing with them. You now need to summarize that material and include it in your business plan.

How prepared are you for a trading career? How did you do in the tests given earlier in this book? What is your trading personality? What are the strengths and challenges of that personality? What are your beliefs about yourself, especially the limiting ones?

Once you have all this material written down, you need to develop a plan for dealing with it. You should answer the following questions:

1. What do I need to do on a daily basis to keep myself disciplined and on track?

2. What are the major emotional issues that come up for me, and how will I deal with them?

3. What is my ongoing plan for working on myself so that I avoid self-sabotage?

4. How can I make myself more efficient as a trader?

5. How can I recognize problems as they come into my trading and deal with them before they become self-sabotage?

My suggestion here is to read through all the ideas in Part 1 about how to deal with these sorts of issues on an ongoing basis. Practice working with them, and then develop a regular procedure that you can follow.

This area is very important and will give you a huge edge. Let me demonstrate how important that edge is with an example.

In January 2008 a large mutual fund hired me to give a oneday workshop for its traders and analysts. I was speaking in a room of about 30 people who were controlling about $50 billion. They wanted me to speak about two topics in which they needed coaching: position sizing strategies and psychological management. Initially I talked about position sizing methods, but they were clearly handicapped because mutual funds are required to be nearly 100% invested. They could not short, and they could not retreat to cash in bad times.

I explained how they could buy their benchmark and then overweight and underweight certain components as a position sizing method. It was clear that they partially understood that concept. Their best performer in 2007 was someone who had an 8% weight in one particular stock throughout that year. It had had a stellar performance, but it was down more than 25% from its high, and he still had the 8% weighting in that stock. I don’t know what happened to him, but the entire market they were trading went down another 50% by the end of 2008.

Then we moved on to the more interesting topic of psychological management. This was especially important since they had little control over their position sizing methods. I decided to show them an exercise to help them solve a problem, and the group picked its star performer to demonstrate the process. However, the star performer picked “being in front of the group” as his problem. This totally defeated the purpose of the demonstration. It was clear that the group was not interested in the topic of psychological management. The participants ended the topic early as they decided that it was more important to spend the rest of the day analyzing the market.

I checked that fund toward the end of 2008, and its performance was disastrous. Many funds would close the year with a similar performance. However, the fund couldn’t do anything to practice good position sizing strategies in such circumstances, and it didn’t care about psychological management. I’m wondering how the participants feel about not taking that part of the talk seriously. Perhaps they were okay because their performance benchmark was also disastrous.

Can you begin to see the huge edge you will have over many professionals if you take these topics seriously?

What Are Your Daily Procedures?

You need to develop a routine that will keep you performing at a top level. What’s on the list will depend on you and what you need for peak performance. Here are a few things to think about:

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What Are Your Daily Procedures?

• Do you need a pre-start-of-day self-assessment? What would that consist of? How will you do it?

• How will you make sure that you do what you need to do today?

• What will you do on a daily basis to prevent mistakes?

• What will you do on a daily basis to keep track of your trades and your thoughts about trading?

• What statistics will you monitor to keep track of your trading? Here are just a few of the things you can monitor if you choose to do so:

R-multiples

• Expectancy

• Standard deviation of R

• Monthly return

• Daily profit and loss (mean and median)

• Annualized Sharpe ratio

• Ratio of largest winning day to largest losing day

• Volume of trading

• Number of winning and losing days

• Largest winning day

• Largest losing day

• Largest drawdown in dollars

• Largest drawdown in time

• Largest drawdown in percentage

• What will you do on a daily basis to work on yourself?

• Diet

• Exercise

• Spiritual practices (for example, meditation)

• Trading practices to keep you in top form

Spend some time thinking about these areas, and develop checklists that you can use to monitor yourself.

What Is Your Education Plan?

Part of your plan should be continual improvement. How do you plan to do that? Companies that invest in themselves and their employees tend to grow and prosper. How will you invest in yourself?

• What do you need to know to improve your trading in terms of both skills and knowledge?

• What do you need to improve about yourself to improve your performance?

• How will you get that information?

• How do you know your source is reliable? Remember that experts are not necessarily what they appear to be. The financial meltdown of 2008 to 2009 should convince you of that.

Make a list of everything you need, and then develop a plan for ways to develop those skills and that knowledge. This should be a major part of your business plan.

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What Is Your Education Plan?

Worst-Case Contingency Planning

The idea behind a worst-case contingency plan is to brainstorm what could happen. Approach the brainstorming as a creative exercise. If you do it from that perspective, there is nothing negative about it.

The purpose behind this planning is to prepare for what could go wrong. The market usually will find something that you are not prepared for and give you a great test of your fortitude. When this happens and you are not prepared, you become stressed and your brain shuts down. Typically, you respond in a very primitive way, but with a lot of energy. For example, you may scream loudly. However, this does you very little good and hurts your account.

Brainstorm everything that could go wrong. You might find that such problems fall into six broad categories:

1. Personal emergencies. For example, one of my clients had a personal emergency and left a number of open positions to go deal with the emergency. When he returned, he came back to a financial emergency!

2. Unexpected market disasters. Examples include the 1987 crash; no one expected the S&P 500 to move 20% in one day, but it did. This category also might include events such as 9/11, when the stock market closed down for a substantial period. We actually had training for our Super Trader program that was like playing war games designed by someone who used to design games for one of the U.S. intelligence agencies. In that training, we had a scenario in which the World Trade Center was blown up. The reaction: “This is so unrealistic. Nothing like this would ever happen.” But it did, and within about five years after we’d done the exercise.

3. Equipment and data problems. What if something happens to your computer? What if something happens with your software, especially if you don’t know it’s happening? What if something happens to your data? What if you get faulty data and false signals? What if something happens to your phone or your Internet service? You need backups for all of these things. As the cartoon shows, what if your computer gets stolen?

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Situation 53: Ninjas Steal My Computer

4. Major life changes. These changes include having a baby, going through a divorce or a major breakup with a loved one, moving your office or your home, a personal or family illness, a personal or family death, and anything else that might be a major distraction, such as a lawsuit. These events tend to occur over a long period, and you need to plan how you’ll respond to them. Sure, you can just stop trading, but perhaps there is another way if you work it out and practice it.

5. Psychological and/or discipline problems. This is where you plan for it and make sure it doesn’t wipe you out.

6. Broker problems. What kind of performance should you expect from your broker? What will you do when there are errors? Bad fills? A broker who questions your judgment? All these are items you should consider.

How to Make a Worst-Case Contingency Plan

Make a list of everything that could go wrong in each of these six categories, plus anything else that might fit in a miscellaneous category. Plan on having at least 100 items; fewer than that and the list will be too short.

Once you’ve generated the list, come up with three ways to deal with each situation. If you have 100 items on the list, you need 300 solutions.

Determine which solution is the most effective for each problem and rehearse it thoroughly until it is second nature. This is the real value of worst-case contingency planning. The more you can rehearse globally, the less you’ll have to deal with in a daily mental rehearsal.

Most people prefer to ignore this section of their plan, but it really is the most important.

Sometimes even good things can be a disaster. In my company business plan when the company was much smaller, I once considered that one of the worst things that could happen would be a large order that might take me several months to fill because I didn’t have enough stock. People often don’t think about how good news can be a disaster.

Mentally Rehearse Your Disaster Plan

Trading at a peak performance level requires that you know exactly how to react in any circumstance. What happens if you are holding 8,000 shares of IBM and it suddenly drops 13 points? What will you do? What if you are day trading S&Ps with about five open contracts and suddenly you get a call from the hospital and learn that your spouse has just been in an accident and is in serious condition? What will you do? What will you do if there is a major stock market crash? What if the Dow Jones Industrial Average moves up 20% in one day and you are short? Will you know what to do in these circumstances?

The key to peak performance is to have a set of well-thought-out rules to guide your behavior and be able to withstand anything that might cause you to break those rules. You need to set those rules before you trade and rehearse your disaster plan as soon as you have one.

Normally, you have a conscious processing capacity of about seven chunks of information. However, under stress the body releases adrenaline into the bloodstream. Blood is diverted from the brain, which normally gets 50% of the oxygenated blood, to the major muscles of the body. You suddenly have more energy (that is, to run away), but your thinking capacity is diminished. Typically, when under stress, you revert to primitive behavior, but with more energy. This is fine if you must run away from a predator, but it is disastrous if you have to think quickly about a market situation.

The trick to dealing with such a situation is to rehearse it in your mind before it happens. When you’ve done that, your unconscious mind will know exactly what to do and stress won’t be a factor. You’ll just do it.

I was introduced to the power of mental rehearsal by an NLP instructor who was a world-class cyclist. To maintain his world-class standing, he had to cycle about 100 miles a day on Southern California roads. About once every 5,000 miles, something dangerous would happen. Several of those mishaps nearly cost him his life. As a result, he decided that if he was to live a normal life span, he had to give up cycling or take some sort of precaution. He chose the precaution: mental rehearsal.

He took his cycle to a field, sat on it, and for two hours thought through every scenario he could come up with that could be disastrous. For each potential disaster, he worked out a course of action and rehearsed it many times in his mind until it seemed like second nature.

Several months later he was doing his daily cycling, traveling at a high speed in heavy highway traffic. When he happened to look down at his front tire, he noticed that it had a bubble. Within seconds a major blowout was going to happen. Before he could even think about it, he did a flip over the handlebars. He landed on his feet with the cycle on his back. If he had not done that, the tire would have burst, probably within the next few seconds, and sent him flying into oncoming traffic.

When he stopped to think about what had happened, he realized that the flip was one of the behaviors he had rehearsed in the field that day. Mental rehearsal had saved his life. It could save your life too—at least your financial life.

Go through steps 1 through 3. Use your mind to make certain that you are ready for whatever the markets bring:

1. Before you start trading, make sure you have a plan to guide your trading. When do you exit to abort a trade? When will you take profits? What could distract you from your plan?

2. Once your plan is developed, brainstorm to determine everything that might go wrong with your plan or your life. This is not an opportunity to be morbid. Instead, consider it a creative challenge to prevent problems.

3. Develop a plan of action for everything that could go wrong. Mentally rehearse that plan until it becomes second nature.

Systems Other Than Trading Systems

Every business has many systems. By system, I mean something automatic that really helps people know what to do in running a business. For example, a fast-food restaurant will have systems to help the employees greet customers and serve them within a minute. It also will have systems for preparing food, cleaning up, managing cash flow, dealing with the problems that arise, and so on. Your trading business needs such systems too.

Cash Flow

The most important of those systems has to do with cash flow and budgeting. What is it going to cost to run your business? What does equipment cost every month? What does Internet connectivity cost every month? What do you pay for data? What do you pay for education? How about subscriptions? What else is part of your regular monthly outflow? How about research time and perhaps your salary?

All this should give you an idea of what you need to make every month to have a profitable business. What is your hourly wage as a trader? Are you making less than the minimum wage? What is your salary? All this should be answered (or at least well planned) in a very detailed manner in your business plan.

Customer Relationships

When trading for others, you will need to get customers; you’ll need some sort of marketing of your business. How will you legally let people know about what you can do for them? That should be a complete plan or at least a section of your business plan.

Next, you need to know how to keep your customers happy. How will you deal with customers who call on a regular basis with questions about your trading? That can be a real distraction. What will you do to minimize the need for your customers to call you? For example, you might want to have a newsletter go out to them weekly or monthly.

How will you report results to them? How will you manage things when your results are poor? Just as important, how will you manage things when you do well and your customers get excited and want that performance to continue?

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Dealing with Customers’ Calls on a Regular Basis?

Back Office Management

The next issue is your back office. How will you keep track of your customers? How will you send statements to them? How will you keep track of your performance, especially if you are managing a lot of individual accounts? How will you handle bookkeeping? These are just a few of the questions you’ll need to answer with respect to your back office. You need to plan for this.

Data Management

How will you manage your data? What if there are errors in the data? What if you have errors in your trade fulfillment?

How will you deal with checking data? Is your historical testing adequate for making decisions? For example, if you test 30 years of S&P 500 data, are you testing on today’s S&P 500 or testing the S&P 500 data that actually existed for the years of your testing?

Does your data account for splits, dividends, and any other adjustments?

If you are trading currencies, do you have 24-hour data? For how far back? If you are trading futures, do you have continuous contracts?

What happens if there are errors in the data you are testing or, worse, errors in the data you are trading? What’s your plan?

Research

What beliefs do you have about conducting ongoing research? Look at the systems you are happy with, and determine how well they will work in the six market conditions. Do you have something that will work well under each condition? If you do not, what’s your plan for developing something, or are there certain conditions in which you just will go to cash?

Operations

How will you run the business? What equipment is necessary for your business? How will you make sure that everything works? Do you have other responsibilities, and if so, how will you coordinate them with your business operations? What will you do if anything critical goes wrong with any key aspect of the business? These are a few of the many questions that should be answered in the operations section of your business plan.

Organization and Management

What kind of organization will you elect to use for your business? Sole proprietor? Corporation? Limited partnership with a C corporation as a general partner? Will you elect to have trader status on next year’s tax return? How will it all work?

In addition, will you do it all yourself or will you have employees? It’s difficult to become infinitely wealthy trading on your own because you still have a lot of work to do. However, if you can design trading systems that your employees can run for you, that’s another story.

The Four Quadrants

I probably did 15 seminars with Tom Basso (who was featured in The New Market Wizards by Jack Schwager) in the early 1990s. We also talked endlessly over meals, and I interviewed Tom twice in my monthly newsletter. During that time, one statement that Tom repeated was this: “I’m a businessman first and a trader second.” His businesslike approach was always the key to his success, and I’d like to explore that approach in detail in this section because the quadrant you operate on in business also will apply to the way you operate as a trader.

In the late 1990s, I also did several Infinite Wealth workshops with Robert Kiyosaki, and so I became very familiar with his thinking. In their book The Cashflow Quadrant4 Robert Kiyosaki and Sharon Lechter explore four types of people. These types are separated by their cash flow patterns. People on the left side of the quadrant—the employee and the self-employed person—work for money. People on the right side of the quadrant—the business owner and the investor—have money working for them. The four quadrants are fascinating because they also perfectly describe various types of traders. The most successful traders are going to be on the right side of the quadrant.

The Employee Trader Works for the System

If you work at a job (which just happens to be trading) and get paid a salary for doing it, you are an employee trader. Kiyosaki doesn’t really define the word system in his book despite using it extensively. However, he gives many examples of systems. For example, the Marine Corps has a system that allows Marines to accomplish their objectives with a minimum loss of life. Soldiers either follow the system or die. Similarly, as I mentioned previously, McDonald’s has many systems. Each franchise runs on hundreds of systems, and that is why McDonald’s is successful. Employees follow the system or (1) the franchise folds or (2) the employees are fired.

Thus, remember that employee traders work for systems; they don’t necessarily understand the systems. I believe this is the key to why they are not necessarily good traders.

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The Employee Trader Works for the System

Bank traders, corporate traders, some mutual fund managers, and even people who have a job and just happen to trade on the side are good examples of employee traders. These people are motivated by security and good benefits. Thus, a top bank trader might make $50 million for the bank. However, she doesn’t make that money; the bank makes the money. This trader simply takes a salary and probably gets a bonus for doing well.

Employee traders work at a job. They get paid with a salary, which is taxed before it is given to them. They work to get paid, which is their primary motivation. They would like to get paid more by doing better-quality work, but their primary thinking is that if I do X, I’ll get paid. For them, the “security” of their “salary” and their “benefits” are more important than the “money.”

I once considered working with the forex traders of a large New York bank. The treasurer gave me a good idea of what I was in for when he made the following statement: “I don’t want any of our traders making over 20%. If they make over 20%, they could lose over 20%. Furthermore, they’d want huge bonuses, and then they’d be making more money than I make.” Even though this man was a key person in the bank, he was still an employee and had an employee mentality.

I’ve noticed that the worst traders I work with are typically employee traders. They know the least about trading, and they generally make very poor traders. Furthermore, people who have an employee mentality and a full-time job (that is, they are into security and benefits) also make poor traders when they try to do it as a vocation. For example, most people consider stockbrokers to be traders. However, stockbrokers are really employees (to the extent that they receive a salary) who are paid to sell stocks. They are self-employed (see the next category) to the extent that they depend on commissions.

When employee traders approach trading, they usually bring the employee mentality into play. They want to be told what stocks to buy or what the market is going to do. They are used to being told what to do, and they abhor making mistakes. Bank trading rooms, for example, usually hold daily meetings in which the employees are told what they should be doing during the day. Furthermore, they are told that they have to trade (even if there are no good ideas) because that is their job. That’s the employee mentality, and it doesn’t fit into good trading.

The Self-Employed Trader Is the System

The self-employed trader is someone who has quit his or her job to be independent through trading. These traders do not like to have their income be dependent on others. Instead, they want to rely on their own hard work. They want to control the situation and do it on their own. Most of the traders I work with have this sort of mentality in regard to trading.

The self-employed trader is quite often a perfectionist. Everything has to be perfect—these traders will settle for nothing less. Thus, they need a perfect trading system and are always searching for something better. They are also likely to be into discretionary trading because a mechanical system cannot do it as well as they can.

Most self-employed traders are usually off searching for ultimate control, looking for a Holy Grail system that perfectly predicts market tops and bottoms. The results are usually very unsuccessful. When self-employed traders are taught principles such as expectancy, trading for large R multiples, and position sizing strategies, they have a chance to become very successful.

The successful ones usually realize that they have limited capital and thus start to manage other people’s money. When one starts to do that, many other systems come into play besides the trading system. Self-employed traders usually insist on doing everything themselves and subsequently run into severe limitations in terms of time and know-how, and they experience much frustration. The result is usually failure. Most people who attempt to be professional money managers approach it from the self-employed perspective.

Are you in one of these two quadrants? How about the people advising you? Are they in one of these two quadrants? Now let’s look at the two quadrants on the right side.

The Business-Owner Trader Owns and Develops the Systems

Let’s look at the people who take the next step: they treat their trading business as a group of systems. They make those systems as automatic as possible and then train other people to run them. You cannot be a perfectionist and develop automatic systems. However, you can develop such systems and free yourself.

Let me give you two examples. The business-owner traders I have met are total systems traders. Everything is computerized. Data come in, computers process the data, and orders are sent for execution automatically. These traders constantly look for ways to make everything automatic. If a task is repetitive, they computerize it to eliminate the need for a human being. The result is that the business-owner trader can leave the business in the hands of someone else and do other things. These traders know the systems will work because they have developed them. The systems might not be perfect. They might not make huge returns, but they work consistently within the parameters for which they were designed. Furthermore, business-owner traders also have systems in place for getting new funds, dealing with clients, managing the back office, and doing research on ongoing systems. When an employee leaves, they can train someone else to run the system that was handled by that employee.

There are several steps to becoming a business-owner trader. The first step is to be able to develop or purchase all the systems needed to run the business. As an example, the business owner would know that position sizing strategies are a key portion of a trading business and have a system to account for that. He or she also would have systems in place to manage the research, the data, the back office accounting, and the other people who are involved—all the things we’ve talked about in this part of the book.

Once their systems are in place, business-owner traders must find employees to run the systems. This requires good leadership skills. A businessperson will own the system and hire good people to run it. Thus, the business ends up generating money for the trader without requiring the trader’s time. The business and its employees work for the trader.

The Investor/Trader Invests in Systems

Traders become investors when they invest in systems that give them a good return on their capital without requiring additional work. For example, if you read Warren Buffett’s criteria for investing in a business in my book Trade Your Way to Financial Freedom, you’ll find that a key criterion for him is investing in businesses with good systems that produce a high rate of return on the owners’ equity. Once such things are found, no additional work is required. The money just rolls in from the investment. The trader/investor has money working for him or her.

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