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Tuesday, September 19, 2017

Paradigm Shifts, Part II — Trading Success by Van K. Tharp Ph.D.

Feature Article
Paradigm Shifts, Part II — Trading Success
by Van K. Tharp Ph.D.

In this three part series, I will explore the idea of major shifts in your thinking and your mental maps of the world. One of the steps to making big changes in your life is to make paradigm shifts — or shifts in your lateral thinking. This means to get out of the box you are in (your perceptual limitations from your current perspectives) and determine what is possible from other perspectives. If you understand the power of paradigm shifts, you can begin to understand what it is to be a genius. You can accomplish what seems like miracles.

In part one we explored six major paradigm shifts that most people must make to gain real wealth. Through paradigm shifts, you can begin to understand what it is to be a genius. You can create money out of nothing. You can accomplish what seems like miracles. In this week's article we'll explore five paradigm shifts specifically related to trading covered in my first book, Trade Your Way to Financial-Freedom. In the next article, we'll explore some techniques that you can use to make your own paradigm shifts.

Trading Paradigm Shifts

Many years ago, I taught Infinite Wealth Workshops but they were very different in structure and content than the one I teach now. The old version covered a lot of financial strategies to attain wealth. Abundance, however, is an internal state and external wealth flows out of that internal state. Without the proper mindset, the best financial strategies in the world are worthless. The new workshop version (I’m teaching it in London in October) focuses much more on understanding the wealth mindset and working on your inner self — being wealthy inside first so that then you can effectively use financial strategies that fit you to achieve infinite wealth. (Infinite wealth does not mean numerous and luxurious possessions but rather having your monthly expenses taken care of by your passive income.)

At an Infinite Wealth Workshop which happened shortly after my first book Trade Your Way to Financial-Freedom was published, I spontaneously started talking about paradigm shifts in the book. Before that, I had never thought about the book including any paradigm shifts but suddenly all of this information about shifts that traders needed to make was pouring out of my mouth. I remarked at the workshop that the book explained four major paradigm shifts. I have no idea where that number came from but I was able to elucidate them very well. After being totally amazed by this discovery, I decided to spend some time thinking about what I had said.

Since that time and with considerable thought, I came up with additional shifts but for today's article, here are the five major paradigm shifts most traders and investors need to make:

1) Trading success has very little to do with what's outside of you such as what the market does. Instead, you must determine who you are and what your objectives are. Once you have done that, you can design a trading system that fits you and that performs very well.

Most people believe that trading success has to do with the markets, indicators, analysis, or finding some magical edge that will help them perform slightly better than their competitors. This is totally wrong! Instead, trading success is an inner search. Success in the markets has to do with finding yourself. Who are you and whom do you choose to be? When you've answered those questions, you can then decide how to express the new you through the markets. This decision, however, is a major one. Most people give it no credence. Even when they are aware of it, they give it no time at all. This is the first step and without it, you cannot climb the ladder of trading success. It supports everything else.

2) There is no Holy Grail in the markets (outside of you). But there is a Holy Grail — it is inside. When you understand this, you can do much more than outperform the majority of market players. Instead, you can achieve levels of performance that others might think is impossible.

Academic psychology is full of people who study the shortfalls of average traders and these academics have done marvelous research. Perhaps by studying human frailties, economists have come to believe they can predict how the markets will perform because they are not efficient. Thus, the field of behavioral finance was born.

I consider myself to be a student of behavioral finance also but I believe I am one of the few people who helps traders really apply it. Applying behavioral finance doesn't mean predicting inefficiencies in the market, however, it means working on yourself to make sure those inefficiencies have no effect on your trading. That is too much of a major shift for most people who are into what the markets are doing and have not mastered this paradigm shift. When I talk about traders being able to make consistent 50-100% returns (or more) with little risk, people who believe “It is all outside of us” think those kinds of returns are just impossible

3) You don't have to predict the market to make money. Instead, making money comes from your exits.

This idea can stimulate an argument in many of my students — even those who have read Trade Your Way to Financial-Freedom several times and think they understand it. I'm not going to discuss this extensively because I've done so many, many times. The golden rule of trading is "Let your profits run and cut your losses short." What does that have to do with prediction? Absolutely nothing. Instead, it has everything to do with getting out of the markets using a systematic plan. Enough said!

The next paradigm shift is simply an elaboration of the third.

4) You don't have to be right to make money. Instead, you must understand R-multiples, expectancy and opportunity.

Once again, I'm going to be brief on this. Suppose you enter a rising stock but get stopped out at your -1R point, say $1 below your entry price. You've lost a dollar per share or -1R. Suppose this happens five more times. Now you've had six -1R losses. On the seventh trade, the stock takes off and you ride it for a $30 gain. That's a +30R profit. You had seven trades, six -1R losses and one +30R profit for a net gain of +24R. Let's say that your transaction costs amount to 0.5R per trade so for the seven trades, we must subtract another 3.5R. Even now, you still have a total profit of +20.5R. If that's your average for every seven trades, how much would you make if you placed 21 trades each month? You'd have a profit of +63R for the month — even though you were “right” on about only 14% of your trades.

If you have not made this paradigm shift yet, you'll probably find all sorts of reasons to refute the logic of this example. I've heard them all. They all come from people who were having trouble with the paradigm shift and needed to defend their position.

5) Making big money does not come from factors where most investors and traders focus their attention. Instead, large returns come from designing and using a position sizing strategy that meets your objectives.

Let's use the results from the example in the previous point. Suppose you risked 0.5% of your equity on every trade. After six losers in a row, your equity would be down about 3%. After your +30R win, however, your equity would be up about 12%. Further, if you made 21 trades per month with those kind of results, (even assuming huge transaction costs of 0.5R or 0.5% of your portfolio per trade), you'd be up over 30% in a single month.

If you could do that for say nine months in a year with small drawdowns in the other three months, your equity would be up hundreds of percent for the year. Now do you understand how some of our day trading clients can make those kinds of returns?

Let's assume for a moment, however, that getting three +30R trades a month is improbable — but that averaging three +15R trades every month could be realistic. Eighteen -1R trades and three +15R trades would still give you a net profit of +27R per month. That scenario makes you a 13.5% return a month risking 0.5% of your equity per trade. Let's add in the previously mentioned unrealistically high transaction costs. You would net a return of +16.5R per month — or 99% on the year. Again, you make that kind of money being right only 14% of the time and risking no more than 0.5% of your equity per trade.

If you haven't made this final paradigm shift, you'll find lots of flaws and you’ll also find logic to support your position. That's okay — it doesn’t bother the people who regularly make big profits while giving up the need to be “right”.

Getting Outside of Your Box

While my purpose in writing this article has simply been to get you to think in new ways about your trading and step outside of your current perspective, I've only scratched the surface on the paradigm shifts that most of you could make. If you would like to explore more paradigm shifts (beyond those covered in this article), there are probably at least five major ones in each of the five volumes of my Peak Performance Home Study Course.

In the third and final article for this series, we’ll look at how you can produce your own paradigm shifts.

About the Author: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp

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