Interview with Trading Psychologist Van K. Tharp

August/September 1996
Page 24

The Trading Mentality
An Interview With Trading Psychologist Van K. Tharp

It seemed inconceivable that a single trader could be the downfall of a British institution. Or close down a major brokerage firm. Or put a large county into severe financial straits. Rogue traders have been at the heart of the losses at Barings Bank, Kidder Peabody, Orange County and, most recently, Sumitomo. Questions are raised about the supervision of these traders. How do you properly supervise the activities of someone who is so important to your bottom line? Futures Industry editor Mary Ann Burns interviewed Van K. Tharp, Ph.D. to find out what he experienced in working with traders and institutions. Over the last 12 years, he has collected profiles on more than 4,000 investors and traders. Tharp has consulted with various banks and companies around the world and is the only psychologist featured in Jack Schwagers Market Wizards.

Burns: Before we talk about the relationship between traders and management, lets talk about what makes a good trader.
Tharp: I find that some of the best traders are "thinkers" as opposed to "feelers." They can see the big picture. Also, their self-esteem, needs to be fairly good because if its not, their egos get all tied up in what they are doing. They should be very much a non-conformist - willing to decide heres my idea, I know it works, this is what Im going to do and I dont care what anybody else around here is doing. They also should have strong math skills.

Burns: What about honesty and integrity?
Tharp: It needs to be very strong. You could measure it with very subtle questioning by putting them in various situations and finding out how they would respond. I know people who evaluate traders by playing golf with them. How a person approaches the games says a lot - their whole attitude towards the game, whether they lied about their score, whether they want to take another shot.

Burns: What type of people would you avoid?
Tharp: Those people who really get caught up in excitement. Its a fairly large percentage of the population. Also, anybody with a big ego who is afraid to look bad and anybody who is very poor at math. Those would be the key danger signals.

Burns: What are some basic tenets of trading?
Tharp: Ill tell you what goes wrong and turn that into a positive. First, people dont begin with specific objectives. Most people approach the markets and they dont have a clue what theyre trying to do. The first rule is to decide what youre trying to accomplish. Thats your business plan.

Burns: What should be in the business plan?
Tharp: In terms of risk, every trader should have a business plan and have specific guidelines in that business plan. The manager should monitor compliance with the business plan. The trader would develop the business plan himself and it would be approved by management. The business plan should have things like what are the worst possible things that could happen and how are you going to deal with it when it happens? Whats your idea on how the market works? Whats your edge? How are you going to get that edge? How are you going to make sure that no disasters any worse than this occur? Whats your long-term expectancy? How can you make sure you can survive the worst possible consequences in the short-term so you can achieve that?

Burns: What is the next rule of trading?
Tharp: The second rule is that your trading system should have a positive expectancy and you should understand what that means. The natural bias that most people have is to go for high probability systems with high reliability. We all re given this bias that you need to be right. Were taught at school that 94 percent or better is an A and 70 or below is failure. Nothing below 70 is acceptable. Everyone is looking for high reliability entry systems, but its expectancy that is the key. And the real key to expectancy is how you get out of the markets not how you get in. How you take profits and how you get out of a bad position to protect your assets. The expectancy is really the amount youll make on the average per dollar risked. If you have a methodology that makes you 50 cents or better per dollar risked, thats superb. Most people dont. That means if you risk $1,000 that youll make on the average $500 for every trade - thats averaging winners and losers together.

Burns: What about risk controls?
Tharp: Once you have a positive expectancy, money management is the key. Its the difference between the ho-hum system and the holy grail. If you want a high reward to risk ratio thats accomplished a whole different way than if you want high rates of return. When youre trading other peoples money, you typically want a high reward to risk ratio, which means lots of diversification and very low risk levels. If you want high rates of return, then you risk a lot more, but you get big drawdowns as well. If you have a 50 percent loss, you have to have a 100 percent gain to get back to zero. All of those three elements are psychological, but the fourth one that is really key is the discipline to carry it all out and to keep emotions out of the way.

Burns: Do these rules also apply to institutions?
Tharp: Institutions should set their own objectives. If theyre going to have traders trading their money, they should figure out exactly what they want them to do and design the money management parameters accordingly. The average institutional trader is put on a desk and told to trade. Hes expected to trade all the time and to make money. Most traders get an edge because they are making markets, but when they actually try to do some position trading they dont understand what their edge is.

Burns: What else?
Tharp: Institutions need a thorough understanding of risk. My definition of risk is how much youre willing to lose on any given day or in any week. They also need to have a thorough understanding of money management and how objectives get produced through money management. An institution needs a good bonus program. Traders also need a low stress environment, which means there is no pressure to conform to the group. Theres no pressure to always have a trade on. Traders should be able to take time off during the day if they need it.

Burns: What goes wrong?
Tharp: Traders arent always given good risk guidelines. They dont know how much money they are trading. Some of them have a loss limit that says if you lose more than this amount you have to stop trading or you are likely to be fired. There can be interference even when traders are doing well. For instance, they are expected to have a position everyday as if there is opportunity every day. If they have a winning position, not all institutions understand that you let your profits run. The manager wants to know "why arent you taking your profits now?"

Burns: What are the characteristics of a rogue trader?
Tharp: Basically, youre looking at the point where a trader is in a loss trap. Hes afraid to take a loss, the loss gets bigger and then its even harder to take until the loss gets big enough he has to take it. But if he has the deep pockets of an institution that can be very big. Im guessing its a combination of initially the big ego, then covering up a mistake and treating that as a loss hes unwilling to take which gets bigger and bigger. Then the behavior becomes desperation. Management is often neglecting them because they are doing so well and "dont need as much supervision."

Burns: What makes a good manger of traders?
Tharp: A good manger needs to act as a coach understanding risk and putting the team first ahead of himself or herself. Thats very difficult when youre the biggest trader on the team and you get paid your bonuses, too. Compensation needs to be organized in such a way that the manger is awarded for the team performance as opposed to his own performance.

Burns: What do you do when a trader goes astray?
Tharp: Well say youve got everything in place and somebody is not doing well. In that case, its probably due to some very strong personal and emotional problems. It could be marital problems or a death in the family. Emotional problems are interfering with trading. At the minimum, the trader needs a vacation, but he may also need counseling. The ideal situation would be to have a coach who could help deal with these problems.

Burns: What is the appropriate response to losses?
Tharp: If you look at an example from Jack Schwagers new book on managed futures, one of the things he talks about is a natural bias that people have to find a hot manager. That means even if you put your money with a superb trader, youre probably going to lose money. What youll end up doing is investing heavily in them at the top of their equity curve and taking your money away at the bottom of the equity curve. That can happen in institutions. Assuming you have a normal trader, the person goes down in the equity curve, then they put all kinds of restrictions on their trading. If they do well enough for a while, they double their equity or the amount of money they are willing to tolerate them losing. If you have a reasonable approach to money, allow people to have their own accounts to grow, but have a certain amount of diversification where to a certain extent you take away from the ones who have done well and give to the ones who havent done well, its amazing how well that could work.