Page 1 of 18

Van Tharp Institute

How to Develop a Winning Trading System That Fits

You Workshop

Handout for the recording of The Overview of the Systems Development

Process

Complete by July 17, 2021

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 2 of 18

Overview of The System Development

Process

Objectives

1. To help you understand the role of systems in a business and the specific roles of

trading systems in your trading business.

2. To introduce the tasks of system development.

3. To identify the ten possible parts of a system—many of which most people neglect.

4. To help you understand that a system that fits you is one that fits your beliefs.

5. To give you the TBTM Format for assessing a system you wish to trade.

6. To help you understand the criteria that might be important for you to be comfortable enough to trade a system. You must understand that your comfort for trading a system is a psychological variable and if you ignore psychology, you may never be comfortable with trading any system.

7. To introduce you to the various concepts that you can use to develop your systems.

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 3 of 18

Levels of Systems in Business Merriam-Webster provides several definitions for system:

• A regularly interacting or interdependent group of items forming a unified whole

• An organized or established procedure • A harmonious arrangement or pattern

McDonald’s doesn’t make the best hamburgers in the world, but they make a lot of money by selling billions of good enough hamburgers and controlling billions of dollars in real estate. From how many pickle slices go on a burger to opening a new location, they use many levels of systems to run their successful business. Levels of systems you might need in your trading business: 1. System for Managing R Multiple Quality (Expectancy, Variation, Frequency) 2. System for Managing Risk (Position Sizing Strategies) 3. System for Playing the Game (you vs. the market or your results versus your investors) In this workshop, we help you with the first three, Blueprint covers the rest- 4. System for Dealing with Back office 5. System for Dealing with Clients 6. System for Dealing with Information 7. System for Accounting 8. System for Marketing Your Performance 9. System for Legal Compliance (for Money Manager) 10. System for Psychological Maintenance 11. System for Dealing with Disaster

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 4 of 18

Traders versus Systems (Based on Kiyosaki’s Cash Flow Quadrant)

The Employee Trader: (Bank Trader, Employee Who Trades for Himself on the Side) • Works for the system. • Wants to be told what to do. • Doesn’t necessarily understand the system. • Motivated by security and fear. The Self-Employed Trader: (Person Who Trades Full-Time for Himself; Self-Employed People Who Trade for Themselves) • These people are the system. • They must do it themselves because they are the best. • Want to be discretionary because they are the system. • Motivated by perfectionism (being right). The Business Owner Trader: (Owns Trading Systems and Has Employees or Computers Who Run Them) • These people OWN the system. • Tom Basso would be good example. (I am a business man first and a trader

second. My job is to automate everything.) • These people can walk away for a year, and should be better off as a result.

The Investor/Trader: • These people invest in systems or in other traders with proven track records. • They are looking for rates of return. Cop

yrigh

t (c) 2

021 V

an Tha

rp Ins

titute

Page 5 of 18

A trading system is a tactical plan with the framework of one or more strategies of your business plan. Ken Long uses this chart to help clarify the role and placement of trading systems within his business. He refers to trading systems here as “Trading Strategy.”

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 6 of 18

Trading System Definitions Revisited A. (1) A set of belief-based rules that fits you for entering and exiting the market (2) that generates a distribution of R-multiples for which (3) a position sizing algorithm is applied that is (4) designed to meet your objectives. For a system to fit you, it must meet the following criteria:

1) It must fit who you are and you must know who you are. 2) It must fit your beliefs for each part of a system. 3) It must have a position sizing algorithm that is designed to meet your objectives, and, of course,

you must have detailed objectives. 4) It must fit within your business plan and your perception of the big picture.

And . . . 5) You must feel comfortable trading it, which means you also need to know your criteria for

feeling comfortable. B. A sample of R-multiples generated by a rule set characterized by the expectancy (mean), standard deviation, and the number of trades. C. A system is a way of generating trades based upon your beliefs, which gives you at minimum…

an entry, a way to define your initial risk, an exit, and a position sizing algorithm designed to help you meet your objectives.

D. A system is a set of beliefs that tells you when to buy and sell. And that system works (1) if it gives you a positive expectancy (that’s at least 20% of its standard deviation), (2) if it generates enough trades, and (3) if it uses a position sizing strategy that allows you to survive the worse possible drawdowns in the short run so that you can achieve its expectancy in the long run. E. A set of trading rules developed for the primary purpose of making it easier for you to achieve your objectives through your position sizing strategies A system is NOT… • A way to pick stocks. • An entry signal. • A way to help you be right.

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 7 of 18

A Summary of Trading System Parts There are multiple parts to a good trading system. Typically, if you do not consider all of these parts, your system may have some weaknesses.

1. Beliefs: Why the system works and why it fits me.

2. Market Selection: Is this a market I want to trade?

3. Market Type/Direction: What direction is the market moving, if any, and how is it moving? Together, 4, 5, and 6 define what 1R means for this system.

4. Setup: Under what conditions will I enter/exit? (The best setups are usually something other than price. For example, everything in the CANSLIM model of William O’Neil is basically a setup.)

5. Market Timing or Entry: When, or under what conditions, should I open a position?

6. Protective Stop: How will I know when to get out to preserve capital?

7. Re-entry: Will I get back in to a trade if I'm stopped out of a good move? If so, how?

8. Taking Profits: Under what conditions will I take my profits?

9. Position Sizing Strategies: The part of my system that tells me “how much” throughout the trade.

10. Portfolio Selection: What kind of basket of commodities or stocks or other investments do I want to trade?

11. Multiple Systems: In order to smooth my equity curve, do I want to trade multiple systems concurrently?

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 8 of 18

The Trading System Development Model NLP Modeling • Find good models

• Who does the tasks well and what do they do? • What do they believe/do/have in common? • Determine Resources

• Beliefs – judgments, categorizations, meanings or comparisons. What you expect depends upon your beliefs – most of which are unconscious. They are filters that shape your reality

• Mental States – The condition of your mind. What most people refer to as

discipline or emotional control. Each step of trading has an optimal mental state, for example – patience for stalking and total commitment for entry.

• Mental Strategies – These are the sequence of perceptions and thoughts that

determine actions and outcomes. There is an optimal mental strategy for each task of trading. For example, here is an optimal mental strategy for several tasks of trading –

See the signal ↓

Recognize it is familiar ↓

Feel good about it ↓

Take Action

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 9 of 18

The Tasks of Trading System Development Task 1: Take an Inventory and Determine Who You Are. This is not a trivial question. Indeed it may relate to your purpose in life. I’d strongly recommend that you at least go through the Peak Performance Home Study Course with the idea of determining who you are and your mission. Van’s Super Traders typically spend about one year of their program on this phase alone. Task 2: Determine Your Mission Relates to Who I am!

What Is My Mission? (Hint – where do you find bliss?) Task 3: Develop an Open Mind/ Creativity

Read/Discuss/Let Your Mind Wander

Recommended: Market Wizards by Jack Schwager The New Market Wizards by Jack Schwager Stock Market Wizards by Jack Schwager Computer Analysis of the Futures Market by C. LeBeau and D. Lucas Dr. Van Tharp's Peak Performance Course Dr. Van Tharp’s Definitive Guide to Position Sizing Strategies Smarter Trading by Perry Kaufman Several books related to the concept and time frame you want to trade.

Does what you read match your inventory?

Write down all your beliefs about the market and then run those beliefs through the belief examination process –

Where did that belief come from? (who or when or where?) What does that belief get me into? What does that belief get me out of? Is it useful?

Cop

yrigh

t (c) 2

021 V

an Tha

rp Ins

titute

Page 10 of 18

Task 4: Determine Your Objectives Business Level Trading Objectives – What do you want from your trading business? (Used to determine position sizing strategies.) 1. What’s the worst % peak to trough drawdown in my equity that I will tolerate at

the end of my trading period and at what probability? (It would be helpful to understand your drawdown in R multiple terms as well.)

2. For how long am I willing to endure a drawdown in my equity? 3. What type of gain for my equity do I expect at the end of my trading period and

at what probability? 4. What is my trading capacity? (How many systems, positions, dollars, hours, and

clients will you be able to effectively manage?) Trading System Level Objectives - What do you want from each system? 1. What types of market(s) do I want my system to work in? (volatile up-trending;

non-volatile up- trending; flat volatile; flat trending; volatile down-trending; non-volatile down-trending)

2. What kind of R-multiple distribution do I expect to have?

a. What’s the expectancy? b. What’s the SQN? c. What’s the winning/losing trade percentage? d. What are the largest, smallest, and most likely R multiples? e. What max R multiple drawdown will it have?

3. How many trades do I expect to make each day? Week? Month? Year? 4. How much equity will I be trading? 5. What time frame do I want to trade?

a. Long time frames have less work; less randomness; lower reliability due to costs; and less psychological strain.

b. Short time frames have more work, more randomness; more

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 11 of 18

psychological strain; but the potential for huge gains and fewer losing months.

6. Is reliability more important to me or is capturing huge moves more important?

a. Objectives are 50% of developing a trading system. That’s part of the reason we asked you to work on this area before you arrived. You just saw the effect of objectives in the results of the first trading game simulation.

b. For your objectives to be meaningful and for you to commit to them, your objectives must fit who you believe you are and fit your mission—they must be connected to your core.

Task 5: Determine the Big Picture and Market Type How will you monitor the big picture and how will you know when it changes? Equally important - What’s the market type and do you have a system(s) designed to work in this market type. How will you know when the market type changes? The first question is macroeconomics, and the second question is technical. Your strategies will need to fit your big picture. Task 6: Determine the best historical moves within the time frame that your system will operate. For example, find out the bandwidth distance for a band system or find out rise/fall after a 40 day breakout for a trend system. Task 7: Determine what those moves have in common and how to trade or participate in each of them. • What concept you are observing? • What are the commonalities among the moves? • Can you figure out a new, creative way to observe these markets? • Can you use statistics and game theory to determine probabilities you can use? Task 8: Determine your setup, entry, and initial stop.

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 12 of 18

Determine the reliability of your setup/entry combination after 5, 10, 20 time periods that you might trade in. Is it consistently profitable? Determine your initial stop point. At what point can you tell with some consistency that the trade is going to be a loss. These trading system parts (as well as all the other system parts) are based upon your beliefs about the market. Identify -

• Your beliefs about setup. • Your beliefs about entry. • Your beliefs about initial stop. • Your beliefs about 1R.

Task 11: Test your ideas by eyeballing all markets for a long period of

time. Estimate rate of -1R trades. Estimate if reward to risk parameters are acceptable. Tom Basso said:

“If you understand in great detail the philosophy and detail of what you are trying to do, then little testing is necessary. However, there is never enough data to test. Create other mental scenarios in your mind. The more imagination you've got, the less data you require.”

Task 12: Generate a sample of live trade results. Generate at least 50 (preferably 100) R-multiples with live trades (using small positions) for your system and determine the mean and standard deviation. What is the ratio of the two? If it’s greater than 0.25 you can probably trade it. If it’s greater than 0.40, then it’s probably very good. Calculate the SQN score for your sample. If it’s unacceptable, then go back to task 5. Task 13: Craft and execute in a position sizing strategy.

• The objective of your position sizing strategy is to help you help you meet your

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 13 of 18

trading level objectives.

• The SQN score helps you determine how easy it will be to use position sizing strategies to help you meet your objectives.

• The two inputs for your position sizing strategy are you trading level objectives and your trading system performance.

• See the position sizing section (Day 3) of this workbook for more details. Test results over multiple markets to determine expected profit range each year and maximum drawdown. If unacceptable, go back to an earlier task. Task 14: Determine how you can improve the system. • Does it meet your objectives? • What can you do to improve it? • What don’t you like about it? Answers to these questions are strongly dependent upon your beliefs about what criteria must be satisfied in order to be comfortable trading the system. Task 15: Do some worst-case scenario mental planning. Consider what could happen to: you or your family, to your broker, to your environment, to you equipment, to laws and regulations that affect trading, to the markets, to your systems, and to your psychology. How would you respond to mild and extreme crises in these areas? You can think about those now in a low stress environment so that when the event occurs and generates related stress, you have already thought it through and have a reference document to think through your responses.

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 14 of 18

Note – Even if you choose not to write

a full-blown business plan,

you should invest the time and effort

into writing a worst-case contingency plan.

IT’S THAT IMPORTANT!!

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 15 of 18

Trading Concepts that Tend to Work 1) Trend Following: Markets tend to trend and I can make money by jumping on the trend. 2) Band Trading: Market will only go so far until they reverse, so I want to buy when they are “oversold” and sell when they are “overbought.” 3) Chart Patterns: Price movements tend to move in patterned behaviors which can be learned. 4) Value Trading/Fundamentals (depending upon how it is defined): When I buy something that is undervalued and have the patience to wait, I will be rewarded. How do I define value? 5) Spread Trading/Arbitrage: There are relationships that I can exploit to make money. 6) There is “An Order to the Universe”: I understand and apply most of the principles taught at this workshop. (However, none of these principles work the way they are normally applied.) Seasonal Fibonacci

Gann and magic numbers Delta Elliot Wave 7) Intermarket Analysis: This involves understanding that we are in a global economy in which many markets are inter-related. I want to trade the dollar and the Euro pair, and I understand the effect of the Aussie dollar, the Japanese Yen, the British pound, the gold market, the oil market etc. all have on the overall picture. 8) Mental Scenario Trading: If I understand the big picture, the relationship between what is going on in the world and how things work, and can observe and measure what is actually happening now, then I can find good profit opportunities. (Very discretionary strategy.)

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 16 of 18

Key Questions to Ask About Your Commitment to the Trading System Development Process

1. Do you have a business plan to guide your trading?

2. Do you have an understanding of the big picture and a way to monitor it?

3. Do you understand market types and know how to measure them in a way that fits

you? (You could have anywhere from three to twenty market types in your classification system)

% Volatile Normal Quiet

Bull 6.78% 23.88% 23.95% 54.61%

Neutral 4.11% 9.38% 5.89% 19.38%

Bear 12.83% 9.33% 3.85% 26.01% 23.72% 42.59% 33.69% 100.00%

4. Do you understand how each of your trading systems will function in each type of market?

5. Do you understand that it is easy to develop a Holy Grail system for any one type of market, but impossible to make one system work well in all sorts of markets?

6. So do you have a combination of systems that will allow you to make money in each market type?

7. Have you collected (or even estimated?) R-multiples for each type of market for your system and analyzed your systems’ performance in each market type?

8. Do you have objectives for your trading and for each system? Do you understand that it is through position sizing strategies that you meet your objectives?

9. Do you have a position sizing algorithm for each system to help you achieve your objectives?

10. Have you tracked your mistakes and measured them in terms of R-multiples? Do you understand the impact that your mistakes have on your trading?

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 17 of 18

11. Do you know what produces your mistakes?

12. Do you spend enough time working on yourself to minimize the impact of

mistakes? It’s important for you to understand each of these elements in order to understand how to do system development/research.

What thoughts, feelings, and emotions come up for you reading through these 12 questions?

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te

Page 18 of 18

We do three workshops that are all critical to developing a system that fits you. Peak Performance 101. This workshop deals with the “you” factor and helps you deal with some of the psychological issues that get in the way of system development. Ask yourself the following question: How can you develop a system that fits you if you don’t understand you? If your belief is that you’ll handle all your psychological issues by just developing the right system, you’ll find that all those issues will come up in system design. Blueprint for Trading Success. This workshop deals with the three key factors in treating trading as a business:

1. Developing a Business Guidebook that guide all aspects of your trading business 2. Developing Strategies or Systems to Fit Your Business Plan 3. Developing Ongoing Methods to Work on Yourself as the Key Factor in Your

Trading This workshop is important in order for you to see the total picture of what you need to do to 1) treat trading like a business, 2) be successful in your trading business and 3) so that you can answer important questions that will arise as you move forward. How to Develop a Winning Trading System that Fits You. You are here.

Copyri

ght (c

) 202

1 Van

Tharp

Institu

te