Tharp is a trading psychologist and the author of one of the best books ever written about making money in the markets, Trade Your Way to Financial Freedom. His key insight into trading is that position sizing as a way to control risk is critical to success.

Tharp used a measurement called Advanced True Range (ATR) to analyze market volatility since 1969. ATR is a way of measuring the degree of price movement of securities developed by J Welles Wilder and introduced in Wilder’s seminal 1978 book on trading, New Concepts in Technical Trading Systems.

By calculating the ATR as a percentage of the close of the S&P 500 index, Tharp reveals that the top 10 most volatile days for stocks in the last 30 years all occurred in October of last year. And that the period from March 3, 2009, to March 12, 2009, the beginning of the current rally, was one of the most volatile periods in history.

Why is this important? Well, as Tharp says, “recent volatility has been off the charts.” And every period of extreme volatility, with the exception of the March 2009 period, are associated with stock market collapses. (The top four most volatile periods since 1969 were October 9 2008 to November 7 2008; October 19 1987 to November 17 1987; July 22 2002 to August 9 2002; and September 27 1974 to November 4 1974.)

In other words, there’s a strong historical relationship between extreme volatility and bear markets – except in the case of the current rally in stocks. As readers know, we are deeply suspicious of the drivers of this rally. And Tharp’s work makes us even more so.

This doesn’t mean there’s not money to be made for nimble investors. But given that May’s volatility levels (as measured by ATR% close values) are still highly volatile, trend following, even on the short side, is unlikely to yield favorable results… unless you are able to withstand large whipsaw actions against you.

Tharp says one of the best ways to trade the market right now is an options strategy “that captures premiums with very little risk.” This is a highly advanced trading strategy. And you need Level 3 clearance from your broker to execute it. But once you get this clearance the results can be nothing short of stunning. Notes contributor and market “geek” Charles Delvalle scored a 100% win rate with this strategy last year.  He calls it the “payout method,” because you literally get instant payouts to your account every month by capturing options premiums.

The average payout during the “alpha trial” phase was $2,504. Charles is looking for 365 more beta testers for highly lucrative strategy. If you’re interested in receiving these payouts in return for beta testing the strategy, follow this link to learn more. (Please act fast, as the next payout is due on June 19.)

Position sizing is what matters, says Brian Hunt, editor in chief of Stansberry Research in yesterday’s Growth Stock Wire. Trading psychologist Dr Van Tharp says its how “great traders manage their money.”

Smart position sizing is easy: never risk more than 2% of your capital on any one trade.

That’s it. We told you it wasn’t complicated. But would be surprised how few traders and investors actually follow this rule.

Here’s how it works. Take it away, Brian…

Let’s say you’re a trader with a $50,000 “grubstake.” And you’re thinking about buying Intel at $20 per share.

How many shares should you buy? Buy too much and you could suffer catastrophic damage if, say, an accounting scandal strikes Intel. Buy too little and you’re not capitalizing on your great idea.

Here’s where intelligent position sizing comes in. Here’s where the concept of “R” comes into play.

“R” is the amount of money you’re willing to risk on any one position. You can easily calculate R from two other numbers: 1) your total account size and 2) the percent of your account you’ll risk on any given position.

Let’s say you want to go “middle of the road” with your risk tolerance. You’re going to risk 1% of your $50,000 account on each idea. Your R is $500. (If you wanted to dial up your risk to 2% of your account, R would be $1,000.)

OK, so you’ve already decided you want to put a 25% protective stop loss on your Intel position. Now you can work backward and determine how many shares to buy.

Your first step is always to divide 100 by your stop loss number: 100/25 = 4.

Now, take that number and multiply it by your R: 4 x $500 = $2,000.

So you should buy $2,000 worth of Intel… At $20 per share, that’s 100 shares. If Intel declines 25%, you’ll lose $500 and exit the position.

If you really want to become a successful investor and stay that way, you should read Dr Van Tharp’s Trade Your Way to Financial Freedom and Jack Schwager’s Market Wizards, if you haven’t already. Both hammer home the importance of proper position sizing.

These books are to trading what the Bible is to Christianity. Make them your friends. We guarantee you’ll be a better investor as a result. We’ll leave the last word on position sizing to Tharp…

Perhaps the greatest secret to top trading and investing success is appropriate money management or what we now call position sizing. I call it a “secret” because few people seem to understand it, including people who’ve written books on the topic. Some people call it risk control; others call it diversification. Money managers call it managing other people’s money and still others call it how to “wisely” invest or spend your money.

Of course, it helps if your trades make gains. Even with proper position sizing, you still need to be right more than you are wrong. Otherwise, you will eventually be forced out of the game.

One Wall Street insider’s “secret formula” produced 438% gains in January 2009. The man behind this strategy hit the markets head on with his brand new formula. It’s based on three ultra-timely criteria. These include a new way to profit from extreme volatility and a signal that Forbes calls “one of our favorite bullish indicators.”

Notes readers can get full access to this formula right now by claiming two free months of his specialized research. But you have to act fast. Once the doors are closed on this offer, you’ll have to pay full price to get in.

I warned him it was crazy to have his entire financial future riding on one stock, especially since he was retired. “That’s what everybody keeps telling me,” he said. “But the stock keeps going up. I’m glad I ignored them all.”

I congratulated him that the stock had appreciated so nicely. But I reminded him there might come a time when it didn’t do so well. But he was stubborn. He wouldn’t part with a share. Furthermore, he grew weary of having the same conversation. He transferred his account out again.

You may already know how this story ends. From a high of over $105 in March 2000, Ericsson took a breathtaking dive. It traded at less than $5 two years later. This is the kind of mistake – especially when you’re already retired – from which recovery is simply not possible. However, I sometimes see other investors making similar mistakes.

Every so often a reader will come up to me at an investment conference and proudly announce, for example, that he has his entire IRA invested in one of my stock recommendations. This is meant as a compliment, I realize. He wants to show me he has confidence in my stock selections. But it makes me cringe inside…

Properly Diversify With Basic Position Sizing

Just as the Ericsson shareholder failed to diversify properly, so do many investors who fail to follow our basic position-sizing strategy.

You shouldn’t put more than 4% of your equity portfolio in any single stock. (At least initially, anyway. It may grow to be a much larger percentage. But that’s fine as long as you protect your profits with a trailing stop.)

Here’s why you should follow this advice, especially if you consider yourself risk averse:

• Our policy is never to let a stock fall more than 25% below our purchase price without selling it.
• If you take the maximum loss (25%) on your maximum position size (4%), it means the value of your stock portfolio has fallen just 1%.
• And if you have no more than 60% of your portfolio in equities, as we currently recommend, the maximum potential harm done by a single stock cratering is this: Your total portfolio is worth six-tenths of a percent less.

Most grandmas could live with that.

How to Maximize Returns & Limit Risk

Everything we do – asset allocation, trailing stops, position-sizing and stock selection – is done with an eye to not only maximizing returns but also limiting risk.

It’s fine if an individual stock grows to become a significant percentage of your total portfolio, provided you are running a trailing stop behind it to protect your profits.

But don’t let your confidence in any stock – or any stock picker – allow you to abandon basic money management principles.

As Thomas Jefferson once remarked, “In matters of style, swim with the current. In matters of principle, stand like a rock.”

Good Investing,

Alex

Source: The Best Way to Lose Everything