Internal control is one of the key determinants of long-term trading success. The following article is based on the book Trade Your Way to Financial Freedom by Van Tharp.

 

The Importance of Internal Control

 

According to Van Tharp, internal control involves three key components:

• Psychology (60% weight)

• Position sizing (30% weight)

• System development (10% weight)

In many ways, trading success is a result of internal control. However, most traders fail to recognize its significance.

• Internal control is essential for effective portfolio risk management.

• Traders who commit to developing internal control are the ones who ultimately succeed.

• Most successful speculators have low win rates (35–50%), yet they remain profitable because their gains significantly outweigh their losses—this requires strong internal control.

• Successful fundamental investors are often contrarians who wait patiently for the right opportunity before entering a position, which also demands internal control.

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Key Things to Consider for Successful Trading

 

There are many factors to consider when trading successfully in global markets, and one of the most critical is money management. However, traders often overlook its importance, particularly in the following areas:

(i) They underestimate the importance of exits in determining profits and losses.

(ii) They neglect the significance of position sizing.

(iii) They fail to recognize the discipline required to make everything work effectively.

 

Four Processes for Making Money in the Market

 

There are four key processes involved in making money in global markets. Each of these is deeply psychological, underscoring the need for strong internal control:

1. The process of trading research

2. The process of position sizing (determining the appropriate trade sizes)

3. The trading process (opening and closing positions)

4. The process of building long-term wealth

 

Identifying the Basic Determinants of Portfolio Success

 

• Winning Ratio

The winning ratio is the number of winning trades divided by the total number of trades. For example, if you made 50 trades in one year and profited from 30 of them, your winning ratio would be 60%. This is sometimes referred to as the "hit rate."

• Relative Size of Profits and Losses

You can calculate the relative size of your profits and losses by comparing the average profit from winning trades with the average loss from losing trades.

For instance, if your average profit per winning trade is $5 and your average loss is $2.50, then your profit/loss ratio would be 2.
A high profit/loss ratio is essential because it means you can be profitable even with a relatively low winning ratio. For example, with a winning ratio of only 40%, you could still generate strong returns.

• Trading Cost

Trading costs are one of the most critical factors influencing your account’s long-term profitability. Excessive trading costs can severely damage your account balance over time. Always consider the following cost categories before opening any position:

• Commissions charged by your broker

• Spreads on various assets and asset classes

• Market liquidity and potential slippage on order execution

• Overnight financing rates (if applicable)

• Account maintenance fees (if any)

• The Opportunity Factor (Trading Frequency)

 

Assuming your trading system has a decent winning ratio and a favorable profit/loss ratio, its overall profitability will largely depend on how often it generates trading opportunities.

The frequency with which your system identifies and executes quality trades can significantly impact its long-term profitability.

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The Necessary Steps to Achieving Discipline Trading

 

Van Tharp argues that, “To be a money master, you must first be a self-master.” The following are the essential steps toward achieving disciplined trading:

 

Step 1: Create a trading plan and test it

A trading plan consists of several components and principles. However, your primary goal is to develop a strong understanding of the concept or asset you are trading.

• Define the concept you are trading
• Determine the financial markets you will be trading
• Create detailed setups with the conditions under which you will buy and sell several assets
• Create rules about the size of the position to be taken
• Determine how you will manage your positions

 

Step 2: Find your weaknesses and work on them

It is important to identify your weaknesses and then work to eliminate them. Here’s how you can do it:

• Develop a diary of several events that occurred in the market, and how you reacted to them
• Identify any emotional patterns behind these events, and try to understand which were your mistakes
• When you stop committing the same mistakes over and over, you may have a chance to be successful in the long run

 

Step 3: Manage risk by creating a global plan 

When trading in global markets, you are exposed to a wide range of risks. Therefore, it is essential to have a comprehensive plan for hedging against these risks:

• Create a full list of everything that could go wrong in the next 12-36 months (according to your investment horizon)
• Evaluate the impact of the above events on your portfolio
• Determine how you will respond to these events by developing multiple courses of action
• Rehearse those action plans until they become second nature

Knowing exactly how you should respond to a great variety of unexpected situations, provides confidence and a great trading advantage. Remember, that if and when some of these situations occur, there will be no time to prepare your actions.

 

Step 4: Evaluate systematically your trading performance and your system

At the end of the trading period (for example, at the end of the year), evaluate your performance by asking the following questions:

• Did you perform as expected?
• Why winners were winners and losers were losers?
• Were you prepared for the events that took place?
• Did you follow your rules? (If the answer is no, determine why)
• How can you alter your system to better adapt to the upcoming market conditions?

 

■ The Importance of Internal Control and Trading Discipline

G.P. for Forex-Investors.com (c) -23rd of December, 2024

Main Source: “Van Tharp - Trade Your Way to Financial Freedom”