Internal control is one of the major determinants of the 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 is about psychology, money management, and system development:

• Psychology {60% weight)
• Position sizing {30% weight)
• System development {10% weight)

In many ways, trading success becomes the product of internal control. However, most traders don’t realize the importance of having it.

• Internal control is necessary for achieving general portfolio risk control
• Traders who dedicate themselves to developing internal control are the ones who will ultimately succeed
• Most successful speculators have low success rates (35-50%), however, they manage to be profitable as the size of their profitable trades far exceeds the size of their losses. This requires tremendous internal control
• Most successful fundamental investors are contrarians and wait patiently for the right opportunity before taking a market position. This also requires internal control

Internal Control and the Processing of Vast Amounts of Information

One major obstacle that traders face every day is the vast amount of information they are exposed to. According to research, human beings can only receive 1-2% of the visual information available at any one time. Consequently, humans are forced to develop several shortcuts. Traders lacking internal control are unable to control these shortcuts, and consequently, they lose key information and can hardly make any money at all.

 

 

Key Things to Consider for Successful Trading

There are many things to consider for trading successfully in the global markets, and one of them is money management.  However, most of the time, traders tend to ignore the importance of money management, and more specifically:

(i) They ignore the importance of exits to their profits and their losses

(ii) They ignore the importance of position sizing

(iii) They ignore the importance of the discipline required to make it all work

 

Four processes for making money in the market:

Generally, the are four key processes for making money in the global markets. All of these processes are very psychological, illustrating the need for having internal control:

(1) The process of trading research

(2) The process of position-sizing (determining the right sizes)

(3) Trading process (open and closing positions)

(4) Process of becoming wealthy in the long run

 

Identifying the Basic Determinants of Portfolio Success

1. Winning Ratio

The winning ratio refers to the number of winning trades, divided by the total number of trades. For example, if you made 50 trades in one year and made money on 30 of them, then your winning ratio is 60%. Sometimes, the winning ratio is called the ‘hit rate.’

2. Relative Size of Profits and Losses

You can easily calculate the relative size of your profits and losses by taking the average size of your winning trades and comparing it with the average size of your losing trades.

• For example, if the relative size of your profitable trades is $5, and the relative size of your losses is $2.5 the relative size of Profits/losses would be 2
• Having a high relative size of Profits/losses is important as it indicates that you can money even if you suffer from a low winning ratio. Meaning, you could have a winning ratio of only 40% and still make good money

3. Trading Cost

The cost of trading is one of the greatest determinants of your account’s long-term profitability. An extreme trading cost would be a destructive force to your account’s balance in the long run. These are some categories of costs that you should always consider before open any position:

• The trading commissions charged by your broker
• The trading spreads when trading different assets and asset classes
• The insufficient market liquidity and the slippage on order execution
• The overnight rates (if any)
• The account’s maintenance costs (if any)

4. The Opportunity Factor (Trading Frequency)

Assuming a trading system is capable of showing a fair winning ratio and a good relative size of profits/losses, then the overall profitability of this system will be determined by how many trades it will execute.

• The frequency of being able to identify and trade good opportunities can make a big difference in terms of the overall profitability of any system

 

The Necessary Steps to Achieving Discipline Trading

Van Tharp argues that “To be a money master, you must first be a self-master.” These are the necessary 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 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 try to eliminate them. This is 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 you trade the global markets, you are exposed to a great number of risks. Therefore, you need a global plan of 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”

 

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