Trade your way to financial freedom- Book notes


Chapter 1: The Legend of the Holy Grail

Definition of the Holy Grail system: A magic system to guide your decision-making so that you(trader or investor) can make money in the market The journey into finding the profits available in the markets usually goes through the following three phases:

  • Following other people’s advice
  • Searching for a magic method
  • Learning the real meaning of the Holy Grail metaphor or going broke

The Holy Grail metaphor: Finding the Holy Grail means leading our own life and thereby attaining the greatest potential of the human psyche. People make money in the markets by finding themselves, achieving their potential and getting in tune with the market. It means following your own unique way and finding something that really fits you. You have to realise that  both wins and losses are a part of trading; you have to accept both the positive and the negative. To do that you need to find that special place within you where you can just be – you have internal control and you have got rid of both fear and greed. You become one with the process.

Ingredients of trading: Some say the ingredients are –

  • Psychology-60%
  • Position sizing-30%
  • System development-10%

and Van Tharp says psychology -100%(includes position sizing and system development)- which then leads on to the fact that we should model successful people in the markets. This is possible, because the science of NLP( neuro-linguistic programming) teaches us that if at least two people can do something well, then the skill can be taught to most other people.

Four important models for trading and building wealth

  • How to be a great trader-investor and master the markets: Low risk ideas, beliefs, thoughts, mental strategies, mental states, able to teach the model
  • How great traders and investors learn their craft and how they do their research: Beliefs, personal goals, comfort, finding out enough about yourself
  • How great traders determine their position size throughout the trade: How much?– throughout the trade
  • Wealth:  Financial freedom occurs when your passive income is greater than your monthly expenses. Thinking of trading as a method of developing passive income

Chapter 2: Judgmental biases: Why mastering the markets is so difficult for most people

There is a lot of information that we have to process. But we cannot actually process them. We therefore, select, delete and distort the information that comes to us. This is called judgmental biases or heuristics and they affect the process of trading or investing.

Biases that affect trading system development are:

  • Representativeness bias: Thinking that concepts are real phenomena. Examples: Daily bar is equal to a day’s worth of market activity, Support level and resistance level are true phenomena
  • Reliability bias: Thinking that our data are really what they are supposed to be – are reliable
  • Lotto bias: Thinking that manipulating data is somehow meaningful and gives us control over the market
  • Law of small numbers: Making conclusions on studies which have a few samples
  • Conservatism bias: Fail to recognise or even see contradictory evidence
  • Randomness bias: Tending to assume that the market is random and making wrong assumptions about that randomness. Not knowing that market price distributions tend to have an infinite variance and cannot be predicted from normally distributed random prices.
  • Need-to-understand bias: Needing to make elaborate theories about what is going on in the markets and trading system design when it is not really possible to do so.

Biases that affect how you test trading systems

  • Degrees-of-freedom bias: Over optimisation of systems. Do not use more than 4 or 5 degrees of freedom( both indicators and filters included) in your system( a degree of freedom is a parameter that yields a different system for every value allowed). Understand how your concept works and use a least amount of historical testing
  • Postdictive error bias: Using information in testing that would actually be available only after the fact.
  • Not-giving-yourself-enough-protection bias: Failing to consider that position sizing and exit strategies are a key part of trading

Biases that affect how you trade your system

  • Gambler’s fallacy bias: Assuming that the chance goes up for a win after a long losing streak or up for a loss after a long winning streak.
  • Conservative with profits and risky with losses bias: Cutting your profits short and letting your losses run
  • My current trade or investment must be a winner bias: Being right has little to do with making money.

Chapter 3: Setting your Objectives

You need to decide what you want to accomplish first. Then you have to decide if your goals are realistic.


  • How much capital you have?
  • How much money do you need to live on each year?
  • How much of that must come out of your trading profits?
  • Who am I?

Part 1: Self-assessment

  • How much time during the day you have to devote to trading?
  • When you are trading, how many distractions can you expect to have?
  • How much do you expect to devote to developing your trading system, doing your personal psychological work, and to working on your business plan for trading?
  • What are your computer skills? What skills do you need before you begin this trading venture?
  • What do you know about statistics?
  • How would you rate your market knowledge?
  • What are your psychological strengths and weakness, especially in terms of trading system development and personal discipline?
  • Do you tend to get compulsive( get caught in excitement of trading), do you have personal conflicts(job, family life, personal trading experience) or emotional issues(fear or anger)?
  • What do you need to learn, accomplish or solve before beginning trading? How will you do that?

Part 2: Defining your objectives

  • Advantage or edge in trading
  • Concept in trading that gives you an edge
  • Personal money asset, money that you can afford to lose
  • Money that you need to make, money you need to live
  • Realistic expectations, short-term, social contact, working alone or team
  • % of trading capital you expect to make each year
  • Risk level, peak-trough drawdown, how will you assess your plan
  • Expectations of clients and types of clients if you are a trading manager

Part 3: Trading ideas

  • Markets, set up conditions to enter, beliefs about entering markets, initial risk stop regarding returns and drawdowns, stop loss
  • How will you exit
  • Position sizing


Chapter 4: Steps to developing a system

  • Take an inventory
  • Develop an open mind and gather information.Remember you don’t trade or invest in markets-you trade or invest according to your beliefs about the markets.

        Books to read:

  1. By Jack Schwager-anything-Market Wizards, The new market wizards, Fundamental analysis, Technical analysis
  2. Charles LeBeau- Computer analaysis of the futures market
  3. Perry Kaufman-Smart Trading
  4. Cynthia Kase- Trading with the odds
  5. William O’Neil- How to make money in stocks
  6. Tushar Chande-Beyond technical analysis

Write down your beliefs about the market-atleast 100 of them

  • Determine your mission and objectives– Spend 20-50% of your time
  • Determine the concept you want to trade
  1. Trend following- move up or down for a fairly long period of time
  2. Band trading – range bound markets
  3. Value trading- buying undervalued stocks
  4. Arbitrage- buy something at a low price in one place and sell it for a higher price in some other place
  5. Spreading- buy one thing and sell something else hoping the relationship is right
  6. Seasonals- taking trades at some particular period that is most appropriate for a market move and deciding that there is some secret order to the universe
  • Determine the big picture
  • Determining your time frame for trading-long term or short term
  • Determine the essence of your trading and how you can objectively measure it: Set up and timing signal: % of time it is profitable after various time periods-45-55% if random, more means better( 1,2,5,10, 20 days)-especially 1 and 5 day time periods. Do not consider stops or transaction costs. Do not optimise. Understand your idea so less historical testing is necessary.
  • Determine what your initial 1 R risk is: when to get out of a trade in order to protect your capital. Calculate reliability using the stop + transaction fees. 3R profit is minimum aim.
  • Add your profit taking exits and determine the r-multiple of your system and its expectancy Long term- wide stops ; Short term-tight stops Look at system results trade by trade
  • Determine the accuracy of your r-multiple distribution. How does it work in different markets.
  • Evaluate your overall system; Expectancy of the system; Expected gain in terms of R at the end of a given period
  • Use position sizing to meet your objectives: How much size will you put on any one position
  • Determine how you can improve your system: adding independent markets, adding non correlated systems( short term + long term)
  • Mentally plan for your worst case scenario-establish actions you will do

Chapter 5: Selecting a concept that works

  • Trend following
  • Fundamental analysis- as applied to futures
  • Value investing
  • Band trading
  • Seasonal tendencies
  • Spreading
  • Intermarket analysis one market might be influenced by many other markets
  • Magic order to markets- human emotions, physical events influencing human behaviour, mathematical order
  • If enough people believe something will work, then the concept becomes “real” and does work.

Chapter 6: Trading strategies that fit the big picture


  • The US debt situation
  • The secular bear market
  • The globalisation of economic factors
  • The impact of mutual funds
  • Changes in rules, regulations and taxes
  • Human beings tendency to play a losing game

Monitor the impact of these factors in some measurable way monthly

Chapter 7: Six keys to a great trading system

  • Reliability or what percentage of the time you make money
  • The relative size of your profits compared to your losses when traded at the smallest possible level-keep your losses to 1R or less. Expectancy=% winning x R(winning)-%losing xR(losing) or mean of your R multiples
  • Your cost of making an investment or trade
  • How often you get the opportunity to trade: expectancy x opportunity=merit
  • Your position sizing model
  • The size of your trading-investing capital


Chapter 8: Using setups to jump-start your system

Setups: conditions that must occur before other action is taken. It forms only around 10% of any trading system.

Five phases of entry:

  1. Appropriate conditions for your system
  2. Market selection
  3. Market direction
  4. Setups- use setups that do not involve market price
  5. Market timing

Chapter 9: Entry or market timing

Random entry: Random entry, 3 times volatility trailing stop, 1% risk made money on 100% of runs

Channel breakouts

  1. 40-100+days.
  2. For equities- stock makes a new all time high, enter at opening price next day, 10 ATR stop, ATR defined by last 45 days.
  3. Use channel break-outs with a setup(such as a strong fundamental data, relative strength, narrow band of volatility before breakout, efficient market)

Visual entry based on charts

Chart patterns

Pure prediction

Volatility breakouts: 0.8 x ATR in one day, 3 x ATR from close

Directional movement and average directional movement

Wilder-14 days, Le beau/Lucas-14-20 days(18 days optimal)

Le beau and Lucas interpretation of ADX:

  • As long as the ADX is rising, any level of ADX above 15 indicates a trend
  • The greater the increase in ADX, the stronger the trend
  • Decreases in ADX only mean that the trend is weakening or the market is no longer trending
  • When the ADX is rising, indicators such as overbrought or oversold oscillators will not work. Such oscillators work only when the ADX is falling.

Some suggestions:

  1. Enter after crosses of the DI+ and DI-. Long trades would occur after the DI+ goes above DI- and the high of the previous day is penetrated. Short trades would occur after the DI- goes above DI- and low of the previous day is penetrated.
  2. Enter in the direction of the market movement when the ADX increases more than 4 points in 2 days
  3. Enter when the ADX reaches the highest value of the last 10 days.

Moving averages and adaptive moving averages

  • Buy when above 1 year moving average and sell when below 1 year moving average out performs buy and hold
  • Double MA: 5,20
  • Triple MA: 4,9,18. 4,9 above 18 enter. 4 below 9 exit.
  • Weighted, exponential, displaced and adaptive moving averages
  • Adaptive MA filter: % x SD( 1 day AMA change over last 20 days). %=100 for equity markets, 10 for future markets.

Oscillators and stochastics

  • Not very useful
  • Trending market reverses. Oscillator gives signal that the reaction has reached its extreme. Enter the market in the direction of the previous trend when the market gives a signal that it will move in that direction(return of price to the previous high)

Designing your own entry signal: using velocity, acceleration, deceleration, direction and momentum

Chapter 10: Knowing when to fold them

You do not have a trading system unless you know exactly when you will get out of a market position at the time you enter it.

What your stop does

  • Setting a maximum loss( risk ) that you are willing to take
  • Set a benchmark against which to measure subsequent gains
  • Primary goal should be to get big R multiple trades

Setting stop losses

  • Going beyond the noise: 10 day moving average of the average true range x 2.7-3.4( futures) or ATR weekly x 3 or ATR daily x10(equity)
  • Make sure that the transaction costs are not greater than the profits
  • Other stops: dollar stops, % retracement( should be based on maximum adverse excursion), Volatilty stops(ATR)
  • Dev-stops: ATR for last 30 days and calculate SD. ATR+1SD+10% correction factor- 1 stop. ATR+2SD+20% correction factor-2nd stop
  • Channel break-outs, moving average, time stops
  • Discretionary stops( time stop) and psychological stops( get out during major life changes)
  • 25% stop for long term equity investors

Chapter 11: How to take profits

Exits that produce a loss, but reduce your initial risk

  • The timed stop- get out after a period of time if you are not profitable or discover a great new investment idea but you are fully invested
  • The trailing stop- adjusted on a periodic basis.

Exits that maximise profits

  • The trailing stop
  • Volatility trailing stop: 2.7 x 3.4 ATR10 or 0.7-2 ATRweekly
  • Dollar trailing stop, channel breakout trailing stop, moving average trailing stop, trailing stops based on consolidation/chart patterns
  • Profit retracement stop: Once you get 2R profit, exit at % retracement from that level and adjust it for 3R, 4R, 5R etc
  • Percentage retracement stop: 25% from the highest since you buy the stock ( excellent for equity)

Exits that keep you from giving back too much profit

  • Profit objective: Take profits at multiple of initial R
  • Profit retracement exit: similar to profit retracement stop
  • Large volatility move against you
  • Parabolic stops
  • Psychological exists

Using stops, profit objectives and multiple exits- personalise

Adaptive exits have a lot of potential


Chapter 12: There’s money for everyone

Need to have the following ten traits:

  1. At least one tested, well-researched, positive expectancy system that makes money
  2. Systems that fit them and their personalities
  3. Understand the concepts they are trading and how it is low risk
  4. Know what 1R risk means for each of their positions
  5. Evaluate reward-risk of each trade
  6. Have a business plan
  7. Understand position sizing-risk at-most 1% of equity on each position
  8. Understand that performance is a function of their own psychology and they spend a lot of time working on themselves
  9. Take personal responsibilty for the results that- have goals, make improvements and course corrections
  10. Understand that a mistake means that they did not follow their system and business plan and they are constantly learning from their mistakes

Chapter 13: Evaluating your system

Expectancy= reliability of your trading system(% of winning trades) x average size of winning trades/average size of losing trades( as R multiples)

Expectunity= expectancy times opportunity to trade

Costs of trading-commissions, execution costs(slippage), taxes, psychological costs in both short term and long term trading

Peak draw downs of our system

Using newsletter recommendations: make back issues available to you, they must track their own performance

Chapter 14: Position sizing- the key to meeting your objectives

Position sizing: “How much” throughout the course of the trade

It is very important for one to be able to win.

Four methods:

  • Units per fixed amount of money( always allows you take one position)
  • Equal units model( commonly used by equity traders)
  • Percent risk model( best model for long term trend followers)
  • Percent volatility model( best for traders who use tight stops)

Chapter 15: Conclusion

Objectives of the book

  • The source of the Holy Grail is inside you
  • Any system can be characterised as a distribution of R multiples
  • You achieve your objectives through position sizing
  • Personal psychology is important in system development
  • The six key elements of making money in the market are-1) system reliability, 2) reward to risk ratio, 3) cost of trading, 4) your trading opportunity level, 5) the size of your equity and 6) your position sizing algorithm
  • How to develop a trading system

Avoiding mistakes

Your net results as a trader and investor, over the very long run will be a function of the expectancy of your system less any mistakes that you make

You make a mistake when you don’t follow your own rules. Trading without a plan, a system and a set of rules is one big mistake.

Costs of trading make the brokerages and the system win.

Common mistakes for investors and traders are-

  1. Concentrating on investment or trade selection rather than the potential reward-risk ratio
  2. Jumping on a trade because it seems exciting rather than using a well thought out plan
  3. Taking  a trade because you hear a recommendation without understanding the reward-risk potential of the trade
  4. Needing to be right and taking a profit quickly in order to do so
  5. Needing to be right and not taking a loss to do so
  6. Not knowing your IR loss( bail out point) when you enter a trade
  7. Risking too much on any given position
  8. Allowing your emotions to overrule your rules in a trade
  9. Having too many positions in your portfolio, causing you to not pay enough attention to something critical
  10. Repeating the same mistakes again and again because you don’t assume responsibility for the results you are getting

Tharp interview:

  • Data, software, testing, understanding that there will be some mistakes, order execution, understanding the concepts behind your system, portfolio testing and multiple systems
  • Criticising the efficient market: Initial risk, expectancy, position sizing, personal strength and discipline are not taken into account
  • Large account size(>5 billion) makes these ideas difficult to implement

Steps to be more disciplined in trading:

  1. Have a trading plan and test it
  2. Assume total responsibility for everything that happens to you
  3. Find your weaknesses and work on them
  4. Do worst-case contingency planning
  5. Analyze yourself on a daily basis
  6. Mental rehearsal prior to trading: what could go wrong and how will you respond
  7. Daily debriefing; did you follow your rules
  8. Look to yourself as the source of everything that happens in your life

Last words:

  • You cannot trade the markets, you can only trade your beliefs about the market.
  • Beliefs about yourself will also determine your success in the market
  • Play the trading game at
  • Read the book 4 or 5 times.

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