All-Time High Stocks: Van K Tharp on Stalking Low-risk Trade Ideas

Although there are still lots of all-time highs and the long-term trend for stocks remains up, the past week has definitely ushered in what Olivier Tischendorf aptly described as a change in the market's tone. In this market environment I find it constructive to patiently refine my watchlists as the market separates the wheat from the chaff and the strongest stocks show what they are made of. Along these lines I want to share some excerpts from an excellent paper by Van K Tharp and Henry O. Pruden: The Ten Tasks of Top Trading (pdf).

When describing the process of effective trading, Tharp and Pruden use the metaphor of a predator waiting at a watering hole for its prey. Lions, for instance, are often seen lounging at the edge of a watering hole. They knows that prey will come to the water eventually and in the meantime they relax and conserve energy. Likewise as a trader it is important to know where your "watering hole" is, which is to say, know what setups you are waiting for and where to look for them. The opposite of this is to chase all kinds of different setups and trading styles. This would be like a lion running around chasing everything that moves in Kruger Park. There is a reason why lions like that don't exist -- they would be extinct! Traders who chase everything that moves will go extinct as well.

Developing A Low-Risk Idea.
Having positioned itself at the water hole, the lion now watches the potential prey as various animals come to drink. As the lion watches it intuitively estimates its chances of success and failure if it were to attack the prey. The lion does not jump at the first gazelle that arrives. On the contrary, it usually lets most of the animals come and go without disruption. The lion waits patiently for a low-risk idea; a prey that can be taken down without spending too much energy or risking major injury. The same applies to successful traders:

"What top traders all do ... is develop a low-risk idea. If your market analysis focuses on developing a low-risk idea, then you are performing a useful task in terms of making money as a trader."

What most traders do, however, is analyze the market in an attempt to predict what will happen next. This is not a useful pursuit.

"Predicting prices has little to do with successful trading. What is important is determining when the risk is overwhelmingly in your favor and then controlling that risk."

"Most traders gather data and jump to a conclusion at the same time. ... Be objective and dispassionate while you are doing the analysis. Avoid opinions of others while you are developing your low-risk idea."

Stalking Your Low-Risk Idea.
Once the lion has identified a low-risk prey -- a young or injured animal, say -- it does not immediately give chase. Rather it first approaches slowly, quietly, waiting for an opening. The lion does not pounce until it has gotten within striking distance or when something distracts the prey's attention. Likewise a mature trader stalks the low risk idea to find the best possible entry opportunity.

"The essence of 'stalking' is to find the best possible price for entry. Thus, stalking is another form of risk control."

"Stalking means making sure the odds are even more in your favor by paying attention to the smallest timeframe possible for you."

"When you are 'stalking' you need to get into the flow of the market."

Action.
This is the culmination of all the patient planning, and careful stalking. It happens in an instant and it must be done decisively. It is a great contrast to the prior two phases, which are relaxed and methodical.

"You just do it. The trader must have quickness, accuracy, and a narrow focus [...] he must be quick or he will miss the opportunity. And he must be accurate, or he might find himself with something other than his prey."

"The contrast between the requirements for the stalking task and the 'action' task is so dramatic that many traders cannot make the abrupt shift. ... As a result, they either take the trade immediately and increase the risk or the situation, or they concentrate on getting the best possible trade and end up getting nothing."

Lions Stalking an Elephant.
In keeping with the hunting metaphor I'll leave you with this incredible BBC footage of lions stalking and taking down an elephant. It's not a perfect illustration of a low-risk idea because the lions do exhibit a certain amount of desperation (akin to forcing a trade to pay the bills). Nevertheless, the video illustrates the following principles that Tharp and Pruden emphasize:

Wait for the prey to come to you. (in the video: at the watering hole)
Stalk the lowest-risk prey. (i.e., the lone elephant)
Take action when the probability of success is most in your favor. (i.e., at night)