The Little Book of Market Wizards

by Jack D. Schwager

  Paul Tudor Jones

  Let me illustrate what I mean by trading to fit your personality by again contrasting two of the traders I interviewed. The first is Paul Tudor Jones, one of the great futures traders of our time. I interviewed Jones about a half year after the October 1987 stock market crash. In that month, which was catastrophic for many, Jones had an incredible 62 percent return. Moreover, he had just nearly achieved five consecutive years of triple-digit returns. I say “nearly” because in one of those years his fund was up only 99 percent.

  When I arranged to interview Jones, he scheduled a time within market hours. I was a bit concerned about this because I knew Jones was a very active trader. Sure enough, when I was ushered into his office, he was shouting an order into one of the speakerphones that directly connected him to the trading floors. This was back in the days before electronic trading, when futures were traded in the pits on the exchange floors.

  I waited until he had finished placing his order before speaking. I explained that I didn’t want to interrupt his trading and suggested that perhaps we should delay the interview until after all the markets had closed.

  “No problem,” Jones answered. “Let’s go.”

  As he was responding to my interview questions, Jones kept his eyes on the large quote monitors spread across the room, intermittently shouting orders to the exchange floor in a particularly frenetic style, the trading equivalent of a professional tennis player aggressively returning a volley: “Buy 300 December crude at even! Go, go, go! Are we in? Speak to me!” All during this time, he was also taking phone calls and speaking to staff members popping into his office with market information and questions.

  Gil Blake

  Keep the image of Paul Tudor Jones trading in his office in mind as we take a look at a very different trader, Gil Blake. Ironically, Blake became involved in trading in an effort to demonstrate to a colleague that the markets were random and that he was wasting his time if he thought he could gain any advantage through market timing. At the time, Blake was working as the CFO for a company. One day a colleague showed Blake research he had done that suggested he would be better off switching out of a municipal bond fund he held anytime it started to go down and switching back in when it started to go up. He asked Blake for his advice.

  Blake was skeptical. “I don’t think the markets work that way,” he told his friend. “Have you ever read A Random Walk Down Wall Street? The problem is that you don’t have enough data. Get more data, and I bet you’ll find this is not something you could make money on over the long run.”

  When Blake got the additional data, he discovered his initial skepticism was unwarranted. There clearly was evidence of nonrandom persistence in fund prices. Moreover, the more research he did, the more decisive were the nonrandom patterns in fund prices he discovered. Blake became so convinced that profitable price patterns existed that he quit his job so that he could devote full time to price research. As Blake describes this early period in his trading career, “I practically lived at the local library, extracting years of data on perhaps a hundred mutual funds off the microfilm machine.” Blake discovered high-probability patterns that were so enticing that he took out multiple second mortgages on his home to increase his trading stake.

  Blake’s track record was incredibly consistent. I interviewed him 12 years after he started. He had averaged a 45 percent return per year during that time, with his worst year being a 24 percent gain with all positive months. In fact, he had only five negative months during the entire 12 years. He had one streak of 65 consecutive winning months.

  Despite his enormous success, Blake had no desire to create a money management business or grow beyond a one-man operation. He did his trading from the bedroom of his house. He turned down offers to manage money, with the exception of a few friends and family accounts.

  Comparing Jones and Blake

  Now compare Jones and Blake. Can you imagine Jones spending months in the library going through prices on microfilm and trading once a day from his bedroom? Or could you imagine Blake trading in the chaotic environment in which Jones thrives? There is something jarring about these images. They just don’t fit. Jones and Blake have succeeded spectacularly because they have utilized methodologies that suit their personalities. But if they had chosen an approach that was out of sync with their natural character (such as each other’s methodology), the results would probably have been very different.

  If I try to teach you what I do, you will fail because you are not me. If you hang around me, you will observe what I do, and you may pick up some good habits. But there are a lot of things you will want to do differently.

  Colm O’Shea

  The essential message is that traders must find a methodology that fits their own beliefs and talents. A sound methodology that is very successful for one trader can be a poor fit and a losing strategy for another trader. Colm O’Shea, one of the global macro managers I interviewed, lucidly expressed this concept in answer to the question of whether trading skill could be taught: “If I try to teach you what I do, you will fail because you are not me. If you hang around me, you will observe what I do, and you may pick up some good habits. But there are a lot of things you will want to do differently. A good friend of mine, who sat next to me for several years, is now managing lots of money at another hedge fund and doing very well. But he is not the same as me. What he learned was not to become me. He became something else. He became him.”

  Personality and Trading Systems

  The idea that using a methodology that suits your personality is an essential component of trading success also helps explain why most people lose money using trading systems they bought. Why is that true? Is it because most trading systems don’t work on data not used in their development? I am not implying that. Actually, I have no idea what percentage of trading systems sold to the public provide a market edge. But even if I assumed that more than 50 percent of the systems sold would be profitable if applied as instructed, I would still expect over 90 percent of the buyers of those systems to lose money trading them.

  Why? Because every trading system, regardless of the strategy employed, is going to hit periods when it does poorly. Now, if you buy a system, by definition, it has nothing to do with your personality or beliefs. In many, if not most, cases, you won’t even have any idea what drives the system’s signals. Consequently, the first time the system hits a bad period, you are not going to have the confidence to stay with the system, and you will stop trading it. That is why, invariably, most people who buy systems will end up losing: They will stop using the system when it goes through a bad period, and they won’t be there when the system recovers.

  Chapter Four

  The Need for an Edge

  Money Management Is Not Enough

  There is a Wall Street adage that says, “Even a poor trading system could make money with good money management.” Have you heard that saying before? Well, if you have, forget it, because it is really one of the stupidest things that has ever been said about trading. If you believe that good money management can salvage a poor system or methodology, I invite you to go to a casino, walk over to a roulette wheel, use your best money management system to bet, and see how well that works out for you. In fact, if you asked a hundred mathematicians the question, “I have $1,000 that I want to bet in roulette—what is the optimal betting strategy I should use?,” all 100 should give you the same answer: Take the entire $1,000 and place it on red or black (or on odd or even) for one spin, and then, win or lose, walk away. That betting strategy will give you the highest probability of being a winner in roulette.1

  Of course, your odds of winning are still less than 50 percent—47.37 percent, to be exact, for a wheel with a double zero—but your negative edge will be smallest for one spin. The more times you play, the greater the probability that you will lose. And if you play long enough, it is a mathematical certainty you will lose. So the point is that if you don’t have an edge (implying you have a
negative edge), then the optimal money management strategy is to bet it all at once—the epitome of bad money management. Money management cannot save you if you don’t have an edge. It is helpful in mitigating losses and preserving capital only if you do have an edge.

  So, it’s not enough to have money management; you also need to have an edge. Having an edge means that you have a method.

  So, it’s not enough to have money management; you also need to have an edge. Having an edge means that you have a method. No trader I ever interviewed for any of the Market Wizards books when asked how he did what he did gave a response like, “I look at the screen, and if bonds look good, I’ll buy some.” None of them approached trading with a cavalier, shoot-from-the-hip attitude. They all had a specific methodology. Some of them could describe their methodology in very specific, almost step-by-step terms. Others described their approach in more general terms. But it was clear they all had a specific methodology.

  So what exactly is your methodology? If you can’t answer that question, you are not ready to be risking money in the markets. If you can answer that question, the next question is, “Does your trading method provide an edge?” If you are unsure about the answer, again, you are not ready to be risking money in the markets. Successful traders are confident that their methodology provides an edge.

  An Edge Is Not Enough

  Just as money management is insufficient without an edge, an edge is insufficient without money management. You need both. Monroe Trout, who achieved one of the best long-term return/risk records ever recorded, nicely summarized this concept. When I asked him what trading rules he lived by, he replied, “Make sure you have the edge. Know what your edge is. Have rigid risk control rules . . . To make money, you need to have an edge and employ good money management. Good money management alone isn’t going to increase your edge at all. If your system isn’t any good, you’re still going to lose money, no matter how effective your money management rules are. But if you have an approach that makes money, then money management can make the difference between success and failure.” We explore the money management part of the equation in Chapter 8.

  Note

  1. The question presupposed that you were going to play roulette, which ruled out the even better strategy of not playing at all.

  Chapter Five

  The Importance of Hard Work

  I interviewed Marty Schwartz in the evening after a long trading day. He was in the middle of doing his daily market analysis in preparation for the next day. It was a lengthy interview, and we finished quite late. Schwartz was visibly tired. But he wasn’t about to call it a day. He still had to complete his daily market analysis routine. As he explained, “My attitude is that I always want to be better prepared than someone I’m competing against. The way I prepare myself is by doing my work each night.”

  My attitude is that I always want to be better prepared than someone I’m competing against. The way I prepare myself is by doing my work each night.

  Marty Schwartz

  I was amazed to find that so many of the great traders I interviewed were workaholics. Although I could provide many examples, we will take a look at just two of the traders I interviewed to provide a flavor of the work ethic that typifies highly successful traders.

  David Shaw

  David Shaw is the founder of D.E. Shaw, one of the most successful quantitative trading firms in the world. Shaw assembled scores of the country’s most brilliant mathematicians, physicists, and computer scientists to develop multiple computer models that in combination could extract consistent profits from the markets by exploiting pricing discrepancies among different securities. The entire trading strategy is exceedingly complex, trading thousands of financial instruments, including equities, warrants, options, and convertible bonds on all the major global markets. You would think that heading up this massive trading operation and directing and supervising ongoing research of a large team of brilliant quantitative scientists would be more than enough work for any individual. But, apparently, it was not enough for David Shaw.

  Over the years, Shaw’s firm has also incubated and spun off a number of other companies, including Juno Online Services (subsequently merged into United Online), a financial technology company sold to Merrill Lynch, an online brokerage firm, and a market-making operation, among others. In addition, Shaw became heavily involved in computational biochemistry, keeping current on the developing research and providing venture capital to several firms in this field. (Shaw eventually turned over the management of D.E. Shaw to a management team so that he could devote full time to research and development in the field of computational biochemistry.) In addition to all these pursuits, Shaw also served on President Bill Clinton’s Committee of Advisors on Science and Technology and chaired the Panel on Educational Technology. It is hard to contemplate how one person could do all of this. I asked Shaw if he ever took any vacation time, and he answered, “Not much. When I take a vacation, I find I need a few hours of work each day just to keep myself sane.”

  John Bender

  John Bender was a brilliant options trader who managed money for George Soros’s Quantum Fund and who also traded his own fund. When I interviewed him in 1999, his fund had an average annual compounded return of 33 percent with a maximum drawdown of only 6 percent. In the following year (the last year of the fund), his fund registered an astounding 269 percent return, as the option trades Bender had positioned in anticipation of a major top in the stock market proved immensely profitable. He closed the fund in 2000 because he had suffered a brain aneurysm. Bender spent the next decade buying up huge tracts of rainforest acreage and establishing a wildlife preserve in Costa Rica. Sadly, Bender suffered from bipolar disorder and committed suicide in 2010 during one of his depressive states.1

  While Bender was trading, he was probably most active in the Japanese options market. He would then stay up and trade the European options markets and, typically, extend his day into the U.S. trading session. It would be normal for Bender to spend as much as 20 hours a day trading. I mention this example not as a recommendation on how to live your life, but as an illustration of the types of extremes to which some of the Market Wizards carried hard work.

  The Paradox

  Now here is the irony. Why are so many people attracted to trading? Because it seems like an easy way to make a lot of money. But the fact is that the people who are really successful in trading are tremendously hard workers. This dichotomy between perception and reality as it pertains to trading success and work leads to the following paradox. You’ll grant me that no sane person would think of going into a bookstore (assuming you could still find one these days), walking over to the medical books section, finding a book titled Techniques of Brain Surgery, studying it over the weekend, and then Monday morning walking into a hospital operating room believing he was ready to perform brain surgery. The operative word here is sane—that is, no sane person would think that way.

  Yet how many people do you know who would think there was absolutely nothing unusual about going into a bookstore, walking to the business book section, buying a book called How I Made $1,000,000 in the Stock Market Last Year, reading it over the weekend, and then Monday morning believing that they can beat the market professionals at their own game. The line of reasoning in both examples is really quite similar. But, while it is obvious that the thinking in the brain surgery scenario is deranged, many people see nothing odd about the thought process in the second scenario. Why such a dichotomy?

  But the fact is: The people who are really successful in trading are tremendously hard workers.

  Well, this is one paradox that I believe has a satisfactory explanation. Trading is probably the world’s only profession in which a rank amateur, the person who knows absolutely nothing, has a 50–50 chance of being right in the beginning. Why? Because there are only two things you can do in trading: You can buy or you can sell. And, as a matter of probability, some significant percentage of people will be right
more than 50 percent of the time—at least in the beginning.

  As an analogy, if you have 1,000 people toss 10 coins in the air, on average, nearly 30 percent of them will toss 60 percent or more heads. In the coin toss experiment, the 60 percent-plus heads flippers will realize their results are a matter of luck and not due to any innate skill in tossing heads. But when it comes to trading, the amateur traders who are right more than 50 percent of the time when they are starting out will attribute their success to their superior decision-making skills, rather than simply being a matter of chance. The fact that it is possible to achieve short-term trading success by pure luck beguiles people into thinking that trading is a lot easier than it is. It fools people into believing that they possess trading skill.

  The same misperception can’t happen in any other profession. If you never trained as a surgeon, the odds of your performing successful brain surgery are zero. If you have never played the violin, the odds of your getting up in front of the New York Philharmonic and playing a successful solo are zero. In any profession you consider, the odds of even short-term success for the untrained beginner are zero. It is just a quirk of trading that you could be successful for the short term without knowing anything, and that possibility fools people.