The Little Book of Market Wizards

by Jack D. Schwager

  Note

  1. There is some controversy on the cause of Bender’s death, as the Costa Rican authorities charged his wife with murder. Knowing his wife and speaking to a close friend of Bender familiar with the details, I am inclined to believe the suicide version of the story.

  Chapter Six

  Good Trading Should Be Effortless

  In reading this chapter’s title you are probably thinking, “Wait a minute. In the last chapter you told us successful trading involves a lot of hard work. Now you are saying good trading is effortless. Make up your mind. Which is it?”

  The hard work in trading comes in the preparation. The actual process of trading, however, should be effortless.

  There is no contradiction. It is the difference between preparation and process. The hard work in trading comes in the preparation. The actual process of trading, however, should be effortless. I will use a running analogy. Picture someone who is completely out of shape, whose longest pedestrian excursions are from the couch to the refrigerator, trying to run one mile in 10 minutes. Now, picture a world-class runner running a marathon one mile after another, easy as can be, at a sub-5-minute per mile pace. Who is doing more hard work? Who is more successful? Well, clearly the out-of-shape runner is doing more hard work, but the world-class runner is much more successful. The world-class runner, however, didn’t get to this level of proficiency by just getting off the couch one day and going for one short run. He has been training hard for many years. So, his hard work came in the preparation. When he is performing successfully, however, the actual process of running should be effortless; he will run his best races when he is running effortlessly. The same concept would apply to many other endeavors. Writers achieve their best work when the writing comes effortlessly; musicians perform best when their playing comes effortlessly.

  The same principles apply in trading. If trading is going well, it will seem effortless. If trading is not going well, you can’t force it right by working harder. If you are in a particularly bad trading period, when nearly every decision you make seems to be wrong, trying harder won’t help. It will probably only make matters worse. You can work harder in doing more research. You can work harder in trying to figure out what’s going wrong. But you can’t work harder at trading. If you are out of sync with the markets, trying harder is often likely to make matters even worse. So if trying harder is not the solution for handling a losing streak, what is? We will address this question in the next chapter.

  Zen and the Art of Trading

  There was an interview I did in which the theme of good trading being effortless came up prominently. Unfortunately, it was an interview I could not include in one of my books. Let me explain.

  People often wonder how I get the traders in my books to agree to be interviewed. One of the things I do to allay the concerns of potential interview subjects is to assure them that they will have a chance to review the finished chapter before I submit the manuscript to the publisher. I also tell them that I will not use the chapter unless they approve it. I believe these assurances are not only helpful in getting traders to participate, but also aid in their being more open and free in their responses to my questions. I am sure that if the traders I interviewed had no control over the process, they would self-censor every reply before it was immortalized in print. Although my promise not to publish the interview without approval serves some very useful purposes, it can also backfire. I can spend weeks honing 200 pages of raw transcript into a 25-page chapter only to have the interview subject decline to let me use it. Fortunately, this has happened only twice.

  On one of these occasions I did a fairly eclectic interview for The New Market Wizards. The scope of the interview was quite unusual, including such topics as dreams and trading, precognition and trading, and Zen and trading. I wrote it all up, and I thought the end result was pretty good. As agreed, I sent the completed chapter to the trader for his review and approval. About a week later, he called me.

  “I read the interview,” he said. “It was quite interesting . . .” I sensed a “but” coming. “But,” he continued, “you can’t use it.” It turned out that he had decided to go into the business of advising corporations on currency hedging and had hired a business manager to help develop and market the service. The business manager had read the interview and saw all this stuff about dreams and trading, and Zen and trading, and he quickly decided the material was not conducive to projecting the desired corporate image. “No way,” said the business manager, and “No way,” said the trader.

  Trying to salvage something from an impending complete loss, I said, “There is a small section that I think has a very important message, and I would hate to lose it. Just let me use this one section, and I won’t identify you by name.” He agreed. As a result, there is a two-page chapter in The New Market Wizards called “Zen and the Art of Trading.” In it, the trader asks me, “Did you ever read Zen and the Art of Archery?”

  “No, I have to admit, I missed that one,” I replied.

  The essence of the idea is that you have to learn to let the arrow shoot itself. . . . In trading, just as in archery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. . . . The perfect trade is one that requires no effort.

  A trader

  He continued earnestly, ignoring my glib response, “The essence of the idea is that you have to learn to let the arrow shoot itself. . . . In trading, just as in archery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. . . . The perfect trade is one that requires no effort.”

  If you are a trader, you will recognize the truth in every one of those words.

  Chapter Seven

  The Worst of Times, the Best of Times

  When Everything Is Going Wrong

  Okay, good trading should be effortless. But what do you do when you hit prolonged periods when trading is a struggle? How do you handle the periods when almost everything seems to be going wrong and you are in a steadily deepening drawdown? This question came up in multiple interviews. Even great traders can experience demoralizing losing periods. The Market Wizards were quite consistent in the advice they offered about handling difficult losing periods. They had two basic recommendations:

  1. Reduce your trading size. Paul Tudor Jones said, “When I am trading poorly, I keep reducing my position size. That way, I will be trading my smallest position size when my trading is worst.”

  Ed Seykota, a pioneer in systematic futures trading who achieved astounding cumulative returns, offered similar advice when I asked him if he had locked away several million dollars to avoid the Jesse Livermore experience. (Livermore was a famous speculator of the early twentieth century who made and lost several fortunes.) Seykota replied that a better alternative was to “Keep reducing risks during equity drawdowns. That way you will approach your safe money asymptotically and have a gentle financial and emotional touchdown.”

  Marty Schwartz will cut his trading size to a fifth or even a tenth of normal if he experiences losses that shake his confidence. “After a devastating loss,” Schwartz said, “I always play very small and try to get black ink, black ink. . . . And it works.” Schwartz recalls that after he took an unusually large $600,000 hit in his account on November 4, 1982, he responded by drastically reducing his trading size, piecing together many small gains and finishing the month with only a $57,000 loss.

  Randy McKay, who parlayed an initial $2,000 trading stake into tens of millions in profit by the time I interviewed him 20 years later, is even more extreme in reducing his position size when he is in a losing streak. “I’ll keep on reducing my trading size as long as I’m losing,” he says. “I’ve gone from trading as many as 3,000 contracts per trade to as few as 10 when I was cold, and then back again.” He considered this drastic variation in position size as a key element in his trading success.

  2. Stop trading. Sometimes reducing trading size is simply not enough, and the best remedy to break the downward sp
iral is to simply stop trading. As Michael Marcus explained, “I think that, in the end, losing begets losing. When you start losing, it touches off negative elements in your psychology; it leads to pessimism. . . . When I have had a bad losing streak, I have been able to say to myself, ‘You just can’t trade anymore.’”

  Richard Dennis, who turned a $400 trading stake into a fortune, estimated by some to be near $200 million at the time of our interview, had a very similar perspective, expressing that losses beyond a certain level will adversely impact the trader’s judgment. His straightforward advice: “When you are getting beat to death, get your head out of the mixer.”

  If you are in a losing streak, the best solution is not trying harder, but rather the exact opposite: Stop trading. Take a break or even a vacation, liquidating all positions or protecting them with stops before you leave. A physical break can serve to interrupt the downward spiral and loss of confidence that can develop during losing periods. Then when you return, ease back into trading, starting small, and gradually increasing if trading has again become effortless.

  If you are in a losing streak, the best solution is not trying harder, but rather the exact opposite: Stop trading.

  Although traders will know when they are in losing streaks, they may be slow to realize the dimensions of the problem until the loss has far exceeded acceptable levels. They allow losses to mount without changing anything and then suddenly are shocked to realize the magnitude of their drawdown. One way to become cognizant of these persistent losing periods more quickly and in time to take corrective action before excessive damage is done is to plot your equity daily. Marcus offered this advice, noting, “If the trend in your equity is down, that is a sign to cut back and reevaluate.”

  When Everything Is Great

  The flip side of persistent losing periods are times when things are going almost unbelievably well. Oddly enough, these are also times to consider playing smaller. After a particularly strong period of profits, Marty Schwartz will also reduce trading size, just as he does after particularly bad losses, because he notes, “My biggest losses have always followed my largest profits.”

  I am sure many traders have had a similar experience. The worst drawdowns often follow periods when everything seems to be working perfectly. Why is there a tendency for the worst losses to follow the best performance? One possible explanation is that winning streaks lead to complacency, and complacency leads to sloppy trading. In these strongly winning periods, the trader is least likely to consider what might go wrong, especially worst-case scenarios. An additional explanation is that periods of excellent performance are also likely to be times of particularly high exposure. The moral is: If your portfolio is sailing to new highs almost daily and virtually all your trades are working, watch out! These are the times to guard against complacency and to be extra cautious.

  Chapter Eight

  Risk Management

  When I asked Paul Tudor Jones what was the most important advice he could give to the average trader, he replied, “Don’t focus on making money; focus on protecting what you have.”

  Most trading novices believe that trading success is all about finding a great method for entering trades. The Market Wizards I interviewed, however, generally agreed that money management (i.e., risk control) was more important to trading success than the trade selection methodology. You can do quite well with a mediocre (i.e., slightly better than random) entry methodology and good money management, but you are likely to eventually go broke with a superior entry methodology and poor money management. The unfortunate reality is that the amount of attention most beginning traders devote to money management is inversely proportional to its importance.

  Don’t focus on making money; focus on protecting what you have.

  Paul Tudor Jones

  Uncle Point and Kovner’s Dictum

  It is instructive to consider how the Market Wizards approach risk control. Marty Schwartz provided perhaps the best succinct description of an effective perspective on risk control. Schwartz’s advice is simply, “Know your uncle point.” I don’t know whether the expression “say uncle” is still used today, but when Schwartz and I were kids, saying “uncle” was the call of surrender to make the pain stop. If two kids were in a fight and one had the other locked in an arm twist, he might demand, “Say ‘uncle,’” an understood sign that his opponent was giving up. So what Schwartz is saying is that before you put on a position, you have to know the point at which you will give up to the market because the pain is too great.

  Bruce Kovner, the founder of Caxton Associates, was one of the best global macro traders ever. When I interviewed him, he had been trading for 10 years and had achieved an astounding 87 percent average annualized compounded return during that period. Although this type of return is impossible to maintain, he continued to do very well in the ensuing decades until he retired in 2011. An early trading experience, in which an act of reckless risk caused him to lose half of his accumulated profit in one day, shocked Kovner into a lifelong respect for risk control. (The details of this trade are discussed in Chapter 17.)

  One of Kovner’s core money management principles was that before he entered any position, he predetermined his exit point based on assessment of where the market should not go if he was right about the trading idea. “That is the only way I can sleep,” said Kovner. “I know where I’m getting out before I get in.” Why is determining where you will get out before you get in so important? Because before you get into the trade is the last time you have complete objectivity. Once you get into the trade, you lose objectivity, which makes it easier to procrastinate by rationalizing a losing position. By making the loss-limit exit decision before he enters a trade, Kovner ensures a disciplined risk control strategy and removes emotionalism from the money management process.

  I know where I’m getting out before I get in.

  Bruce Kovner

  On a personal note, Kovner’s rule about determining where you will get out of a trade before you get in lies at the heart of a trade that I consider my transition point from net losing trader to net winning trader. Ironically, this trade, which I consider one of my best trades ever, was a losing trade. At the time, I had made several prior trading attempts, each time starting with a small stake, wiping out (often because I let the loss on a single trade get out of hand), and then waiting for a while before I made another attempt. The pivotal trade that changed everything involved the deutsche mark, which was the primary European currency prior to the launch of the euro. The deutsche mark had been in a prolonged trading range that formed following an extended decline. Based on my analysis, I believed that the deutsche mark was forming a major price base. I went long within the trading range, anticipating an eventual upside breakout. I simultaneously placed a good-till-canceled sell stop just below the low of the consolidation. I reasoned that if I was right, the market should not fall to a new low. Several days later, the market started falling, and I was stopped out of my position at a small loss. The great thing was that after I was stopped out, the market decline accelerated sharply. Previously, this type of trade would have wiped out my account; instead I experienced only a minor loss.

  If I were asked to provide what I thought was the most important trading advice and restricted to using only 10 words, my reply would be what I would term Kovner’s dictum: Know where you will get out before you get in.

  How Not to Place Your Stops

  Protective stops, or predetermined exit points to limit losses, such as those employed by Schwartz and Kovner, are one of the most effective tools for risk management. However, many traders use such wrongheaded approaches in placing stops that the stop can actually make matters worse. Colm O’Shea, a successful London-based hedge fund manager who managed money for Citigroup, Balyasny Asset Management, and George Soros before starting his own fund, COMAC Capital LLP, recalled how a flawed stop-placement process sabotaged his very first trade.

  As a newly hired trader at Citigroup, O’Shea d
id a fundamental analysis of the UK economy and decided that the rate hikes the forward interest rate market was pricing in were not going to happen. His forecast proved precisely correct. Three months later, there had still not been any rate increase, and short-term interest rate futures had risen 100 points. Although O’Shea had been exactly right, he actually lost money. How did O’Shea manage to lose money despite being right? O’Shea’s problem was that he had a longer-term idea about interest rates, but he traded the market with short-term risk constraints. He was continually being stopped out of his position by insignificant adverse price moves because he was too afraid of losing money.

  That first trade taught O’Shea that you have to be willing to allow enough risk for the trade to work. O’Shea described how stops should be set and then contrasted that recommended approach to what many traders actually do. “First,” said O’Shea, “you need to decide where you are wrong. That determines where the stop level should be. Then you work out how much you are willing to lose on the idea. Last, you divide the amount you’re willing to lose by the per-contract loss to the stop point, and that determines your position size. The most common error I see is that people do it backwards. They start with position size. Then they know their pain threshold, and that determines where they place their stop.”