The Little Book of Market Wizards

by Jack D. Schwager

  Placing a stop too close is also likely to lead to multiple losses. As O’Shea explained, commenting on such traders, “They will get out because their stop is hit, and they are disciplined. But very soon afterwards, they will want to get back in because they don’t think they were wrong. That’s how day traders in NASDAQ in 2000 and 2001 lost a ton of money. They were disciplined, so they would close out their positions by the end of the day. But they kept repeating the same trading mistake.”

  Essentially, O’Shea is saying that you should place a stop at a level that disproves your trade premise, as opposed to placing a stop based on your pain level. The market doesn’t care about your pain threshold.

  An Option to Stops1

  Although stops can be an invaluable risk management tool, one disadvantage of stops is that the original position can reverse after the stop has been triggered, leaving a trader with a loss on a position that would otherwise have been a gain. Options can be used as an alternative risk management tool that avoids this frustrating scenario at a predetermined fixed cost.

  As an example, consider a trader who wants to buy stock XYZ, which is trading at $24, and is willing to risk a maximum loss of $2. The straightforward approach would be to buy the stock and then place a protective stop at $22. (Of course, the loss could still exceed $2 if the stop order is filled below $22.) If the stock declined to $21.80 and then rebounded to $30, the trader would still be left with an approximate $2 per share loss, despite being right in the directional expectation for the stock.

  As an alternative to using a stop, the trader could, for example, buy a one-year $22 call on XYZ. In this illustration, we assume the option premium is $3 (or $1 more than the in-the-money amount of the option). If the stock falls below $22 and is still below $22 when the option expires, the trader’s loss would be limited to the $3 premium paid for the option, regardless how low the price of the stock falls. If, however, the stock falls below $22 and then rebounds to $30 at the time of the option expiration, the trade would earn a profit of $5 per share (the difference between the $30 expiration price and the $22 strike price, less the $3 premium paid for the option). Whereas, in this scenario, the trader with the stop lost $2 per share, the trader who bought the option had a $5 per share profit ($1 less than the net increase in the share price). Of course, if the stop is not hit, the trader with the stop would be $1 per share better off (the amount by which the premium paid exceeded the in-the-money amount of the option). In-the-money options have the additional advantage of requiring a much lower cash outlay than outright long positions.

  So is it better to control position risk with stops or in-the-money options? The answer depends on the preferences of the individual, the liquidity of the options, and the relative expensiveness of options at the time of the trade. The intention here is merely to point out that, in some circumstances, and for some traders, in-the-money options may provide a more attractive risk management tool than stops and therefore should be considered as a possible alternative to stop-protected outright positions.

  Risk Management at the Portfolio Level

  BlueCrest’s flagship fund, a multimanager fund run by Michael Platt, which is designed to keep losses very constrained, has achieved annual returns in excess of 12 percent2 (after deducting all fees) over a 13-year period, while keeping the peak-to-valley equity drawdown under 5 percent for the entire period. How could BlueCrest deliver double-digit returns over an extended period while keeping the maximum drawdown so low? The answer lies primarily in the portfolio risk management strategy, which tightly limits the amount each manager can lose before capital is withdrawn. Each calendar year starts with a clean slate. Each manager is allowed to lose only up to 3 percent before his allocation is cut by 50 percent. If the manager then loses another 3 percent on the remaining assets, the entire allocation is withdrawn for the year. These rigid risk control rules are designed to keep each manager’s maximum loss for the year under 5 percent. (The combination of two successive 3 percent losses is less than a 5 percent loss because the second 3 percent loss is incurred on only 50 percent of the assets.)

  You might think that maintaining such tight reins on the maximum allowed loss would also keep returns very subdued. How then has the fund managed to attain annual returns that have averaged two-and-a-half times the size of the single largest equity drawdown for the entire period? The key is that the 3 percent/3 percent risk rule applies only to a manager’s starting stake for the year. So while the risk control rules encourage the fund’s managers to be very cautious at the outset, managers can take increasingly greater risk as they build a profit cushion. Effectively, a manager can risk the original 3 percent plus any accrued profits for the year before an allocation reduction would be triggered. This structure assures capital preservation while, at the same time, keeping upside potential open-ended by allowing greater risk taking with profits.

  Some traders may find that the BlueCrest risk management approach can serve as a model for constraining yearly losses to some preset maximum, while still allowing for greater upside potential. Traders can choose their own appropriate loss levels as thresholds for reducing exposure as well as trading cessation.

  Quick Exits When Wrong

  The Market Wizards have the ability to get out quickly when they are wrong. When I interviewed Steve Cohen, the founder of SAC Capital and one of the world’s most successful traders,3 he told about a trade in which he was dead wrong. “I went short the stock at $169. The earnings came out and they were just phenomenal—a complete blowout! I got out sharply higher in after-the-close trading, buying back my position at $187. The trade just didn’t work. The next day the stock opened at $197. So thank God I covered that night in after-hours trading.”

  I asked Cohen if he always had the ability to turn on a dime when he was wrong. Cohen answered, “You better be able to do that. This is not a perfect game. I compile statistics on my traders. My best trader makes money only 63 percent of the time. Most [SAC] traders make money only in the 50 to 55 percent range. That means you’re going to be wrong a lot. If that’s the case, you better make sure your losses are as small as they can be, and that your winners are bigger.”

  The Trader’s Dilemma

  Here is a common dilemma, which most traders have faced at one time or another: You have a position that is going against you, but you still believe in the trade. On the one hand, you don’t want the loss on the position to get any worse, but, on the other hand, you are concerned that as soon as you get out, the market will turn around in favor of the liquidated trade. This conflict can cause traders to freeze and do nothing as their losses mount. Steve Cohen also had some useful advice about how to handle this type of situation. “If the market is moving against you, and you don’t know why, take in half. You can always put in on again. If you do that twice, you’ve taken in three-quarters of your position. Then what’s left is no longer a big deal.”

  Taking a partial loss is much easier than liquidating the entire position and provides a way to act rather than procrastinate. Yet, most traders will resist the idea of partial liquidation. Why? Because partial liquidation absolutely guarantees that you will be wrong. If the market reverses, then you shouldn’t have liquidated anything, and if continues to move further against you, then you should have just liquidated the entire position. No matter what happens, you will be partially wrong. The need to be 100 percent right prevents many traders from considering partial liquidation. Unfortunately, by trying to be 100 percent right, many traders end up being 100 percent wrong. The next time you are undecided between liquidating a losing position and gritting your teeth and riding it out, remember that there is a third possible choice: partial liquidation—an alternative that, as Cohen points out, can be used multiple times on the same position.

  When in doubt, get out and get a good night’s sleep. I’ve done that lots of times and the next day everything was clear. . . . While you are in [the position], you can’t think. When you get out, then you can think clearly a
gain.

  Michael Marcus

  Michael Marcus makes the point that when you are confused about what to do with a position, getting out is the best way to gain clarity. “When in doubt,” he says, “get out and get a good night’s sleep. I’ve done that lots of times and the next day everything was clear. . . . While you are in [the position], you can’t think. When you get out, then you can think clearly again.” Marcus’s observation that clarity is best obtained when not in the position echoes the reasoning behind Bruce Kovner’s advice to decide on an exit before entering a trade.

  Underappreciated Reason for Avoiding Large Losses

  The direct adverse consequence of letting a loss grow unnecessarily large is quite obvious. However, there is another far less obvious consequence of large losses that can have a major negative impact on equity. Large losses will mentally impede the trader and result in missed winning opportunities. This observation was colorfully expressed by Michael Platt, talking about the aftermath of taking a large loss: “You feel like an idiot, and you’re not in the mood to put on anything else. Then the elephant walks past you while your gun’s not loaded. It’s amazing how annoyingly often that happens. In this game, you want to be there when the great trade comes along. It’s the 80/20 rule of life. In trading, 80 percent of your profits come from 20 percent of your ideas.”

  It’s Not Rocket Science

  Money management doesn’t have to be complex. Although there are entire books devoted just to the subject of money management, I believe a rule so simple that it can be described in a single sentence can get you 90 percent of the way there.

  Larry Hite, the cofounder of Mint Investment, one of the largest and most successful commodity trading advisors (CTAs) of the 1980s, was very clear about what he felt was the most important component of the firm’s strategy: “The very first rule we live by at Mint is: Never risk more than 1 percent of total equity on any trade.” There you have it: effective money management in just one sentence. As Hite elaborated, “By only risking 1 percent, I am indifferent to any individual trade.” This type of simple rule works because it prevents any single bad trade from doing much damage. You may still lose money trading, but you won’t be knocked out of the game because of one or a few bad trades that are allowed to accumulate losses without limit—a painful outcome experienced by many traders, even those with effective trade entry methodologies.

  There is nothing magical about the 1 percent limit; you could use 0.5 percent, or 2 percent, or whatever number is most appropriate for your strategy. The key point is that there is a strict loss limit on every trade. Effective money management is not a matter of complexity, but rather a matter of discipline. Even simple risk control rules will probably work fine, as long as you have the discipline to follow them.

  Notes

  1. Readers unfamiliar with options can skip this section or first read the Appendix before returning to this section.

  2. Performance statistics obtained from www.barclayhedge.com.

  3. Multiple former employees of SAC Capital either pleaded guilty or were convicted of insider trader. The firm itself also pleaded guilty to insider trading charges, paying a total of $1.8 billion in fines. Steve Cohen was charged with failure to properly supervise employees, but not with directly participating in insider trading. Nevertheless, the aforementioned convictions and the fact that Cohen routinely encouraged managers who worked for him to share their trading ideas have led to controversy over whether, and to what extent, Cohen’s trades may have benefited from insider information. As far as I see it, you could cut Cohen’s returns in half and still have an exceptional track record. Whatever the influence of insider trading on Cohen’s record (if any), it was certainly much smaller than this amount, or else there certainly would have been more than enough evidence for Cohen to have been charged directly. Thus, from a purely statistical perspective, I still believe there is little question that Cohen is a highly skilled trader. These comments are only intended to explain why I believe Cohen is a great trader, regardless of what assumptions might be made about the influence of insider trading, and in no way are intended to imply that he directly participated in insider trading—I am unwilling to speculate on this matter—or to condone such action if he did.

  Chapter Nine

  Discipline

  When I asked the Market Wizards what differentiated them from the majority of traders, the most common reply I got was “discipline.” Now, the need for discipline is one of those items of trading advice that you have probably heard so often before that if I just mention it here again, you’ll ignore it. Rules are boring and are quickly forgotten, while stories have the potential to capture interest and be remembered. So instead of just repeating the rule about the need for discipline in trading, let me instead tell you a story about discipline, which I hope you will remember the next time you are at the brink of letting your discipline in the markets lapse. My favorite story about discipline in the interviews I’ve conducted concerns Randy McKay, a very successful discretionary trader who began his trading career with the birth of currency futures trading.

  McKay’s Lapse of Discipline

  McKay’s career path got off to a very inauspicious start. He flunked out of college in 1968—six Fs due to lack of attendance did the trick. The year 1968 was near the height of the Vietnam War, and soon after losing his college deferment, McKay was drafted by the Marines. (Although the Marines don’t normally draft recruits, there were two months in 1968 when they were allotted a small portion of draftees.) When McKay returned from Vietnam in 1970, his brother, who was a broker on the Chicago Mercantile Exchange (CME), got him a job as a runner on the floor. The job allowed McKay to work in the morning and attend college classes in the late afternoon and evening.

  McKay had no intention of becoming a trader. But just as he was finishing college in 1972, the CME launched a subdivision, the International Monetary Market (IMM), to trade currencies. In an effort to try to generate trading activity in the new currency futures contracts, the CME gave away free IMM seats to all existing members. McKay’s brother had no need for the seat at the time, and he asked Randy if he would like to use it in the interim. In that initial year of currency futures trading, these markets were so inactive that floor traders in the currency pit spent more time playing chess or checkers or reading the newspaper than trading. McKay found that he had a knack for trading. He was successful in his first year and then made more money in each successive year.

  In order to provide context, it is important to make clear that McKay was a very disciplined trader. Perhaps the best illustration of this point was his experience in the aftermath of the November 1978 Carter dollar rescue plan. The dollar had been sliding steadily against all the major currencies all year long. Then on a weekend in November, with major currencies near highs against the dollar, the Carter administration announced a plan to support the dollar. This announcement caught the market by surprise and triggered a huge downside gap in foreign currencies.

  At the time, McKay was positioned heavily long in the British pound. Monday morning, British pound futures opened locked limit down.1 Although futures were locked limit down (a 600-point decline) on the Monday opening, it was possible to trade currencies on the interbank market, which instantly moved to an equilibrium price and traded freely. McKay liquidated his long pound position Monday morning on the interbank market, which was trading 1,800 points lower, equivalent to about three consecutive limit-down price moves in futures.

  I asked McKay, “In catastrophic situations, when a surprise news event causes futures to lock at the daily limit and the cash market to immediately move the equivalent of several limit days in futures, do you find that you’re generally better off getting out right away, as opposed to taking your chances by waiting until the futures market trades freely?”

  When I get hurt in the market, I get the hell out. It doesn’t matter at all where the market is trading. I just get out, because I believe that once you are hurt in the mar
kets, your decisions are going to be far less objective than they are when you’re doing well.

  Randy McKay

  McKay’s reply to this question left little doubt about where he stood on the question of discipline. “There’s a principle I follow that never allows me to even make that decision,” McKay said. “When I get hurt in the market, I get the hell out. It doesn’t matter at all where the market is trading. I just get out, because I believe that once you are hurt in the markets, your decisions are going to be far less objective than they are when you’re doing well. And if the market had rallied 1,800 points that day to close higher, I couldn’t have cared less. If you stick around when the market is severely against you, sooner or later they’re going to carry you out.”

  This trade was by far McKay’s largest loss up to that point, costing him $1.5 million. I asked what emotions he felt at the time. McKay had no regrets. “As long as you’re in the position,” he said, “there’s tremendous anxiety. Once you get out, you begin to forget about it. If you can’t put it out of your mind, you can’t trade.”

  So clearly, McKay was a disciplined trader. Now let’s fast-forward 10 years to McKay’s “next-to-last trade.” In his last trade, McKay was going to reach his goal of making $50 million in the markets. This next-to-last trade was supposed to get McKay close enough to his target so that one more strong trade would achieve his goal. That is not quite how things worked out, however. The trade involved a huge long position in the Canadian dollar. The currency had broken through the psychologically critical 80-cent barrier, and McKay was convinced the market was going much higher. As the market moved in his favor, McKay added to his longs, ultimately amassing a 2,000-contract long position.