The Little Book of Market Wizards

by Jack D. Schwager

  At the time, McKay was having a house built in Jamaica and would travel there every few weeks to supervise the construction. One Sunday evening, before he rushed off to the airport to catch his connecting flight to Miami, McKay stopped to check the quote screen. He cared about only one position: the Canadian dollar. He looked at the screen and was momentarily shocked. The Canadian dollar was down exactly 100 points! He was late for his flight, and the limo was waiting. The Canadian dollar rarely moves 20 points in the overnight session, let alone 100 points; it must be a bad quote, thought McKay. He decided that the market was really unchanged and that the hundreds digit in the quote was off by one. With that rationalization in mind, McKay rushed off for the airport.

  It turned out that the quote that evening had not been an error. The market was down 100 points at the time, and by the next morning, it was down 150 points from the IMM Friday close. What had happened was that, with the Canadian election a month away, a poll had come out showing that the liberal candidate—who held some extreme views, including support for an independent Québec, and who had been thought to have no chance of winning—had closed most of the gap versus his opponent. Overnight, the impending election had gone from a foregone conclusion to a toss-up.

  To make matters worse, although construction was sufficiently complete for McKay to stay at his new house, phones had not yet been installed. We are talking pre–mobile phone days here. So McKay had to drive to the nearest hotel and stand in line to use the pay phone. By the time he got through to his floor clerk, his Canadian dollar position was down $3 million. Since by that time the market was down so much, McKay got out of only about 20 percent of his position. The Canadian dollar, however, continued its plunge. A few days later, McKay was down $7 million. Once he realized the extent of his loss, he exclaimed to his clerk, “Get me out of everything!”

  So here was an experienced trader who committed a momentary lapse of discipline by assuming that an unexpected price decline was due to a bad quote rather than being real—an expediency fostered by concern over being late for his flight—and it cost him $7 million. It is truly amazing how the market will not let traders get away with even a momentary lapse of discipline. The next time you find yourself tempted to ease up on discipline and violate one of your own trading or risk control rules, think of McKay.

  Note

  1. Many futures markets have limits on the maximum price move that is allowed to occur on any single day. If an event causes a great imbalance between buyers and sellers, as was the case after the announcement of the Carter plan, futures will move to the limit price with virtually no trading occurring. Futures will continue to experience limit price gaps on successive days until the market finally reaches a level where there are enough balancing orders for the market to trade freely—in this instance, until the price had fallen far enough for buyers to enter the market.

  Chapter Ten

  Independence

  It should come as no surprise that highly successful traders are independent. Michael Marcus commented on the need for independence. “You have to follow your own light,” he said. “. . . As long as you stick to your own style, you get the good and bad in your own approach. When you try to incorporate someone else’s style, you often end up with the worst of both styles.”

  A Personal Story

  I have often found that listening to other people’s advice and opinions can be detrimental to one’s trading health. One experience stands out as a perfect illustration. As I go through this story, you may think I may be tweaking it a little bit to make it fit, because the events seem to line up so perfectly, but I can assure you that all the events are described exactly as they occurred.

  After I had written Market Wizards, one of the traders I interviewed for that book—I won’t mention his name here—would call me periodically to discuss the markets. At the time, in addition to being a director of futures research, I was also the firm’s technical analyst for the futures markets. This trader was interested in my technical reading of the various futures markets. I was baffled why he would want my opinion when he was a much better trader than I was. For all I knew, maybe he called so that he could fade my opinions on the markets. That made as much sense as anything else.

  One morning, this trader called and started going through the markets, asking my opinion. He got to the Japanese yen. At the time, I had been in a poor trading streak and had greatly pared down the positions in my account. The only market I had a strong opinion about was the Japanese yen. “I think the yen is going lower,” I said. “The market has had a sharp downswing followed by a very tight consolidation. In my experience, when you have that combined pattern, the market usually goes down again.”

  The trader then went on to give me 58 reasons why I was wrong. This oscillator was oversold and that oscillator was oversold, and so on. “You’re probably right,” I said. “It’s just an opinion.”

  Even back then, which was over 20 years ago, I knew enough not to listen to anybody’s opinion. But here’s the thing: I had to travel to Washington, D.C., that afternoon, and I was going to be gone for a couple of days. I had a very busy schedule and knew that I wouldn’t have time to watch the markets. I thought, I haven’t been doing so great lately. I have one significant position left. Do I really want to fade one of the best traders I know—and here is where the rationalization comes in; wait for it—when I won’t even be able to watch the market? So against my better judgment, I walked over to the after-hours trading desk and put in an order to liquidate my position. It was a rationalization because I could have just put in a protective stop order. I didn’t need to be able to watch the market to prudently keep the position.

  I am sure you will not be surprised to learn that when I returned from my trip several days later, the yen was down several hundred points. But here is where you have to believe me. On that same day, the trader called me. Although I was quite curious about his opinion on the yen now that it had fallen sharply in exact contradiction to his opinion in our last conversation, I wasn’t going to be so gauche as to raise the subject. But then he said, “What do you think of the yen?”

  Playing dumb as if just reminded about our last conversation on this market, I said, “Ah yes, the yen. Are you still long?”

  He exclaimed over the phone, “Long? I am short!”

  The point is that if you listen to anyone else’s opinion, no matter how skillful or smart the trader might be, I guarantee it is going to end badly.

  What I didn’t mention was that he is a very short-term trader. For him, a long-term trade might be a day, while for me a short-term trade might be two weeks. So, when he talked to me, he was indeed bullish. He was looking for a short-term (read: intraday) bounce. But when the market didn’t behave as he expected, he decided he was on the wrong side, liquidated his long, went short, and made 200 points—whereas I, who was right all along, made nothing. The point is that if you listen to anyone else’s opinion, no matter how skillful or smart the trader might be, I guarantee it is going to end badly. You just cannot get ahead by listening to other people’s opinions. As Michael Marcus says, “You have to follow your own light.”

  Chapter Eleven

  Confidence

  When I asked Paul Tudor Jones whether he kept his own money in his own funds, he answered, “Eighty-five percent of my net worth is invested in my own funds.” Why such a large portion? Because in his own words, “I believe that is the safest place in the world for it.” This comment was made by a futures trader. In Jones’s view, keeping almost all his net worth in his own futures trading fund was the safest investment he could make. What does that tell you? It tells you that he has a tremendous amount of confidence in his ability to manage money.

  Monroe Trout, another futures trader, did Paul Tudor Jones one better. He told me he kept 95 percent of his money in his own funds. Some traders were so confident in their approach that they exceeded 100 percent of their net worth invested in their own strategy. In his early years of tradi
ng, Gil Blake took out four successive second mortgages over a three-year period (which he was able to do because housing prices were rising quickly) so that he could increase his trading stake. When I asked Blake if he had any reticence about borrowing money to trade, he answered, “No, because the odds were so favorable. Of course, I had to overcome the conventional wisdom. If you tell someone that you are taking out a second mortgage to trade, the responses are hardly supportive. After a while, I just stopped mentioning this detail to others.”

  Most people would view the large percentage of their net worth that these traders placed in their own funds or trading accounts as high-risk behavior. But that is definitely not how these traders viewed it. On the contrary, as their comments reflect, they placed such a large percentage of their assets in their own trading strategy because they considered it to be a safe investment—a perspective that reflects the high level of confidence they had in their own approach and their ability to manage money.

  Indeed, I have found that confidence is one of the most consistent traits exhibited by the successful traders I have interviewed.

  This observation leads to a critical question: Are these traders successful because they are confident or are they confident because they are successful? Although it is impossible to definitively answer these two-way cause-and-effect questions, I believe both cause-and-effect directions are true. Certainly, their success in trading led to confidence, but I also believe that their confidence led to trading success. Indeed, I have found that confidence is one of the most consistent traits exhibited by the successful traders I have interviewed.

  One way to gauge whether you will be successful as a trader is whether you are confident that you will succeed. Only you can decide on your level of confidence. How will you know when you are confident enough to succeed as a trader? Based on the interviews I have done, all I can say is that you will know when you are there. If you are unsure, you are not there yet, and you need to be aware of that lack of absolute confidence and move more cautiously in committing risk capital. One sure sign that you lack confidence is seeking the advice of others.

  Chapter Twelve

  Losing Is Part of the Game

  The Link between Confidence and Taking Losses

  Closely related to confidence is the idea that losing is part of the game. Linda Raschke exemplifies the mind-set associated with this perspective. Raschke initially enjoyed a successful career as a floor trader before injuries sustained in a horse-riding accident forced her to abandon floor trading and trade from an office instead. Raschke then continued to be a consistently profitable trader in her ensuing years as an off-the-floor trader.

  At one point in our interview, Raschke said, “It never bothered me to lose, because I always knew that I would make it right back.” Superficially, that might sound like an arrogant, egotistical comment. But that is not at all in keeping with Raschke’s personality. She is not bragging about her trading. Effectively, what Raschke is really saying is: “I have a methodology that I know is going to win in the long run. Along the way there are going to be some losses. If I lose now, I will win subsequently. As long as I stick with my methodology and keep doing what I am doing, I am going to come out ahead.” She is saying that losing is part of the process and that a trader needs to understand that to be successful.

  Now, if you know you have won the game of trading before you start, then there is no problem taking a loss, because you understand that is just part of the way of getting to the ultimate gain.

  Dr. Van Tharp, a research psychologist I interviewed for Market Wizards, had done his own analysis of the difference between winning and losing traders. Dr. Tharp listed a number of critical beliefs he found that top traders shared. Two of these beliefs directly related to the theme of this chapter. First, top traders believed it was okay to lose money in the market. Second, they knew they had won the game before they started. Now, if you know you have won the game of trading before you start, then there is no problem taking a loss, because you understand that is just part of the way of getting to the ultimate gain.

  The Rationalization of a Losing Trader

  Marty Schwartz described how his transition from a losing trader to a winning trader required accepting that losing was part of the game. He said, “What is the ultimate rationalization of a trader in a losing position? ‘I’ll get out when I am even.’ Why is getting out even so important? Because it protects the ego. I was able to become a winning trader when I was able to say, ‘To hell with my ego—making money is more important.’”

  If you get out even, you can say, “I wasn’t wrong. I didn’t make a mistake.” That need not to be wrong is exactly why people lose. So, the irony is that amateur traders lose money because they try to avoid losing. Professional traders, however, understand that they need to take losses in order to win. They understand that taking losses is an integral part of the trading process. To win at trading, you need to understand that losing is part of the game.

  The Four Types of Trades1

  Most traders think there are two types of trades: winning trades and losing trades. Actually, there are four types of trades: winning trades and losing trades plus good trades and bad trades. Don’t confuse the concepts of winning and losing trades with good and bad trades. A good trade can lose money, and a bad trade can make money. A good trade follows a process that will be profitable (at an acceptable risk) if repeated multiple times, although it can lose money on any individual trade.

  Suppose I offer to bet you on coin tosses with a coin you know is fair (your coin and your toss): heads, you pay me $100; tails, I pay you $200. You accept the bet, toss the coin, and it lands on heads. Was that a bad bet? Of course not. It was a good bet that was also a losing bet. But if we repeated that bet numerous times, you would fare very well, and taking the first bet was a correct decision, even though you lost money. Similarly, a losing trade that adheres to a profitable strategy is still a good trade because if similar trades are repeated numerous times, the process will win on balance.

  Trading is a matter of probabilities. Even the best trading processes will lose a significant percentage of the time. There is no way of knowing a priori which individual trade will make money. As long as a trade adheres to a process with a positive edge, it is a good trade, regardless of whether it wins or loses, because if similar trades are repeated multiple times, they will come out ahead on average. Conversely, a trade that is taken as a gamble is a bad trade, regardless of whether it wins or loses, because, over time, such trades will lose money. As a betting analogy, a winning slot machine wager is still a bad bet (i.e., trade) because if repeated multiple times, it has a high probability of losing money.

  Willing to Lose

  You can’t win if you are not willing to lose. Bruce Kovner says that one of the most important things Michael Marcus taught him was that “you have to be willing to make mistakes regularly; there is nothing wrong with it. Michael taught me about making your best judgment, being wrong, making your next best judgment, being wrong, making your third best judgment, and then doubling your money.”

  Note

  1. Portions of this section have been adapted from Jack D. Schwager, Market Wizards, new ed. (Hoboken, NJ: John Wiley & Sons, 2012).

  Chapter Thirteen

  Patience

  When asked what he thought the average trader did wrong, Tom Baldwin, who in the days before electronic trading was the largest individual trader in the Treasury bond pit, replied, “They trade too much. They don’t pick their spots selectively enough. When they see the market moving, they want to be in on the action. So, they end up forcing the trade rather than waiting patiently. Patience is an important trait many people don’t have.”

  Century-Old Wisdom

  Perhaps the most famous book about trading ever written was Reminiscences of a Stock Operator by Edwin Lefèvre, which was published in 1923 and still remains remarkably pertinent now 90 years later. The book is a fictionalized autobiographical account of the t
rading experiences of a protagonist widely assumed to be Jesse Livermore. The book so accurately captures the mind-set of a trader that I recall when I first read it 35 years ago many people mistakenly assumed Edwin Lefèvre was a pseudonym for Jesse Livermore.

  There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time.

  From Reminiscences of a Stock Operator by Edwin Lefèvre

  In Reminiscences the narrator states, “There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time.” Elsewhere, he explains the reasons for the compulsion of traders to trade every day and the consequences of this mind-set: “The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.” The message is clear: You need to have the patience to wait for real opportunities and resist the temptation to trade all the time.