The Little Book of Market Wizards

by Jack D. Schwager

  A Master of Patience

  When I interviewed Michael Marcus, he identified Ed Seykota as the most influential person in transforming him into a successful trader. Seykota was one of the pioneers in the systematic trading of futures and achieved remarkable compounded returns. One of his accounts, which started in 1972 with $5,000, had increased by 250,000 percent by the time I interviewed Seykota in 1988.

  One of the most important lessons Marcus learned from Seykota was patience. As Marcus recalls, “One time, he was short silver, and the market kept edging down, a half penny a day, a penny a day. Everyone else seemed bullish, talking about why silver had to go up because it was so cheap, but Ed stayed short. Ed said, ‘The trend is down, and I’m going to stay short until the trend changes.’ I learned patience from him in the way he followed the trend.”

  When I interviewed Seykota, I was surprised that he did not have a quote machine on his desk and asked him about it. Seykota wryly replied, “Having a quote machine is like having a slot machine on your desk—you end up feeding it all day long. I get my price data after the close each day.” Seykota’s systems would give him trade signals when the conditions for a trade were met based on daily price data. Seykota did not even want to know about intraday market gyrations, as they could only provide a temptation to trade more frequently than dictated by his methodology. The dangers of watching every tick are twofold: It can lead to overtrading, and it is likely to increase the chances of prematurely liquidating good positions on insignificant adverse market moves.

  The Power of Doing Nothing

  The basic idea is that you have to wait for the trading opportunities and resist the natural urge to trade more frequently. Jim Rogers stressed the importance of trading only when you have very strong convictions. “One of the best rules anybody can learn about investing,” he said, “is to do nothing, absolutely nothing, unless there is something to do.”

  When I then asked Rogers whether he always had to have everything line up before taking a position, or whether he might occasionally put on a trade based on his hunch of an impending price move, he answered, “What you just described is a very fast way to the poorhouse. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up.” In other words, until the trade is so obvious that it’s like picking money up off the floor, he does nothing. Waiting for such ideal opportunities requires the patience to allow a lot of nonoptimal trades to pass by without participating.

  The idea that you don’t have to trade was also brought up by Joel Greenblatt, the manager of Gotham Capital, an event-driven hedge fund. During the 10 years of its operation (1985–1994), Gotham realized an average annual compounded return of 50 percent (before incentive fees) with a worst single year of positive 28.5 percent. Greenblatt closed Gotham Capital because assets had grown to the point where they were impeding returns. After an interim of trading only proprietary capital, Greenblatt returned to money management using value-based strategies that could accommodate more capital.

  There are no called strikes on Wall Street.

  Warren Buffett

  As a hobby, Greenblatt has taught a course in the Columbia Business School for many years. In our interview, Greenblatt related the advice he gave students when they asked him what to do with companies whose future earnings were very difficult to predict because of rapid technological changes, new products, or other factors. Greenblatt is a big fan of Warren Buffett and invoked a Buffett aphorism in advising his students how to handle such ambiguous investment situations. “I tell them to skip that company and find a company that they can analyze. It is very important to know what you don’t know. As Warren Buffett says, ‘There are no called strikes on Wall Street.’ You can watch as many pitches as you want and only swing when everything sets up your way.”

  Claude Debussy said, “Music is the space between the notes.” One could also say that successful trading is the space between the trades. Just as the notes not played are important to music, the trades not taken are important to trading success. Kevin Daly, an equity trader I interviewed in Hedge Fund Market Wizards, provides a perfect example of this principle. Although, technically speaking, Daly is a long/short equity manager, his total short position is invariably very small—almost always measured in single-digit percentages of assets under management. So, in this sense, Daly is much closer to a long-only equity manager than to a long/short manager. Daly launched his fund in late 1999, only about a half-year before the major stock market top in early 2000. Clearly, this was an unpropitious staring point for a manager whose portfolio primarily consists of long equities. Yet, despite this unfavorable timing, at the time I interviewed Daly, he had managed to achieve a cumulative gross return of 872 percent during an 11-year period in which the Russell 2000 was up only 68 percent and the S&P 500 was actually down 9 percent.

  How did Daly achieve such strong returns during a period of near flat stock prices, despite running a portfolio that was predominantly long? Part of the answer is that he was very good at picking stocks that outperformed the indexes. But perhaps the most important factor in explaining Daly’s outperformance is that he had the discipline to remain largely in cash during negative market environments, which allowed him to sidestep large drawdowns during two major bear markets. During a time span in which the S&P 500 witnessed two separate occasions where it lost nearly half its value, Daly’s largest peak-to-valley drawdown was only 10 percent. The key is that by avoiding large losses by not trading, Daly was able to increase his cumulative return tremendously. Achieving this result necessitated maintaining a very low exposure for much of the extended 2000–2002 bear market. Think of the patience that required. Daly’s patience and the trades that he did not take made all the difference.

  Mark Weinstein, a trader I interviewed in Market Wizards, used an animal kingdom analogy to illustrate the link between patience and good trading: “I also don’t lose much on my trades because I wait for the exact right moment. . . . Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but preferably one that is sick and lame. Only then, when there is no chance it can lose its prey, does it attack. That, to me, is the epitome of professional trading.”

  As the foregoing illustrations demonstrate, the Market Wizards wait patiently, doing nothing until there is a sufficiently compelling trade opportunity. The lesson is that if conditions are not right, or the return/risk trade-off is not sufficiently favorable, don’t do anything. Beware of taking dubious trades born out of impatience.

  Doing nothing is harder than it sounds because it requires resisting the natural human tendency to trade more frequently—a consequence of the addictive nature of trading. William Eckhardt, a long-term successful trader and CTA and former partner of Richard Dennis, who along with Dennis trained the group of CTAs known as the Turtles, explained why trading is addictive. “When behavioral psychologists have compared the relative addictiveness of various reinforcement schedules, they found that intermittent reinforcement—positive and negative dispensed randomly (for example, the rat doesn’t know whether it will get pleasure or pain when it hits the bar)—is the most addictive alternative of all, more addictive than positive reinforcement only.”

  The Wisdom of Sitting

  Patience is not only essential in getting into a trade, but also critical in getting out of a trade. Once again quoting from Reminiscences of a Stock Operator, “It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and. . . . they made no real money out of it. Men who can both be right and sit tight are uncommon.”

&nb
sp; The theme of what I would call “the importance of sitting” also came up in some of my interviews. One particular proponent of this concept was William Eckhardt, who cited “You can’t go broke taking a profit” as one of the most wrongheaded adages about trading. “That’s precisely how many traders do go broke,” said Eckhardt. “While amateurs go broke by taking large losses, professionals go broke by taking small profits.” The problem, Eckhardt explains, is that human nature seeks to maximize the chance of gain rather than the gain itself. Eckhardt believes that the desire to maximize the number of winning trades works against the trader by encouraging the premature liquidation of good trades. In effect, the need to ensure that a trade will end up in the winning column leads traders to leave a lot of money on the table, thereby severely reducing their total gain in order to increase their winning percentage—a misguided and detrimental goal. As Eckhardt says, “The success rate of trades is the least important performance statistic and may even be inversely related to performance.” The message is that regardless of your methodology or the time frame of your trades, you have to allow the good trades to work to their reasonable fruition if you want to pay for the losing trades and still leave a good margin of profit. As Marcus succinctly phrased it, “If you don’t stay with your winners, you are not going to be able to pay for the losers.”

  In summary, patience is a critical quality for a trader—both in getting into and in getting out of trades.

  Chapter Fourteen

  No Loyalty

  Loyalty is a good trait—in family, friends, and pets, but not in a trader. For a trader, loyalty is a terrible trait. As a trader, loyalty to an opinion or position can be disastrous. The absence of loyalty is flexibility—the ability to completely change your opinion when warranted. It is the trait Michael Marcus points to when asked what makes him different from most traders. As Marcus explains, “I am very open-minded. I am willing to take in information that is difficult to accept emotionally. . . . When a market moves counter to my expectations, I have always been able to say, ‘I had hoped to make a lot of money in this position, but it isn’t working, so I’m getting out.’”

  “The Market Was Telling Me I Was Wrong”

  In April 2009, in the aftermath of the financial collapse of late 2008 and early 2009, Colm O’Shea was still very pessimistic about the markets and positioned accordingly. “But,” says O’Shea, “the market was telling me I was wrong.” O’Shea described his thought process at the time: “China is turning around, metal prices are turning higher, and the Australian dollar is moving up. What is that telling me? There is a recovery somewhere in the world. . . . So I can’t stick with the-whole-world-is-terrible thesis. What hypothesis would fit the actual developments? Asia actually looks all right now. A scenario that would fit is an Asian-led recovery.”

  Recognizing that his major fundamental view was wrong, O’Shea abandoned it. Sticking with his original market expectations would have been disastrous, as both equity and commodity markets embarked on a multiyear rally. Instead, by having the flexibility to recognize his worldview was wrong and reversing his market directional bias, O’Shea achieved a profitable year, even though his original market outlook was totally incorrect.

  O’Shea cites George Soros as a paragon of flexibility. “George Soros,” he says, “has the least regret of anyone I have ever met. . . . He has no emotional attachment to an idea. When a trade is wrong, he will just cut it, move on, and do something else. I remember one time he had this huge FX [foreign exchange] position. He made something like $250 million on it in one day. He was quoted in the financial press talking about the position. It sounded like a major strategic view he had. Then the market went the other way, and the position just disappeared. It was gone.”

  Jones Reverses Course

  I interviewed Paul Tudor Jones on separate visits spaced about two weeks apart. On the first interview Jones was very bearish on the stock market and heavily short the Standard & Poor’s (S&P) 500 index. By my second visit, his view on the stock market had changed dramatically. The failure of the stock market to follow through on the downside as he had anticipated convinced Jones that he was wrong. “This market is sold out,” he announced emphatically on my second visit. He not only had abandoned his original short position but had gone long based on the evidence that his original projection was wrong. This 180-degree shift within a short time span exemplified the extreme flexibility that underlies Jones’s trading success. And, yes, his change of heart proved well timed, as the market moved sharply higher in the ensuing weeks.

  Caught by a Surprise

  At a time when Michael Platt held a massive long position in European interest rate futures, the European Central Bank (ECB) hiked rates very unexpectedly. It was a devastating hit for the position, but Platt was completely unaware of the situation because, at the time, he was on a flight from London to South Africa. As soon as his plane landed, he received an urgent call from his assistant, telling him what had happened and asking for instructions.

  “How much are we down?” asked Platt.

  “About $70 million to $80 million,” his assistant replied.

  Platt reasoned that if the ECB had started raising rates, the rate hikes were likely to continue. He could see the trade turning into a $250 million loss within a week if he didn’t act quickly. “Dump everything!” he instructed his assistant.

  When I am wrong, the only instinct I have is to get out. If I was thinking one way, and now I can see that it was a real mistake, then I am probably not the only person in shock, so I’d better be the first one to sell. I don’t care what the price is.

  Michael Platt

  Commenting on this experience, Platt said, “When I am wrong, the only instinct I have is to get out. If I was thinking one way, and now I can see that it was a real mistake, then I am probably not the only person in shock, so I’d better be the first one to sell. I don’t care what the price is.”

  Surviving the Worst Trading Blunder Ever

  Perhaps the best example I ever came across of lack of loyalty to a position involved Stanley Druckenmiller, whose Duquesne Capital Management hedge fund achieved an average annual return near 30 percent over a 25-year period—surely one of the best long-term track records ever. Our story begins on October 16, 1987. If you are having trouble placing the significance of that date, I’ll give you a hint—it was a Friday.

  At the time, Druckenmiller was managing multiple funds for Dreyfus in addition to his own Duquesne fund. Druckenmiller came into that Friday net short. Many people forget that the October 19, 1987 crash was not an abrupt event that materialized out of nowhere. Prior to that day, the market was, in fact, in the midst of a near 20 percent slide that had begun two months earlier, with 9 percent of the decline occurring in the prior week alone. By the afternoon of Friday, October 16, 1987, Druckenmiller decided the market had fallen far enough and was near what he believed would be a major support area. So he covered his short position. Bad move, right? Well, it was actually much worse. He not only covered his short position, but also went net long—heavily long. In fact, on that day, Druckenmiller switched from net short to 130 percent long (that is, a leveraged long position).

  In the past, when describing this episode in a talk, I used to ask the audience if anyone had ever made a worse trading mistake. I stopped asking the question because I realized you couldn’t even make up a worse trading blunder than switching from a net short equity position on Friday, October 16, 1987 to a leveraged long position.

  Despite this enormous error, if you check Druckenmiller’s track record, incredibly, October 1987 shows up as only a moderate loss. How is that possible? Well, first of all, during the first half of the month, Druckenmiller was short, so he made money. Now here is the thing: Between Friday’s close and Monday’s opening, Druckenmiller decided he had made a terrible mistake. Why is not important here. If you are curious, the reasons were fully detailed in The New Market Wizards. What is important is that Druckenmiller realized he
had gravely erred by going heavily long and was determined to get out of his position Monday morning. The only problem with this plan was that the market opened enormously lower on Monday morning. So what did Druckenmiller do? He covered his entire new long position in the first hour of trading on Monday. Not only did he cover his long position, he went net short again! Think of the incredible lack of loyalty to a position that is required to reverse a large position and then reverse it again on the next trading day after the market had moved tremendously against the previously reversed position.

  Good traders liquidate their positions when they believe they are wrong; great traders reverse their positions when they believe they are wrong.

  Good traders liquidate their positions when they believe they are wrong; great traders reverse their positions when they believe they are wrong. If you want to succeed as a trader, you can’t have loyalty to your position.

  A Bad Idea Transformed

  Flexibility, or lack of loyalty, also applies to entering trades, as illustrated by Jamie Mai’s biggest short trade in 2011. Jamie Mai is the portfolio manager of Cornwall Capital, a hedge fund with strong return/risk numbers, which was one of big winners on the short side of subprime mortgage-backed securities that was originally profiled in Michael Lewis’s excellent book, The Big Short. Indeed, it was Lewis’s book that made me aware of Mai and led to my interviewing him for Hedge Fund Market Wizards.

  In 2011, Mai noted that China, which was both the world’s largest producer and its largest consumer of coal, had transitioned from being a net exporter to a net importer and that this trend was accelerating. It had taken a decade for Chinese coal exports to decline from 100 million tons to zero, but only two years for imports to grow by one-and-a-half times this amount. Mai’s initial impression was that this huge, unabated growth in Chinese coal imports would lead to a sharp increase in demand for dry bulk freight. Moreover, the dry bulk shippers were trading at depressed cash flow multiples. Going long these stocks seemed like a perfect trade. But Mai, who comes from a private equity background, is very deliberate in his trade placement; every trade idea must be thoroughly researched before it is implemented. As Mai dug deeper, he discovered that high freight rates due to rising commodity demand from emerging market economies had led to a shipbuilding boom several years earlier and that these freighters were just coming onstream, with fleet capacity increases running at about 20 percent annually. Mai realized that even with the most optimistic expectations for freighter demand by China, there was still going to be a large surplus of dry bulk capacity coming on line. So, ironically, although Mai had started out with the idea of going long dry bulk shippers, he ended up doing the reverse trade by going short via long out-of-the-money put positions—the firm’s highest-conviction short trade for the year.