Don’t Publicize Your Market Calls
As a tangential comment, you should be very wary of trumpeting your predictions about what a market will do. Why? Because if you announce what you believe a market will do, presumably to impress others with your market acumen, you will tend to become invested in that prediction. If the evolving price action and market facts seem to contradict your forecast, you will be more reluctant to change your view than you might otherwise have been. You will find all sorts of reasons why your original forecast might still be right. Paul Tudor Jones is very cognizant of the danger of letting prior market pronouncements affect trading, an issue he specifically addressed. “I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.”
In his early trading years, Ed Seykota had fallen into the trap of broadcasting his opinions. He told a lot of friends that he expected silver prices to keep going up. Then, when silver went down instead, he kept ignoring all the market signs that he was wrong and told himself it was just a temporary correction. “I couldn’t afford to be wrong,” said Seykota, recalling this episode. Fortunately, he was saved by his subconscious. He kept having dreams in which a big, silver aircraft started going down, headed for an inevitable crash. Seykota got the message. “I eventually dumped my silver position,” said Seykota. “I even went short, and the dreams stopped.”
Chapter Fifteen
Size Matters
The Power of Bet Size
Edward Thorp’s track record must certainly stand as one of the best of all time. His original fund, Princeton Newport Partners, achieved an annualized gross return of 19.1 percent (15.1 percent after fees) over a 19-year period. Even more impressive was the extraordinary consistency of return: 227 out of a total of 230 were winning months and a worst monthly loss under 1 percent. A second fund, Ridgeline Partners, averaged 21 percent annually over a 10-year period with only a 7 percent annualized volatility.
Before he ever became interested in markets, Edward Thorp was a math professor whose avocation was devising methods to win at various casino games—an endeavor widely assumed to be impossible. After all, how could anyone possibly devise a winning strategy for games in which the player had a negative edge? One might think that a math professor would be the last person to devote time to such a seemingly futile goal. Thorp, however, approached the problem in a completely unconventional manner. For example, in roulette, Thorpe, along with Claude Shannon (known as “the father of information theory”), created a miniature computer that used Newtonian physics to predict the octant of the wheel in which the ball was most likely to land.
By analogy to blackjack, trading larger for higher-probability trades and smaller, or not at all, for lower-probability trades could even transform a losing strategy into a winning one.
In blackjack, Thorp’s insight was that by betting more on high-probability hands than on low-probability hands, it was possible to transform a game with a negative edge into a game with a positive edge. This insight has important ramifications for trading: varying position size could improve performance. By analogy to blackjack, trading larger for higher-probability trades and smaller, or not at all, for lower-probability trades could even transform a losing strategy into a winning one. Although probabilities cannot be accurately defined in trading as they are in blackjack, traders can often still differentiate between higher- and lower-probability trades. For example, if a trader does better on high-confidence trades, then the degree of confidence can serve as a proxy for the probability of winning. The implication then is that instead of risking an equal amount on each trade, more risk should be allocated to higher-confidence trades and less to lower-confidence trades.
Michael Marcus specifically cited varying position size as a key element of his success. He recognized that he did much better on trades when the fundamentals, the chart pattern, and the market tone (how the market responded to news) all were supportive to the trade. He realized that he would probably be better off if he restricted his trading to only those trades that met all three conditions. However, such opportunities didn’t occur that often, and by his own admission, he “enjoyed the game too much” to wait patiently for only those situations. “I placed the fun of the action ahead of my own criteria,” he said, acknowledging that these nonoptimal trades might have been detrimental on balance. “However, the thing that saved me,” Marcus said, “was that when a trade met all my criteria, I would enter five to six times the position size I was doing on the other trades.”
The Danger of Size
In Paul Tudor Jones’s early years in the markets when he was still a broker, he experienced the most devastating trade of his career. At the time, he was managing speculative accounts in the cotton market. The nearby July contract had been in a trading range and Jones had built up a 400-contract long position for his accounts. One day, he was on the floor of the exchange when July cotton broke below the low end of its range, but then rebounded. Jones thought that with the stops below the range having been taken out, the market would rally. In an act of bravado, he instructed his floor broker to bid higher for 100 contracts, which at the time was a very large order. In an instant, the broker for the firm that held most of the deliverable cotton stocks yelled, “Sold!” Jones immediately realized that the firm intended to deliver its stocks against the July contract he held and that the 400-point premium of July over the following contract (October) price was going to quickly evaporate. He knew right then that he was on the wrong side of the market and instructed his floor broker to sell as much as he could. The market plunged and within 60 seconds was locked limit down. He had only been able to liquidate less than half of his position.
The next morning, the market locked limit down again before Jones could fully liquidate his remaining position. Finally, on the following day, he was able to get out of the remainder of his position, selling some contracts as much as 400 points below the point he had known he wanted to be out.
Jones said that his problem was not the number of points he lost on the trade, but rather that he was trading far too many contracts relative to the equity he managed. His accounts lost about 60 to 70 percent on that single trade! Recalling this painful experience, Jones said, “I was totally demoralized. I said, ‘I am not cut out for this business; I don’t think I can hack it much longer.’ I was so depressed that I nearly quit. . . . It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?’”
That trade was so traumatic that it changed Jones. His focus shifted to what he could lose on a trade, not what he could make. He became much more defensive in his trading. He would never again take a huge risk on a single trade.
Overtrading was also inherent in a disastrous trade that caused Bruce Kovner to lose half of his accumulated profits in a single day. This trade, which is detailed in Chapter 17, instilled in him a bias for maintaining smaller positions. Kovner believes most novice traders trade too large. His advice to traders is: “Undertrade, undertrade, undertrade. . . . Whatever you think your position ought to be, cut it at least in half. My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 percent risks.”
In our interview, Kovner mentioned that he had tried to train about 30 traders, but that only about five of them turned out to be good traders. I asked him if there was some distinguishing characteristic between the majority who weren’t successful at trading versus the minority who were. One of the key differences Kovner highlighted was that the successful traders were disciplined in sizing their positions correctly. “A greedy trader always blows up,” he said.
The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience.
The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment
and experience. Steve Clark, the portfolio manager for the London-based Omni Global Fund,1 a strategy with a strong return/risk record, said that you have to trade within your “emotional capacity.” Otherwise, you will be prone to getting out of good trades on meaningless corrections and losing money on trades that would have been winners. According to Clark, one sure way of knowing your position is too large is if you wake up worrying about it.
Howard Seidler, one of the best-performing of the group of traders trained by Richard Dennis and William Eckhardt, popularly known as the Turtles, learned the lesson of trading beyond his “emotional capacity” very early in his trading career. After he had taken a short position, the market started moving in his direction so he decided to double the position. Shortly afterward, the market started moving back up. It wasn’t a large move, but because of the doubled position size, Seidler was so concerned about his losses that he liquidated not only his added position, but his original position as well. Two days later, the market collapsed as he had originally anticipated. If Seidler had just maintained his original position, he would have made a large profit on the trade, but because he had traded too large and then overreacted, he missed the entire profit opportunity. Speaking of this experience, Seidler said, “There are certain lessons that you absolutely have to learn to be a successful trader. One of those lessons is that you can’t win if you’re trading at a leverage size that makes you fearful of the market.”
Marty Schwartz cautioned traders against increasing their size too quickly when they started to make money. “Most people make the mistake of increasing their bets as soon as they start making money,” he said. “That is a quick way to get wiped out.” He advised waiting until you had at least doubled your capital before beginning to trade larger.
Stepping on the Accelerator
Although trading too large is one of the most common reasons why traders fail, there are times when trading large is justified, and even desirable. Stanley Druckenmiller said that one of the most important lessons he learned from George Soros was that “it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” He said that the few times Soros ever criticized him was when he was right on the market but didn’t “maximize the opportunity.” As an example, Druckenmiller cited an episode that occurred shortly after he started working for Soros. At the time, Druckenmiller was very bearish on the dollar versus the deutsche mark and had placed what he thought was a large position. The position had started working in his favor, and Druckenmiller felt rather proud of himself. Soros came into Druckenmiller’s office and they talked about the trade.
“How big a position do you have?” asked Soros.
“One billion dollars,” answered Druckenmiller.
“You call that a position?” said Soros dismissively. Soros encouraged Druckenmiller to double the position, which he did, and the trade went dramatically further in his favor.
Druckenmiller says that Soros taught him that “when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig.”
Although Druckenmiller had not yet joined Soros Management at the time, he heard what had happened at the firm in the aftermath of the Plaza Accord in 1985, a meeting in which the United States, United Kingdom, West Germany, France, and Japan agreed to a unified policy to depreciate the dollar versus the other currencies. Soros had been heavily long the yen going into the meeting, and other traders in the office had piggybacked his position. The Monday morning after the agreement had been reached, the yen opened 800 points higher. The traders at Soros Management couldn’t believe the size of their sudden windfall gain and started taking profits. Soros came bolting out of the door, telling them to stop selling the yen and that he would assume their positions. Druckenmiller drew the lesson from this episode. “While these other traders were congratulating themselves for having taken the biggest profit in their lives, Soros was looking at the big picture. The government had just told him that the dollar was going to go down for the next year, so why shouldn’t he be a pig and buy more [yen]?”
Readers should be careful in the lesson they draw from this section. The point is not that traders should be willing to take large, aggressive trades, but rather that they should be willing take larger trades when they have very high conviction.
Volatility and Trading Size
Too many traders maintain the same position sizing through different market conditions. However, if the desire is to keep risk approximately equal through time, then position sizing needs to adjust for significant changes in market volatility. Colm O’Shea recalls that in 2008 he would run across managers who said they had cut their risk in half. O’Shea would say, “Half—that’s quite a lot.” Then they would continue and say, “Yes, my leverage was four, and it is now two.” O’Shea would answer, “Do you realize volatility has gone up five times?” These managers had thought they had reduced risk, but in volatility-adjusted terms, their risk had actually gone up.
Correlation and Trading Size
Different positions are not independent like separate coin tosses. Although they sometimes may be independent, at other times they may be significantly correlated. If different positions are positively correlated, then the probability of a portfolio loss of any given magnitude is increased because there will be a tendency for losses in different positions to occur simultaneously. To account for this greater risk, position sizing should be reduced when different positions are positively correlated.
After a long career of trading a variety of arbitrage strategies, Edward Thorp developed and traded a trend-following strategy. When I asked him how he achieved significantly better return/risk performance than other trend-following practitioners, he attributed the improvement, in part, to incorporating a risk-reduction strategy based on correlations. He described the process as follows: “We traded a correlation matrix that was used to reduce exposures in correlated markets. If two markets were highly correlated and the technical system went long one and short the other, that was great. But if it wanted to go long both or short both, we would take a smaller position in each.”
Note
1. The strategy was rebranded as the Omni Global Fund in February 2007. Prior to that time, the strategy was called the Hartford Growth Fund and was not open to outside investors.
Chapter Sixteen
Doing the Uncomfortable Thing
The Outperforming Monkey
William Eckhardt believes that the natural human tendency to seek comfort leads people to make decisions that are worse than random in trading. I want to be clear. You have probably heard the famous quote by Burton Malkiel, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts,” or some variation of that theme frequently uttered by those deriding the purported folly of trying to beat the market. Eckhardt is not saying that. He is not saying a monkey could do as well as the professional money managers. Eckhardt is saying the monkey will do better.
What feels good is often the wrong thing to do.
William Eckhardt
Now, why will the monkey do better? The monkey will do better because humans have evolved to seek comfort, and the markets don’t pay off for being comfortable. In the markets, seeking comfort means doing what is emotionally satisfying. Eckhardt says, “What feels good is often the wrong thing to do.” He quotes his former trading partner, Richard Dennis, who used to say, “If it feels good, don’t do it.”
As an example of doing what feels good in the markets, Eckhardt cites what he terms “the call of the countertrend.” Buying on weakness and selling on strength appeals to the natural human desire to buy cheap and sell dear. If you buy a stock when it falls to a six-month low, it feels good because you are smarter than everyone else who bought that stock in the past six months. Although these trades may feel better at the moment of implementation,
for most people, following such a countertrend approach will be a losing, and possibly even disastrous, strategy.
As another example, Eckhardt explains that because most small profits tend to vanish, people learn the lesson to cash in profits right away, which may feel good, but is detrimental over the long run because it will also impede the ability earn large profits on any trade. As a third example, Eckhardt says that the tendency of markets to trade through the same price repeatedly leads people to hold on to bad trades in the hope that if they wait long enough, the market will return to their entry level.
The Little Book of Market Wizards Page 8