The Little Book of Market Wizards

by Jack D. Schwager

  “Okay, what is the good news?” Marcus asked.

  “The good news is that the export commitment figure was fantastic. The bad news is that you don’t have a limit position.” (A limit position is the maximum permissible speculative position size.)

  The report was so bullish that the general expectations were that the market would be limit up for three consecutive days. Even though he was heavily long, and the report implied his position would realize spectacular profits, Marcus actually felt a little depressed because he did not have the maximum permissible position for a speculator. The next morning, Marcus put in an order to buy more contracts on the opening, just in case he got lucky and the market traded momentarily before locking limit up. Then, “I sat back to watch the fun,” Marcus said.

  The market opened limit up as had been expected, but then prices eased off the limit. The phone rang. It was Marcus’s broker reporting his buy orders had all been filled. The market started moving lower. Marcus thought, Soybeans were supposed to be limit up for three days, and they can’t even hold limit up for the first morning. He immediately called his broker, frantically giving him sell orders. Marcus was so excited that he lost count of the amount he sold and actually ended up not only getting out of his entire position, but also going significantly net short as well—short positions he ultimately bought back at much lower prices. “It was the only time I made a lot of money on an error,” Marcus said.

  When Marcus told me this story, it strongly reminded me of an event I had experienced during the largest bull market in cotton in the twentieth century when prices reached nearly $1.00 per pound—their highest level since the Civil War. I recall I was long cotton, and the weekly export report showed sales of a half million bales to China. It was by far the most bullish cotton export report I had ever seen. But instead of locking limit up (200 points higher) the next morning, cotton opened up only about 150 points higher and then started trading down. That opening proved to be the exact market top—a high that would not be seen again for well over 30 years.

  Druckenmiller Is on the Wrong Side of the Market

  In the aftermath of the fall of the Berlin Wall and German reunification, Stanley Druckenmiller held a large long position in the deutsche mark based on the premise that Germany would adhere to both an expansionary fiscal policy and a tight monetary policy—a bullish combination. He was still very heavily long at the start of the first Iraq war. Being long the deutsche mark would prove to be a very bad position in the ensuing period. Druckenmiller, however, largely avoided the impending losses, as he abandoned his long-standing bullish position in the deutsche mark, selling $3.5 billion worth in one day.

  I asked Druckenmiller what caused his sudden change in opinion on the deutsche mark. He explained, “The dollar had been supported by safe-haven buying during the initial stage of the U.S. war with Iraq. One morning, there was a news story that Hussein was going to capitulate before the start of the ground war. The dollar should have sold off sharply against the deutsche mark on the news, but it declined only slightly. I smelled a rat.”

  The Invincible Position

  In 2009, Michael Platt placed a large position in a trade that sought to benefit from a widening yield curve (i.e., long-term interest rates rising more or falling less than short-term rates). There was a succession of news items that were detrimental to the trade. Each time, Platt thought, I am going to get screwed in this position, and each time nothing happened. After this scenario repeated several times, Platt thought that the yield curve just couldn’t get any flatter no matter what news came out. He quadrupled his position, and the yield curve went from 25 points to 210 points (albeit Platt took his profits about halfway into this move). It was his biggest winning trade of the year.

  The Submerged Volleyball

  Scott Ramsey is the portfolio manager for Denali Asset Management, a commodity trading advisory firm, which has an average annual compounded return of 15 percent (net) with annualized volatility of 11 percent during its 13-year history. Ramsey compared the ability of the market to shrug off a crisis event to the release of a volleyball pushed underwater. Speaking of the ability of the European and U.S. equity markets to rally to new highs a day after the European Central Bank bailed out Ireland, Ramsey said, “Think of taking a volleyball and pushing it underwater—that is your crisis event. Then you let go—the event dissipates—and the ball goes popping out of the water. That is exactly what we experienced in the markets.” To Ramsey, this type of price resilience indicated that the markets were in a “risk-on” mode and very likely to continue moving higher.

  Buy the Strongest, Sell the Weakest

  Ramsey also believes that the relative strength of markets during a crisis can be a useful predictor. “Just a simple exercise of measuring which markets were the strongest during a crisis,” he says, “can tell you which markets are likely to be the leaders when the pressure is off—the markets that will be the volleyball popping out of the water.”

  Just a simple exercise of measuring which markets were the strongest during a crisis can tell you which markets are likely to be the leaders when the pressure is off—the markets that will be the volleyball popping out of the water.

  Scott Ramsey

  Ramsey considers the relative strength of markets an important factor in all circumstances, not just crisis events. He always wants to be long the strongest market and short the weakest. As an example, when QE2 (the second phase of quantitative easing by the Federal Reserve) was ending, Ramsey expected that the shift of assets out of the dollar would stop and the dollar would recover. The question was which currency should be used as the short against the dollar. “The weak link,” Ramsey said, “turned out to be the Turkish lira, which was breaking out to a two-year low against the hated dollar. If it couldn’t rally versus the dollar when the Fed was printing money like crazy, what was it going to take?”

  Michael Marcus made the same point about buying the strongest market and selling the weakest. “You absolutely want to put down a bet when a market acts terribly relative to everything else,” he said. “When the news is wonderful and a market can’t go up, then you want to be sure you are short.” As an illustration, he recalled a very inflationary period in the 1970s when all the commodity markets were trading in lockstep fashion. On one particularly extreme day, almost all the commodity markets were limit up. On that same day, cotton opened limit up, but then sold off, finishing only marginally higher for the day. “That was the market peak,” Marcus said. “Everything else stayed locked limit up, but cotton never saw the light of day again.”

  Most novice traders will seek to buy the laggards in a sector based on the premise that these markets provide the best return/risk potential because they have not yet moved as much as the others. Marcus and Ramsey are saying that traders should do the exact opposite.

  Correlation as a Clue

  There are periods when different markets will move in relative tandem. During such periods, the failure of a market to respond as expected to the price action of a correlated market can provide an important price clue. Ramsey cited the example of the complete breakdown in the correlation between commodity prices and equity prices in September 2011.

  Following the 2008 financial crisis, previously uncorrelated markets became highly correlated, as the markets shifted between “risk-on” and “risk-off” environments. During risk-on periods, equities, commodities, and foreign currencies (versus the dollar) all tended to move higher. On risk-off days, the exact opposite price behavior prevailed.

  In mid-September 2011, this correlation pattern completely broke down. Even though equity prices had rebounded to the top of a two-month trading range, copper, which is typically a leading indicator for commodity prices, was near its low for the year, completely unresponsive to the rebound in equity prices. Ramsey took this price action as a sign that commodity prices in general, and copper in particular, were vulnerable to a decline—a downtrend that subsequently occurred.

  Chapt
er Twenty

  The Value of Mistakes

  To do my vacuum cleaner, I built 5,127 prototypes. That means I had 5,126 failures. But as I went through those failures, I made discoveries.

  James Dyson

  I have not failed. I’ve just found 10,000 ways that won’t work.

  Thomas Edison

  More is learned from one’s errors than from one’s successes.

  Primo Levi

  Improvement through mistakes is probably a good thumbnail description of Ray Dalio’s core philosophy as well. Dalio loves mistakes because he believes mistakes provide the learning experiences that lead to improvement. The idea that mistakes provide the pathway to progress permeates the corporate culture that Dalio has sought to instill in his company, Bridgewater. Dalio is almost reverential in his comments about mistakes:

  I learned that there is an incredible beauty in mistakes because embedded in each mistake is a puzzle and a gem that I could get if I solved it (i.e., a principle that I could use to reduce my mistakes in the future). I learned that each mistake was probably a reflection of something that I was (or others were) doing wrong, so if I could figure out what that was, I could learn how to be more effective. . . . While most others seem to believe that mistakes are bad things, I believe mistakes are good things because I believe that the most learning comes via making mistakes and reflecting on them.

  Dalio has written down his life philosophy and management concepts in Principles, a 111-page document that is required reading for all Bridgewater employees. The second portion of this work is a list of 277 management rules, which, not surprisingly, includes rules that pertain to mistakes. A sampling:

  Recognize that mistakes are good if they result in learning.

  Create a culture in which it is okay to fail but unacceptable not to identify, analyze, and learn from mistakes.

  Recognize that you will certainly make mistakes and have weaknesses; so will those around you and those who work for you. What matters is how you deal with them. If you treat mistakes as learning opportunities that can yield rapid improvement if handled well, you will be excited by them.

  If you don’t mind being wrong on the way to being right, you will learn a lot.

  Marty Schwartz drew a contrast between trading and other careers in regard to how people respond to mistakes, “Most people, in most careers, are busy trying to cover up their mistakes. As a trader, you are forced to confront your mistakes because the numbers don’t lie.”

  Analyzing Your Trades

  Steve Clark advises traders who work for him to dissect their profit and loss (P&L) to see what is working and what is not. He says traders often don’t know where their profits are coming from. Even when they do, this knowledge may be ignored. He described a common experience of traders seeking his advice who say, “I have been running this book, and these things have been going really well, but I keep losing money on this.” Clark would tell them, “Do more of what works and less of what doesn’t.” This comment may sound like obvious advice, but it is surprising how many traders fail to follow this simple rule.

  Do more of what works and less of what doesn’t.

  Steve Clark

  The Trader’s Log

  Several of the Market Wizards mentioned that writing up and analyzing their trades were critical to their success. Ray Dalio traced the origin of the Bridgewater system to this process: “Beginning around 1980, I developed a discipline that whenever I put on a trade, I would write down the reasons on a pad. When I liquidated the trade, I would look at what actually happened and compare it with my reasoning and expectations when I put on the trade.”

  Randy McKay attributed his early success to a rigorous routine of analyzing his trades. He described beginning this process in the years when he traded on the exchange floor: “One of the things I did that worked in those early years was analyzing every single trade I made. Every day, I made copies of my cards and reviewed them at home. Every trader is going to have tons of winners and losers. You need to determine why the winners are winners and the losers are losers. Once you can figure that out, you can become more selective in your trading and avoid those trades that are more likely to be losers.”

  Each mistake, if recognized and acted upon, provides an opportunity for improving a trading approach. Most traders would benefit by writing down each mistake, the implied lesson, and the intended change in the trading process. Such a trading log can be periodically reviewed for reinforcement. Trading mistakes cannot be avoided, but repeating the same mistakes can be, and doing so is often the difference between success and failure.

  Chapter Twenty-One

  Implementation versus Idea

  A Post-Bubble Trade

  How a trade is implemented can be more important than the trade idea itself. Colm O’Shea viewed the runaway bull market in NASDAQ in 1999 and early 2000 as a bubble. When the market broke sharply in March 2000, he was relatively sure that a major top was in place and that equities would surrender most of their prior gains. Despite this expectation, O’Shea never considered going short equities. Why? Because, as he explained, while the price rise during a bubble can be quite smooth, the price decline after a bubble bursts is typically interspersed by treacherous bear market rallies.

  O’Shea thought the repercussions of a market top would be much easier to play than a direct short in equities. Specifically, he reasoned that the U.S. economy had been artificially boosted by the massive mispricing of assets. Once the NASDAQ bubble burst, O’Shea thought it was clear that the economy would slow down. A weakening economy would, in turn, lead to a decline in interest rates. So instead of implementing a short equity position, O’Shea went long bonds. Although both trends materialized—that is, stocks declined and interest rates declined—the big difference was that, as O’Shea had anticipated, the stock price decline was highly erratic, while the interest rate decline (bond price rise) was relatively smooth.

  The trade was highly successful, not because the underlying premise was correct, which it was, but rather because of the way the trade was implemented.

  Even though the March 2000 peak in the NASDAQ led to a plus-80 percent decline lasting two and a half years, in the summer of 2000 the NASDAQ witnessed a plus-40 percent rebound. If O’Shea had executed his idea through a short stock index position, he would have been correct in his call, but most likely would have lost money by being stopped out during this massive bear market rally. In contrast, the long bond position, which he had implemented instead of going short equities, witnessed a fairly smooth uptrend. The trade was highly successful, not because the underlying premise was correct, which it was, but rather because of the way the trade was implemented.

  A Better Option

  Sometimes, options may offer a much better means of implementing a trade than an outright position. Joel Greenblatt’s description of his trade in Wells Fargo provides a perfect example of a situation in which an option position implied a much higher return/risk ratio than a straightforward long position.

  As Joel Greenblatt explained, “In the early 1990s, Wells Fargo, which had an excellent long-term, consistent fee-generating business, came under a lot of pressure because of its high concentration of commercial real estate loans in California, at a time when California was in the midst of a deep real estate recession. It was a possibility, although unlikely, that the real estate downturn could be so severe that Wells Fargo would go through all its equity before investors could get the benefit of its long-term fee generation. If it survived, though, the stock would likely be much higher than its current depressed price of $80, which reflected prevailing concerns.

  “The way I looked at the risk/reward of the stock was that it was a binary situation: The stock would go down $80 if Wells Fargo went out of business and up $80 if it didn’t. But by buying LEAPS [long-term equity anticipation securities] with more than two years until expiration instead of the stock, I could turn that 1:1 risk/reward into a 1:5 risk/reward. If the bank survived, the stock should
be a double, and I would make five times my money on the options, but if it failed, I would lose only the cost of the options. I thought the odds were much better than 50–50 that the bank would survive, so the stock was a buy. But in terms of risk/reward, the options were an even better buy. The stock did end up more than doubling before the options expired.”

  Chapter Twenty-Two

  Off the Hook

  A Unique Observation

  Some items of trading advice, such as the importance of risk management and the need for discipline, albeit absolutely critical, were cited by many of the traders I interviewed. Occasionally, however, a trader offered an insight that no one else had mentioned before. I particularly like these unique observations.

  A perfect example of this type of trading principle was Marty Schwartz’s dictum related to situations in which you are very worried about your position and the market lets you off the hook easily. Schwartz said, “If you’re ever very nervous about a position overnight, and especially over a weekend, and you’re able to get out at a much better price than you thought possible when the market trades, you’re usually better off staying with the position.”