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.
Marty Schwartz
On the Hook
An illustration of Schwartz’s observation came up in my interview with Bill Lipschutz when he described the first time in his trading career that he was truly scared. At the time, he traded a very large proprietary foreign exchange (FX) account for Salomon Brothers. It was the fall of 1988, and Lipschutz was looking for the dollar to decline vis-à-vis the deutsche mark. He explained that since the market was in a low-volatility period, his position size was much larger than normal. He was short $3 billion against the deutsche mark. It was a Friday afternoon, and Mikhail Gorbachev gave a speech at the United Nations in which he stated that the Soviet Union was going to implement troop reductions. The market took that to mean that the United States would now be more likely to cut its defense spending, which, in turn, would be beneficial for deficit reduction. In response, the dollar immediately started to strengthen.
Lipschutz fully expected the market to continue to move against him. He would have liquidated his position if he could have, but given the large size of his holdings, this action was impossible in light of the thin liquidity of the late Friday afternoon market in New York. Lipschutz thought his only possibility for exiting the position was to wait for the Tokyo open (Sunday evening New York time) when there would be much greater liquidity. In the meantime, his strategy was to keep the dollar from rallying further versus the deutsche mark in the thin Friday afternoon market. So, in an effort to push down the dollar vis-à-vis the deutsche mark, Lipschutz sold an additional $300 million. The market absorbed this large order like a sponge. There was not even a hint of weakness. Lipschutz knew he was in deep trouble.
He walked over to firm’s president and said, “We have a problem.”
“What is it?” the president asked.
Lipschutz replied, “I’m short the dollar, and I’ve misjudged my liquidity in the market. I’ve tried to hold the market down, but it’s not going to work. And I can’t buy them back.”
The president calmly asked, “Where do we stand?”
“We’re down somewhere between $70 and $90 million,” Lipschutz answered.
“What’s the plan?” he asked.
Lipschutz answered, “When Tokyo opens, I have to see where it’s trading. My intention is to cover half the position at that time and go from there.”
Lipschutz sweated out the weekend. Then when Tokyo opened Sunday night, the dollar was actually moving lower. The market was letting Lipschutz off the hook. Lipschutz, however, abandoned his prior plan to cover half the position in the early part of the Tokyo session. Instead, he waited. The dollar kept on sliding. Lipschutz eventually covered the entire position in the European session with an $18 million loss, which seemed like a great victory after having been down nearly five times that amount Friday afternoon.
I asked Lipschutz why he held on to his entire position when most people in his situation would have been so relieved to get out at a better price that they would have liquidated everything on the Tokyo opening. Lipschutz replied, “The reason I didn’t get out on the Tokyo opening was that it was the wrong trading decision.”
Schwartz Saves Me Money
I had a personal trading experience in which Schwartz’s advice figured prominently. In 2011, the NASDAQ rallied sharply from a mid-June relative low into early July, approaching the highs of the entire long-term up move. The day before the release of the July unemployment report, the market set its highest close since the start of the rebound, suggesting bullish expectations for the following day’s report. The actual report released the next day, however, reflected extremely bearish expectations. Typically, when an unemployment report is bearish, market commentators will find some mitigating statistic or factor. This report was so negative that commentators couldn’t find any element of it that was constructive. The market sold off sharply in response to the report and continued to move lower in the ensuing hours. Then, in the early afternoon, prices began to rebound and continued to trend steadily higher for the remainder of the session. By the close, the market had erased 75 percent of the losses from the low of the day. This was a Friday, so it was also a strong weekly close, with prices finishing not far below the recent multiyear high.
At the time, I was looking for an intermediate top and had come into the day positioned extremely short. The market’s ability to shrug off very bearish news, combined with a strong weekly close near multiyear highs, looked like extremely bullish price action to me. By any objective assessment of the day’s price action, I had to admit to myself that I was likely on the wrong side of the market. I expected the market to open higher on Sunday night and then to see another upward leg. After Friday’s price action, I was resigned to liquidating a major portion of my position beginning Sunday night and into Monday. On Sunday night, however, although I was dreading the worst, the market actually traded down 15 full points from the Friday close in the first 10 minutes. Recalling Schwartz’s dictum, I liquidated only a token 10 percent of my short position. The market was much lower on Monday’s equity market opening and continued sharply lower thereafter. Following Schwartz’s advice had saved me a lot of money.
If the market lets you off the hook easily, don’t get out.
Why does the rule about not getting out when the market lets you off the hook easily tend to work more often than not? Because—think about it—if you are really worried about a position overnight, and especially over the weekend, it will be because something dramatic has happened. Perhaps some unforeseen news has come out that is detrimental to your position. Or, perhaps, the market closed Friday with a strong breakout to new highs and you are still short. Whatever the news or development, you are hardly the only one who knows about it. On the contrary, everyone will be aware of these same facts. And if, despite developments that suggested the market should move strongly against you at the next opening, the market instead barely moves against you at all or goes the other way, it implies that there are some very strong hands positioned in the same direction you are. The lesson is: If the market lets you off the hook easily, don’t get out.
Chapter Twenty-Three
Love of the Endeavor
The language that the Market Wizards use to describe trading is quite revealing. Consider the following samples:
Bruce Kovner: “Market analysis is like a tremendous multidimensional chess board. The pleasure of it is purely intellectual.”
Jim Rogers: “[The markets are] one big, three-dimensional puzzle. . . . But this puzzle is not one in which you can spread out the pieces on a great big table and put them all together. The picture is always changing. Every day some pieces get taken away and others get thrown in.”
David Ryan: “[Trading] is like a giant treasure hunt. Somewhere in here [he pats a weekly chart book] there is going to be a big winner, and I am trying to find it.”
Steve Clark: “I thought I was playing a video game, and I couldn’t believe I was getting paid to do it. I enjoyed it so much that I would have done it for nothing.”
Monroe Trout: “I can retire today and live very comfortably off the interest for the rest of my life. The fact is that I like to trade. When I was a kid, I loved to play games. Now I get to play a very fun game, and I’m paid handsomely for it. I can honestly say that there isn’t anything else I would rather be doing. The minute I don’t have fun trading, or I don’t think I can make a profit, I’m going to quit.”
What do all these quotes have in common? They are all gamelike analogies. This tells you that for the Market Wizards trading is not a matter of work or a matter of getting rich. Rather, trading is something they love to do—an endeavor pursued for the fun of the challenge.
It is not a matter of work. It is not a matter of getting rich. Rather, trading is someth
ing they love to do—an endeavor pursued for the fun of the challenge.
When I interviewed Bill Lipschutz, I was struck by how trading permeated his life. One physical manifestation of this complete integration of trading into his daily life was the presence of quote monitors in every room, including one next to his bed so that could roll over, half asleep, to check prices. He even had a monitor at standing height in the bathroom—a self-mocking statement of his obsession with the markets, or a manifestation of it, or perhaps both.
I asked Lipschutz, “With trading consuming most of your day, not to mention night, is it still fun?”
“It’s tremendous fun!!” he answered. “It’s fascinating as hell because it’s different every day. . . . I would do this for free. I’m thirty-six years old, and I almost feel like I have never worked. I sometimes can’t believe I’m making all this money by essentially playing an elaborate game.”
There we go, another game analogy. Interviewing the Market Wizards, it becomes clear that they are drawn to trading because they love the challenge of winning what in their eyes is a complex game. They are trading because they love trading. They are not trading to achieve some other goal, such as getting rich, and that makes all the difference.
Responding to my question of what determines who will succeed as a trader, Colm O’Shea said, “Frankly, if you don’t love it, there are much better things to do with your life. . . . No one who trades for the money is going to be any good. If successful traders were only motivated by the money, they would just stop after five years and enjoy the material things. They don’t. . . . Jack Nicklaus had plenty of money. Why did he keep playing golf well into his sixties? Probably because he really liked playing golf.”
I am sure that if you look at the people you know who are successful, regardless of their occupation, you will find that the one thing they have in common is that they love what they are doing. It is true for trading. It is true for any pursuit. Love of trading may not guarantee success, but its absence will likely lead to failure.
Appendix
Options—Understanding the Basics1
There are two basic types of options: calls and puts. The purchase of a call option provides the buyer with the right—but not the obligation—to purchase the underlying item at a specified price, called the strike or exercise price, at any time up to and including the expiration date. A put option provides the buyer with the right—but not the obligation—to sell the underlying item at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, while selling a put is a bullish trade.) The price of an option is called a premium. As an example of an option, an IBM April 210 call gives the purchaser the right to buy 100 shares of IBM at $210 per share at any time during the life of the option.
The buyer of a call seeks to profit from an anticipated price rise by locking in a specified purchase price. The call buyer’s maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price was above the prevailing market price. For example, if IBM was trading at $205 when the 210 option expired, the option would expire worthless. If at expiration the price of the underlying market was above the strike price, the option would have some value and would hence be exercised. However, if the difference between the market price and the strike price was less than the premium paid for the option, the net result of the trade would still be a loss. In order for a call buyer to realize a net profit, the difference between the market price and the strike price would have to exceed the premium paid when the call was purchased (after adjusting for commission cost). The higher the market price, the greater the resulting profit.
The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Like the call buyer, the put buyer’s maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the market price by an amount greater than the premium of the put at purchase (after adjusting for commission cost).
Whereas the buyer of a call or put has limited risk and unlimited potential gain, the reverse is true for the seller. The option seller (often called the writer) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position at the strike price if an option is exercised. For example, if a call is exercised, the seller must assume a short position in the underlying market at the strike price (since by exercising the call, the buyer assumes a long position at that price).
The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call provides the most attractive trading opportunity. However, a trader expecting a large price decline would usually be better off going short the underlying market or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market.
Some novices have trouble understanding why a trader would not always prefer the buy side of the option (call or put, depending on market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurrence (i.e., prices in the vicinity of the market price when the option trade occurs) would result in a net gain to the option seller. Roughly speaking, the option buyer accepts a large probability of a small loss (cost of the premium) in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain (premium income).
The option premium consists of two components: intrinsic value plus time value. The intrinsic value of a call option is the amount by which the current market price is above the strike price. (The intrinsic value of a put option is the amount by which the current market price is below the strike price.) In effect, the intrinsic value is that part of the premium that could be realized if the option were exercised at the current market price. The intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic value, a trader could buy and exercise the option and immediately offset the resulting market position, thereby realizing a net gain (assuming that the trader covers at least transaction costs).
Options that have intrinsic value (i.e., calls with strike prices below the market price and puts with strike prices above the market price) are said to be in-the-money. Options that have no intrinsic value are called out-of-the-money options. Options with a strike price closest to the market price are called at-the-money options.
An out-of-the-money option, which by definition has an intrinsic value equal to zero, will still have some value because of the possibility that the market price will move beyond the strike price prior to the expiration date. An in-the-money option will have a value greater than the intrinsic value because, if priced at the intrinsic value, a position in the option would always be preferred to a position in the underlying market. Why? Because both the option and the market position would then gain equally in the event of a favorable price movement, but the option’s maximum loss would be limited. The portion of the premium that exceeds the intrinsic value is called the time value.
The three most important factors that influence an option’s time value are:
1. Relationship between the strike price and market price. Deeply out-of-the-money options will have little time value since it is unlikely that the market price will move to the strike price—or beyond—prior to expiration. Deeply in-the-money options have little time value because these options offer positions very similar to the underlying market—both will gain and lose equivalent amounts for all but an extremely adverse price move. In other words, for a deeply in-the-mon
ey option, the fact that risk is limited is not worth very much, because the strike price is so far from the prevailing market price.
2. Time remaining until expiration. The more time remaining until expiration, the greater the value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specified amount prior to expiration.
3. Volatility. Time value will vary directly with the estimated volatility (a measure of the degree of price variability) of the underlying market for the remaining life span of the option. This relationship is a result of the fact that greater volatility raises the probability of the intrinsic value increasing by any specified amount prior to expiration. In other words, the greater the volatility, the greater the probable price range of the market.
Although volatility is an extremely important factor in the determination of option premium values, it should be stressed that the future volatility of a market is never precisely known until after the fact. (In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the implied volatility.
On average, there is a tendency for the implied volatility of options to be higher than the subsequent realized volatility of the market until the options’ expiration. In other words, options tend to be priced a little high. The extra premium is necessary to induce option sellers to take the open-ended risk of providing price insurance to option buyers. This situation is entirely analogous to home insurance premiums being priced at levels that provide a profit margin to insurance companies—otherwise, they would have no incentive to assume the open-ended risk.
The Little Book of Market Wizards Page 12