The Little Book of Trading

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The Little Book of Trading Page 7

by Michael W Covel


  Chapter Five

  Think Like a Poker Player and Play the Odds

  Larry Hite

  I made a documentary film that featured Nobel Prize winners, top traders, fund managers, and professional poker players. Some people questioned why poker players were in a film primarily about markets and the recent economic crisis. Unknown to many, there is a great connection between successfully trading and successfully playing poker. The winning traders and the winning poker players both think in terms of odds.

  At all times when you are betting your hard-earned money, you need to think of the odds. You always want to put the odds on your side. What do I mean? Look at the lottery. People have no chance to win. The odds are stacked against them, but they still play.

  Larry Hite is famous for putting the odds on his side as a trend following trader for over three decades. That means betting big money when you have a chance to win big, and not betting big when you’re guaranteed to lose.

  Hite is one of my favorite traders and favorite people. What makes me like him so much? More importantly how can his experience help translate to increasing your net worth?

  Let’s start back in the day. Hite joked about growing up. He said that he failed at blocks in kindergarten. Out of the gate, that should put his views on formal education into context. Like many rags to riches success stories, Hite grew up in the prototypical middle-class, New York-area apartment. His father owned a small business, but there were no silver spoons for his kids. Hite was blessed with learning disabilities, vision problems, and, by his own account, a short attention span. With a big smile and a touch of sarcasm, he proudly stated that those problems were the secret to his success. They made him a great trader.

  Well, those issues really didn’t cause his success, but knowing that Hite overcame many negatives is where your inspiration can start.

  So how can you become a trend following winner like Hite?

  Be curious! Hite first read an article about commodity trading in Playboy. That spurred him to go see the local winner who was working as a commodities broker in the neighborhood. This broker explained that if Hite put down $2,000, he could make $1,000 a day. Hasn’t everyone heard some version of that scam? (The other day some guy e-mailed me that Mark Zuckerberg would be willing to sell me shares in Facebook right now today—before their IPO.)

  These kinds of guys don’t know anything about pork bellies, gold, or stocks. Even if you, like Hite in the early days, are naïve when it comes to pork bellies, you immediately know that a $2,000 investment will not make you $1,000 a day—or at least you should know that.

  Hite saw another obvious contradiction. Since he was in jeans, dressing exactly how he wanted, and sleeping as late as he wanted, how could a broker who had to show up promptly at nine o’clock to work for the man make him rich?

  Irrelevant Information

  It’s another day at the grind and you are listening to a financial adviser pitch you on investment ideas. One broker gets up and tells you that he can be your money savior. His reasoning? When he goes to a company to talk with management he can tell you what color the CEO’s eyes are.

  Hite looked at that real life broker, a true story, and thought, “Geez, he’s one of the stupidest people I’ve ever met in my life. The color of the CEO’s eyes does not matter. There’s no data that blue-eyed guys are better than brown-eyed guys.”

  You have to stay supremely focused on exactly what is relevant. What information is verifiable? What can you actually know that’s not just someone’s opinion? Then if it’s verifiable, is it relevant? And if you have the right verified and relevant information, what follows?

  You can’t just take information. You have to process it and you have to think that most of the information available, like most opinion, is suspect.

  You don’t swing at every pitch. You can wait for your perfect pitch.

  Hite Gems

  I have spent a great deal of time with Larry Hite. His lessons are fast, furious, and can jump from one idea to the next in quick speed. Here are some of my favorite quick gems from Hite that I know will spark Aha! moments in you and your trend following trading.

  There is a great book by Ted Williams about hitting. Williams divided the plate into sectors. He figured out there were a certain number of sectors in his strike zone, like a chessboard, and he figured out his batting average depending where the ball came across the plate. He was that detailed. He was thinking in odds. He was finding good useful information that could possibly help him to improve his batting average.

  Pretend you have a friend who made a fortune in the sanitation business. His beginnings were in a trailer park and, after hard work, he made a small fortune. Your friend decides that the silver market will go up, which it does. It goes way up, but then it starts to sink like a stone. When silver begins to fall he calls and says, “It really can’t go down.” You don’t know. I don’t know. Hite didn’t know. The market is simply telling you that you are wrong. If you have a trade that is going one way while the market is going another, how can you be right? True story—that accomplished businessman wound up living back in the same trailer park before his success.

  The first part of the winning process is evaluating who you are and what you’re comfortable doing. You have to figure out what you can do. You have to ask yourself: “Who are you?” “What’s important to you?”

  It doesn’t stop there. Ask yourself, “Could I do this?” “Could you do it again, again, and again?” “Do you like doing it?” For example, Larry Hite likes trading systems. He doesn’t just take action on a whim, he likes action to fit into context—that’s the mentality he needed to be a trend following trader.

  “What do you want?” “What is the purpose of you doing this?” “What is it that you’re investing in?” “Are you investing for appreciation?” “Are you investing for income?” “What is it that you want and how are you going to find yourself an unfair (legal) advantage?”

  Ask yourself another question, “When?” “When is this supposed to happen?” “What’s the time frame?” “If you think something’s going to happen, when is it going to happen?” The “whens” are going to tell you how much you’re going to make, and what your return is going to be on a compounded basis. You have to know the answer.

  “How is it supposed to happen?” You need a goal, but in order for that goal to happen, what needs to occur for you to get from where you are today to where you want to be tomorrow?

  Nothing is more powerful in trading than compound interest. Compound interest is interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan, or debt. Compounding of interest allows a principal amount to grow faster than simple interest, which is calculated as a percentage of only the principal amount.

  One final important gem from Hite is that being wrong is okay. He says he was never very good in school and not much of an athlete either. But he turned that to his advantage because he was able to grasp the idea that he could be wrong. In fact, it came as no surprise to him when he was wrong.

  Hite recalls with pride: “I’ve always built in an assumption of wrongness [in my trading]. I always ask myself: What is the worst thing that can possibly happen in this scenario? Then I use that worst-case scenario as my baseline. I always want to know what I’m risking, and how much I can lose. And sometimes, when you really look at it, there’s really not all that much risk [which is why you can get rich].”

  So ask yourself “What is the worst that can happen?” and go from there.

  Perfect Knowledge

  If you’re playing a positive expectation game, you don’t want to be knocked out. Good stuff always takes care of itself, but you have to stay alive. You can’t play if you’re dead.

  Imagine you run a company with hundreds of employees. One day you walk in and say to everyone, “What is the value of perfect knowledge? What if we knew the year-ending market prices across a portfolio of markets?” Everyone would want th
at situation, right? Your employees would immediately all agree. Hold tight. There is more to it.

  With perfect knowledge of what the prices would be on December 31 of any given year, how much leverage could you use to get maximum advantage at the beginning of that same year on January 1?

  Hite found that even with perfect foresight of the ending year price you could not sustain more than three to one leverage because you can’t predict the path a market might take while heading to that ending, December 31, price.

  Think of it this way. GOOG is trading at 300 today on January 1, but at the end of the year, I am telling you in advance, it will be trading at 600. What would you do? Get every credit card you could and buy GOOG? Use every bit of margin in your brokerage account? Buy all the cheap options you could? After all you have perfect knowledge of the year-end price so back up the truck and load up, right? Wrong!

  You can lose. How? Real simple. Even though you know the year-end price of GOOG, it could go from 300 to 50 first and then to 600. That potentially volatile up and down path can massacre your account—and if you have added leverage on top of leverage by the time it’s all over you may have lost your house. See what it means to respect leverage?

  Follow the Leader

  You’ve got to know the odds when you bet but there’s calculation involved. Here’s how to do it.

  Calculating expected value is a way of measuring the positive or negative value of every bet you make. Expected value allows you to look at your choices, or bets, objectively as opposed to emotionally. While it might seem appealing to be right 95 percent of the time, if you lose more than 20 times what you would make, you’ve made yourself a bad bet. By calculating the odds of winning or losing, and the amount of each outcome, you can figure out when you’ve got a good or bad bet on your hands.

  Take a coin flip game where you win or lose the same amount every time—with 50-50 odds of coming up heads or tails in every toss. That particular bet has an expected value of zero. That’s because your chance of winning is equally offset by your chance of losing. But instead of getting paid the same amount for each outcome, assume you can get paid $2 for every tail and lose $1 for each head. With a 50-50 chance of winning on each flip, but with twice the earnings payable on tails, you’ve now got a positive expected value game to play all day.

  In its simplest form, expected value equals the amount you can win multiplied by the probability of winning minus the amount you can lose multiplied by the probability of losing. The formula looks like this:

  EV = W × P(W) − L × P(L)1

  1Source: Stephen Fenichell and Larry Hite, “The Losers Guide to Winning,” International Creative Management.

  Even Mentors Have Mentors

  His name has come up a few times already, but amazingly, trend following pioneer Ed Seykota reappears. Seykota was one of the first to trade “across the board”—meaning he traded all markets in a similar fashion with a system.

  Hite shared a story: “Seykota had a trend following system and one day his boss came to him and said, ‘Ed, you don’t have a potato trade.’ And he said, ‘Yeah, my system doesn’t have a potato trade.’ Three days later his boss came back to him again and said, ‘Look, Ed, you’ve not recommended a potato trade . . . do you hear me?’ And Seykota said, ‘My system doesn’t have a potato trade.’ And the boss said, ‘Look, we have a trading desk on the potato trading floor. You have to recommend for the whole trading floor. How is this going to look that you don’t have a potato trade?’”

  This went on for about a month until Seykota left the firm. Like today, with many brokers and talking heads, his boss could have cared less that there was no trade to take. They wanted to fill in the blanks and give their clients something—even if it was worthless trading advice. Sound familiar?1

  A big lesson: Focus on what is important, not the extraneous. Extraneous is trying to create a trade out of nothing just to have a trade.

  Trend following trading is not about being a hero. Said another way, it is not about being right in your opinion, but rather about winning in the long run. Some people just want to be perceived superstars, like reality TV wannabes, but that is not what you want to be.

  You want to be practical. For example, how much are you willing to lose? You can say, “I’m willing to lose 5 percent of my capital or 100 percent of my capital,” but you have to know the number.

  Yes, you are going to be a trend follower and yes, you are going to be looking for trends, but you can’t predict those trends, their duration, or their timing. That said you have to give yourself leeway so you can survive the inevitable downturns or bad times. That’s why you need to know what kind of loss you are talking about.

  Dating Game

  Here is a great (and funny) story about the ability to win by properly thinking in terms of odds. You are a young guy. You are a freshman in college. What are you thinking about? One thing: girls. How do you meet them? How do you get one? Hite has the solution for all guys unlucky in love—and it’s all about numbers.

  Imagine leaving the house routinely. You see the same guy pass you, always with a fabulous-looking woman—not necessarily the same one—yet you walk alone.

  One day you say to the other guy, “Excuse me.” You ask how he meets the beautiful women parading by on his arm: “Where do you find all of these good-looking girls?” And he says, “Not a problem.”

  He says, “Look, it’s really very simple. Whenever I see a really attractive girl I go over and say, ‘Hi, my name is Harry. I’d like to buy you a cup of coffee.’” He added, “One out of 10 will go for coffee with me. One out of the 10 that go for coffee will end up being more serious.”

  Hite thought that this was one of the greatest examples of thinking in odds that he had ever heard because it involved the two things that he was most interested in—probabilities and the opposite sex.

  Not only is this story about numbers and odds, the more people you meet the better chance you have, but it is also about rejection (read: loss). Can you stand to be rejected? Can you stand to lose?

  Which brings us back to risk.

  Nine times out of 10 is how often you are going to lose with that dating technique, but it comes down to the simple question, “Is the risk worth the reward?” For many, whether those looking to date or looking to trade, the risk is certainly worth the reward.

  A soldier came back from Vietnam and said, “There are two kinds of helicopter pilots. There are old pilots and bold pilots, but there are no old bold pilots.”

  The trading game is about bets and Hite is clear about that: “There are four kinds of bets. There are bets you win and bets you lose. There are good bets and bad bets. You can win on a bad bet. You can lose on a good bet, but the point is you do a lot better on good bets.”

  Ask yourself, “What’s a good bet and are you regularly taking them?”

  How Much Can You Lose?

  It starts with what can you tolerate: “How much money are you willing to lose on a trade?” You want to let the market have room to go within your preset stop parameters. You are always in control of this, and you always know what you are doing—no matter what happens. You are making sure that you are as prepared as possible. You can’t be totally prepared because that is impossible (i.e., a meteor wiped out the dinosaurs, for example), but you can be prepared enough to handle whatever problems may arise in your trading, and handle them correctly (read: Get out when your stop is hit).

  If Alan Greenspan and Ben Bernanke could be fooled by the economic crisis, what would stop Hite (or you) from being fooled as well? Nothing. But at least Hite knows that. He starts from an assumed position of ignorance. You have to be realistic. But you don’t actually have to do anything. You can go broke by ignoring this wisdom too.

  You have to know that you don’t know. No matter what information you have, no matter what you are doing, you can be wrong. A friend of Hite’s, who amassed a fortune in excess of $100 million, passed on prescient lessons: If you never bet your
lifestyle, from a trading standpoint, nothing bad will ever happen to you, and if you know what the worst possible outcome is from the outset, you will have tremendous freedom. Freedom from what, you say? Stress for starters!

  The simple and time immemorial truth is that while you can’t quantify reward (no one knows when the big trend will come and no one knows how big it will be), you can quantify risk. Non-academic version? You alone control how much of your limited supply of money (and we all have some version of a limited supply) you are willing to lose.

  A constant principle within Hite’s trading: Never risk more than 1 percent of your total account on any one trade. If you only risk 1 percent, you are indifferent to any individual trade, and more importantly it can’t kill you.

  I want you to have one major numero uno takeaway from Larry Hite: You don’t trade markets. You trade money.

  Hite has two basic rules about trading and life:

  1) If you don’t bet, you can’t win.

  2) If you lose all your chips, you can’t bet.

  The Backstory

  Larry Hite is a legend. I did not lead with the details of his career on purpose. I wanted you to see his wisdom and find an Easter egg at the end of this chapter—namely the severe credibility upon which his wisdom is based.

  Hite is without a doubt one of the founding fathers of systematic trend following trading. He founded Mint Investments in 1981 and by 1990 it was the largest trend following fund in the world. Hite later formed a partnership with Man Group. Man soon bought AHL, another trend follower named after its three founders: Michael Adam, David Harding (see Harding next chapter) and Martin Lueck. Today, Man Investments is the largest trend firm in the world by a country mile. Much of this success chain traces back to Hite. Recently, Hite partnered up with his longtime Man colleague, Stanley Fink.

 

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