Market Wizards

Market Wizards Study Notes by Zhipeng Yan Market Wizards Interviews with Top Traders Jack D. Schwager Part I FUTURES AND CURRENCIES ....................................................................... 2 Michael Marcus: Blighting Never Strikes Twice ........................................................... 2 Bruce Kovner: the World Trader. ................................................................................... 4 Richard Dennis: A Legend Retires ................................................................................. 6 Paul Tudor Jones: The Art of Aggressive Trading ......................................................... 7 Gary Bielfeldt: Yes, They do Trade T-Bonds in Peoria ................................................. 9 Ed Seykota: Everybody Gets What They Want.............................................................. 9 Larry Hite: Respecting Risk.......................................................................................... 11 Part II MOSTLY STOCKS.......................................................................................... 12 Michael Steinhardt: The Concept of Variant Perception.............................................. 12 William O’Neil: The Art of Stock Selection ................................................................ 12 David Ryan: Stock Investment as a Treasure Hunt ...................................................... 15 Marty Schwartz: Champion Trader .............................................................................. 16 Part III A LITTLE BIT OF EVERYTHING................................................................. 17 James R. Rogers, Jr.: Buying Value and Selling Hysteria............................................ 17 Mark Weinstein: High-Percentage Trader .................................................................... 18 Part IV THE VIEW FROM THE FLOOR .................................................................... 20 Brian Gelber: Broker Turned Trader ............................................................................ 20 Tom Baldwin: The Fearless Pit Trader......................................................................... 20 Tony Saliba: “One-lot” Triumphs................................................................................. 21 Part V THE PSYCHOLOGY OF TRADING.............................................................. 21 Dr. Van K. Tharp: The Psychology of Trading ............................................................ 21 1 Market Wizards Study Notes by Zhipeng Yan Part I FUTURES AND CURRENCIES Michael Marcus: Blighting Never Strikes Twice 1. Start as a commodity research analyst, then a floor trader, then work for Commodities Corporation. He attributes his success to Ed Seykota, who taught him how to cut losses, as well as the importance of riding winners. Ed is a trend follower, who utilized classic trading principles. Ed said, “The trend is down, and I’m going to stay short until the trend changes.” He learned patience from him in the way he followed the trend. 2. Plywood price case: it was theoretically frozen at $110 per 1000 square feet. One day, the futures price was trading 20 cents over the legal ceiling. So I started calling around to see what was going to happen, but nobody seemed to know. I used the following reasoning: if they let it trade over $110 today, they might let it trade anywhere. So I bought one contract. Ultimately, plywood went to $200. The futures market functioned as a supply of last resort to users who couldn’t get supplies elsewhere. Basically, it created a two-tiered market, a sort of legal black market. 3. Things leaned from the floor: you develop an almost subconscious sense of the market on the floor. You learn to gauge price movement by the intensity of the voices in the ring. I learned the importance of intraday chart points, such as earlier daily highs. At key intraday chart points, I could take much larger positions than I could afford to hold, and if it doesn’t work immediately, I would get out quickly. My trading in those days was a bit like being a surfer. I later used that surfing technique as a desk trader. Although that approach worked real well then, I don’t think it would work as well in today’s markets. 4. The best trades are the ones in which you have all three things going for you: fundamentals, technicals, and market tone. First, the fundamentals should suggest that there is an imbalance of supply and demand, which could result in a major move. Second, the chart must show that the market is moving in the direction that the fundamental suggest. Third, when news comes out, the market should act in a way that reflects the right psychological tone. For example, a bull market should shrug off bearish news and respond vigorously to bullish news. If you can restrict your activity to only those types of trades, you have to make money, in any market, under any circumstances. All my profits come from the trades that met the criteria. The other trades broke even and kept me amused. The thing that saved me 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. 5. I believe that the era of trend following is over until and unless there is a particular imbalance in a market that overrides everything else. Another exception would be if we were to enter a major inflationary or deflationary environment. One reason we don’t have many good trends anymore is that the central banks are preventing currency moves from getting out of hand by taking the other side the trend. 6. I try to avoid the currencies, because I feel it is a totally political situation; you have to determine what the central banks are going to do. During late 1978, the dollar was getting battered, falling to new lows every day. One day, we noticed 2 Market Wizards Study Notes by Zhipeng Yan that the dollar got mysteriously strong. There was an intense price movement that couldn’t be explained by any known information. We just bailed out of our long currency positions like crazy. That weekend, President Carter announced a dollar support program. That situation illustrates one of the principles we believed in – namely, that the big players, including the governments, would always tip their hand. If we saw a surprise price move against us that we didn’t understand, we often got out and looked for the reason later. I believe the European central banks are notified about major changes we are going to make, and they often act ahead of US policy announcements. Consequently, the price move shows up in Europe first, even if it is because of something we initiate. 7. One of my rules was to get out when the volatility and the momentum became absolutely insane. One way I had of measuring that was with limit days. In those days, we used to have a lot of situations when a market would go limit-up for a number of consecutive days. On the third straight limit-up day, I would begin to be very, very cautious. I would almost always get out on the fourth limit-up day. And if I had somehow survived with any part of my position that long, I had a mandatory rule to get out on the fifth limit-up day. I just forced myself out of the market on that kind of volatility. 8. I think to be in the upper echelon of successful traders requires an innate skill, a gift. But to be a competent trader and make money is a skill you can learn. 9. Advice for beginners: always bet less than 5% of your money on any one idea. If you take a long position in two different related grain markets, that is still one idea. Always use stops. If you become unsure about a position, and you don’t know what to do, just get out. While you are in, you can’t think. When you get out, then you can think clearly again. Perhaps the most important rule is to hold on to your winners and cut your losers. 10. E.g., when we were in a very inflationary period and all the commodity markets were trading in lockstep fashion. On one particularly powerful day, almost all the markets went limit-up. On that day, cotton opened limit-up, fell back, and finished only marginally higher for the day. You absolutely want to put down a bet when a market acts terribly relative to everything else. When the news is wonderful and a market can’t go up, then you want to be sure to be short. 11. Gut feel is very important. Being a successful trader also takes courage; the courage to try, the courage to fail, the courage to succeed, and the courage to keep on going when the going gets tough. 12. If trading is your life, it is a tortuous kind of excitement. But if you are keeping your life in balance, then it is fun. All the successful traders have a balanced life; they have fun outside of trading. 13. On success: I am very open-minded. I am willing to take in information that is difficult to accept emotionally, but which I still recognize to be true. I look for confirmation from the chart, the fundamentals, and the market action. I don’t trade the Dow Stocks. I prefer the little ones, because they are not dominated by the big professional traders who are like sharks eating each other. Commitment to an exit point on every trade. 3 Market Wizards Study Notes by Zhipeng Yan Bruce Kovner: the World Trader. 1. Harvard graduate >> Professor in political science at Harvard and UPenn >> Trader in the interbank currency and futures markets. << influenced by Michael Marcus, who told him that “you have to be willing to make mistakes regularly; there is nothing wrong with it.” 2. One of the primary anomalies Kovner discovered was related to the price spread between different futures contracts. Given the prevailing phase of the business cycle, interest rate theory predicted that the nearby contract (say, March) should trade at a higher price than the next contract (say, June). Although the nearest two contracts did indeed tend to reflect this relationship, Kovner found that the price difference between more forward contracts often started trading at near-zero levels. His first trade involved buying a forward interest rate contract and selling a more forward contract. 3. To this day, when something happens to disturb my emotional equilibrium and my sense of what the world is like, I close out all positions related to that event. The first rule of trading is that don’t get caught in a situation in which you can lose a great deal of money for reasons you don’t understand. 4. on own success: I have the ability to imagine configurations of the world different from today and really believe it can happen. Second, I stay rational and disciplined under pressure. 5. Successful trainees are strong, independent, and contrary in the extreme. They are able to take positions others are unwilling to take. They are disciplined enough to take the right size positions. A greedy trader always blows out. 6. I almost always trade on a market view; I use technical analysis a great deal and it is terrific, but I can’t hold a position unless I understand why the market should move. Every position I take has a fundamental reason behind it. But I would add that technical analysis can often clarify the fundamental picture. Technical analysis is like a thermometer. If you are a responsible participant in the market, you always want to know where the market is – whether it is hot and excitable, or cold and stagnant. You want to know everything you can about the market to give you an edge. Technical analysis reflects the vote of the entire marketplace and therefore, does pick up unusual behavior. It is very important for me to study the details of price action to see if I can observe something about how everybody is voting. Studying the charts is absolutely crucial and alerts me to existing disequilibria and potential changes. 7. On trend-following system. The only thing that will save those technical systems is a period of high inflation, when simple trend-following methodologies will work again. However, if we have stable, moderate rates of inflation, the technical trading systems will kill each other off. 8. I sometimes put on a trade because “I’ve seen this pattern before, and it is often a forerunner of a market advance.” I usually go with breakouts. Tight congestions in which a breakout occurs for reasons that nobody understands are usually good risk/reward trades. 9. – (Jack) How about breakouts that occur because there is a story in the WSJ that day? – that would be much less relevant. If corn is in a tight consolidation and then breaks out the day the WSJ carries a story about a potential shortage of corn, 4 Market Wizards Study Notes by Zhipeng Yan the odds of the price move being sustained are much smaller. If everybody believes there is no reason for corn to break out, and it suddenly does, the chances that there is an important underlying cause are much greater. 10. – (Jack) It sounds like you are saying that the less explanation there is for a price move occurring, the better it looks. – I do think that. The more a price pattern is observed by speculators, the more prone you are to have false signals. The more a market is the product of nonspeculative activity, the greater the significance of technical breakouts. 11. Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I’m getting out before I get in. the position size is determined by the stop, and the stop is determined on the technical basis. I always place my stop beyond some technical barrier. Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are will to lose per contract. 12. – What eventually tells you that you are wrong on a major position trade? – First, a loss of money itself slows me down, so I reduce my positions. Second, in the change in the technical picture will give me second thoughts. 13. – On emotional control. On any given day, I could lose millions of dollars. If you personalize these losses, you can’t trade. I never had a lot of difficulty with the process of losing money, as long as losses were the outcome of sound trading techniques. But as a day-in, day-out process, taking losses does not bother me. 14. Bear markets have different characteristics than bull markets. The principal characteristics of a bear market is very sharp down movements followed by quick retracements. I would always sell too late and then get stopped out in what subsequently proved to be part of a wide-swinging congestion pattern. In a bear market, you have to use sharp countertrend rallier to enter positions. I had too many correlated trades in 1981 when I lost about 16%. 15. From that point on, I paid strict attention to the correlations of all my positions. I measured my total risk in the market every day. 16. I assume that the price for a market on any given day is the correct price, then I try to figure out what changes are occurring that will alter that price. One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what eh world should be like and wait for one of them to be confirmed. We create a scenario for every currency at least once a week. We define the range we expect for each currency and what we will do if it breaks out of these ranges. 17. Forgetting trading for a minute, one of the reasons I am in this business is that I find the analysis of worldwide political and economic events extraordinarily fascinating. For me, market analysis is like a tremendous multidimensional chess board. 18. On risks – I try not to risk more than 1% of my portfolio on any single trade. I study the correlation of my trades to reduce my exposure. In all my trading, if I am long something, I like to be short something else. 19. On different markets – the stock market has far more short-term countertrends. After the market has gone up, it always wants to come down. The commodity 5 Market Wizards Study Notes by Zhipeng Yan market are driven by supply and demand for physical goods; if there is a true shortage, prices will tend to keep trending higher. 20. Advice: a. risk management is the most important thing to be well understood. B. undertrade, undertrade, undertrade. Whatever you think your position ought to be, cut it at least in half. C. don’t personalize the market. A common mistake is to think of the market as a personal nemesis. The market, of course, is totally impersonal; it doesn’t care whether you make money or not. D. if you don’t work very hard, it is extremely unlikely that you will be a good trader. 21. Regardless of the approach used, once a strategy is selected, the trader should stick to his game plan and avoid impulsive trading decisions. Richard Dennis: A Legend Retires 1. Started as a runner on the exchange floor >> borrowed $1600 from family, bought a seat on the Mid America Exchange and run $400 to approach $200 million. 2. – (Jack) Do you know traders for whom early success proved to be their undoing? For many traders, it doesn’t matter so much whether their first big trade is successful or not, but whether their first big profit is on the long or short side. Those people tend to perennial bulls or bears, and that is very bad. Both sides have to be equally OK. 3. – Most dramatic emotional trading experience. One day, I made a particularly bad trade and lost about $300. I then compounded the error by reversing my original position and losing again. To top things off, I then reversed back to my original position and lost a third time. By the end of the day, I had lost $1,000, or 1/3 of my entire capitalization. Since then, I have learned that when you have a destabilizing loss, get out, go home, take a nap, do something, but put a little time between that and your next decision. Looking back, I realized that if I had had a trading rule about losses, I wouldn’t have had that traumatic experience. I learned to avoid trying to catch up or double up to recoup losses. I also learned that a certain amount of loss will affect your judgment, so you have to put some time between that loss and the next trade. 4. I always say that you could publish trading rules in the newspaper and no one would follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80% as good as what we taught our people. What they couldn’t do is give them the confidence to stick to those rules even when things are going bad. 5. Most traders who do a trade that works will not think: why did it work? What did I do here that I might be able to do in another market, at another time? There is not a lot of reflection on the process of trading. In contrast, I think I always have been analytical about trading, even before I ever researched a mechanical system. On the opposite extreme, you have the academic types who research before they have ever traded. They lack the seat-of-the-pants knowledge necessary to develop good trading systems. Mercifully, I did the trading first. Therefore, the research we do is more applicable to the real world. 6. You should expect the unexpected in this business; expect the extreme. Don’t think in terms of boundaries that limit what the market might do. There were 6 Market Wizards Study Notes by Zhipeng Yan plenty of guys who went short soybeans at $4 in 1973, because just like sugar at 4 cents couldn’t go any lower, beans at $4 couldn’t go any higher. Well, not only did they go higher, they went to a high of $12.97 in a matter of four or five months.