The New Market Wizards: Conversations with America's Top Traders (11 page)

Obviously you changed your mind at some point. What happened?

Just at the time I was finishing college, in 1972, the CME launched a subdivision, the International Monetary Market [IMM], to trade currencies. At the time, CME seats were selling for $100,000, which is equivalent to nearly $500,000 today. The seat price was such an astronomical amount to me that becoming a floor trader didn’t even appear to be a remote possibility. When the exchange started the IMM division, they sold seats for only $10,000 in an effort to try to get bodies into these new trading pits. They also gave away free IMM seats to all existing members. As a member, my brother received one of these seats. He had no particular need for this seat at the time, and he asked me if I’d like to use it in the interim.

While working on the floor, I had become interested in the mechanics of the market. I had always liked juggling numbers and playing strategy games, such as bridge and chess. I enjoyed watching prices fluctuate and trying to outguess the market. I thought that trading might be an interesting thing to do.

You said that your studies were directed toward a career goal of being a clinical psychologist. Did you see a connection between psychology and the markets?

As a matter of fact, I did. While I was on the floor during those two years, I realized that prices moved based on the psychology of the people who were trading. You could actually see anxiety, greed, and fear in the markets. I found it very interesting to follow the customers’ moods and to see how these emotions translated into orders and ultimately into market price movements. I was fascinated by the process.

I decided to accept my brother’s offer. He gave me the use of the seat and lent me $5,000. I put $3,000 in the bank to pay my living expenses, and I used the $2,000 for my trading account.

As I recall, currency futures didn’t trade very much in the first couple of years.

That’s right. There was a bit of activity in the first few weeks the contracts traded, but once the novelty wore off, the market liquidity completely dried up. In an effort to keep the market alive, each day the president of the exchange, Leo Melamed, who had conceived and spearheaded currency futures, would collar traders in the livestock pits once those markets had closed and cajole them into trading in the currency pit. Thus, the currency futures markets were dead all day long, but then there was a small flurry of activity after the livestock markets closed. For most of the day, though, we just sat around playing chess and backgammon.

How did you manage to trade the markets during those years of minimal liquidity?

A few limit orders [buy or sell orders indicating a specific execution price] would come in from the brokerage houses. In those days, the prices were still posted on a chalkboard. If I saw someone buying up all the offers in the Swiss franc, I would buy the offers in the Deutsche mark. I had no idea, however, as to the probable direction of the overall price move. On average, I made about two trades per day.

That doesn’t sound like very much. Given the market’s very limited liquidity, how much were you making off your trading?

Currency trading began in May 1972. By the end of that calendar year, I had made $70,000, which was a sum beyond my wildest dreams.

It’s amazing that you could have made so much in such an inactive market.

It is. Part of the explanation is that the price inefficiencies were very great in those days because of the tremendous amount of ignorance about the currency markets. For example, we didn’t even realize that the banks were trading forward currency markets, which were exactly equivalent to futures.

Did you continue to meet success after your initial year? Were there any pivotal trades in those first years?

I read your other book [
Market Wizards
]. There are traders you interviewed whom I respect tremendously. Many of them talked about their early experiences of going broke two or three times before they made it. I didn’t have that experience. I don’t want to sound arrogant, but I was successful at trading right from the start. The trade that was a turning point for me was the one that took me from being a twenty-to-forty-lot trader to trading hundreds of contracts.

In 1976, the British government announced that they weren’t going to allow the pound to trade above $1.72. They were concerned that the pound’s strength would lead to increased imports. At the time, the pound was trading in the mid-160s. To my surprise, the market responded to the announcement by immediately going to $1.72. The pound then fell back to $1.68 and rebounded again up to $1.72. Every time it reached $1.72, it fell back, but by smaller and smaller amounts each time. The price range steadily converged until the pound was trading narrowly just below the $1.72 level.

Most of the people I knew said, “They’re not going to let it go above $1.72. We might as well sell it. It’s a no-risk trade.” I saw it differently. To me, the market looked like it was locked limit-up. [In many futures markets, the maximum daily price change is restricted by a specified limit. “Limit-up” refers to a price rise of this magnitude. When the market’s natural equilibrium price lies above this limit price, the market will
lock
at the limit—that is, trading will virtually cease. The reason for this is that there will be an abundance of buyers but almost no sellers at the restricted limit-up price.]

I felt that if the government announced that they weren’t going to let the price go above a certain level and the market didn’t break, it indicated that there must be tremendous underlying demand. I thought to myself, “This could be the opportunity of a lifetime.” Up to that point in time, the largest position I had ever taken was thirty or forty contracts. I went long two hundred British pound contracts.

Although intellectually I was convinced that I was right, I was scared to death because the position was so much larger than what I had been trading. In those days, there was no Reuters or similar service providing cash market quotes in the currencies. I was so nervous about my position that I woke up at five o’clock each morning and called the Bank of England to get a quote. I would mutter something about being a trader from CitiBank or Harris Trust and needing a quote quickly. I would normally talk to some clerk who thought I was a big shot, and he would give me the quotes.

One morning, I made the call from my kitchen, and when I asked the clerk for the quote, he answered, “The pound is at $1.7250.”

I said, “What!? You mean $1.7150, don’t you?”

“No,” he replied. “It’s $1.7250.”

I realized that was it. By that time, I had gotten my brother and a number of my friends into the trade, and I was so excited that I called all of them with the news. I was so confident that I even bought some more contracts for myself. I then just sat back and watched the market ride all the way up to the $1.90 level.

How long did it take for the market to get up that high?

About three or four months.

Weren’t you tempted to take profits in the interim?

Once the market pushed past the $1.72 level, it was like water breaking through a dam. I knew there was going to be a big move.

How did you decide on $1.90 as the level for getting out?

I thought that, as a round number, it would be a psychologically critical area. Also, I think $1.90 had been an important chart point on the way down.

The day that I got out was one of the most exciting days of my life. I had a total of fourteen hundred contracts to sell, because I had talked everyone that I knew into the position. That morning, it seemed like everyone in the world was buying, arbitrageurs included. I went into the pit and started hitting all the bids. It lasted for about forty-five minutes. I was so excited that I actually ended up selling four hundred contracts more than I was supposed to. When the impact of my selling finally hit the bank market, the pound fell about a hundred points, and I actually ended up making money on those four hundred contracts as well.

What part of the fourteen hundred contracts represented your own position?

About four hundred contracts.

How much did you end up clearing on the trade?

About $1.3 million.

I assume that up to that point your maximum profit had been under $100,000.

Correct. But the most important thing about that trade was that it propelled me into being a hundred-lot trader. One of my goals at the time was to become a larger trader as quickly as possible, because I felt the business was just too damn easy and that it couldn’t possibly last forever. Fortunately I had that insight, because trading is much more difficult now than it was then.

The insight being that those were really good days to be involved in the market?

Right. Many of the people I knew were spending money as fast as they were making it, assuming that they would be able to continue making the same rate of return ad infinitum. In contrast, I thought that some day the opportunity wouldn’t be there.

When did things change?

The markets started getting more difficult during the 1980s. The high inflation of the 1970s led to many large price moves and heavy public participation in the markets. The declining inflation trend in the eighties meant there were fewer large moves, and those price moves that did occur tended to be choppier. Also, more often than not, the price moves were on the downside, which led to reduced public activity, because the public always likes to be long. Therefore, you ended up with more professionals trading against each other.

What about today [1991], when the professionals account for an even larger portion of total trading activity, while inflation rates have remained low? Has trading become even more difficult?

Trading has not only become much harder, but it has also changed. In the 1970s, the price moves were so large that all you had to do was jump on the bandwagon. Timing was not that critical. Now it’s no longer sufficient to assume that because you trade with the trend, you’ll make money. Of course, you still need to be with the trend, because it puts the percentages in your favor, but you also have to pay a lot more attention to where you’re getting in and out. I would say that in the 1970s prognostication was 90 percent and execution 10 percent, whereas today prognostication is 25 percent and execution 75 percent.

You provided a good example of prognostication in the British pound trade you talked about earlier. However, can you generalize your approach in forecasting prices?

I watch the market action, using fundamentals as a backdrop. I don’t use fundamentals in the conventional sense. That is, I don’t think, “Supply is too large and the market is going down.” Rather, I watch how the market responds to fundamental information.

Give me a specific example.

Over the past year or two, we’ve had a severe recession—probably worse than the government is admitting—the worst real estate bust since the depression, and a war. Moreover, the market should have been particularly vulnerable after a nine-year advance. In the midst of all this negative news, the stock market has hardly budged, and we’re still trading just below all-time highs. The fact that the stock market has been a lot stronger than it should have been tells me that it’s likely to go higher.

Can you give me another example?

On the eve of the U.S. air war against Iraq, gold was trading near the crucial $400 level. The night our planes started the attack, gold went from $397 to $410 in the Far East markets and closed the evening at about $390. Thus, gold had broken through the critical $400 level, starting the rally that everyone expected, but it finished the evening significantly lower, despite the fact that the United States had just entered the war. The next morning, the market opened very sharply lower and it continued to move down in the following months.

I’ll keep pumping you for examples, as long as you can think of them. Any others?

During the past summer, soybean prices were trading at relatively low levels just under $6.00. In close proximity, we witnessed a dry spell as the critical phase of the growing season approached, and we saw dramatically improved relations with the Soviet Union, which enhanced the chances of increased grain sales to that country. Export sales and the threat of drought have always been the two primary price-boosting factors. Here we had both these factors occurring at the same time, with prices at relatively low levels. Not only did soybeans fail to manage more than a short-lived, moderate rally, but on balance prices actually moved lower. In this context, the more recent price break down to the $5.30 level was almost inevitable. If prices couldn’t sustain an advance with large exports expected to the Soviet Union and the threat of a drought, what could possibly rally the market?