The New Market Wizards: Conversations with America's Top Traders (16 page)

In other words, the computer doesn’t lie; believe it rather than your intuitive notions of a pattern’s reliability.

Yes, because, as I mentioned before, the human mind will tend to find patterns where none exist.

Do you follow your systems absolutely, or do you sometimes intervene?

At this stage of the game, computer trading systems are rote algorithms. They may be complex, but they are still simpleminded. Any system that I know of, if traded at a level that is large enough, will occasionally stray into overly risky terrain. Of course, this vulnerability can be avoided by trading too small—that is, scaling to the worst cases—but that is a costly solution in terms of overall performance. It’s better to trade at a reasonable level, and when you find yourself with too much exposure, override your system and cut back. Also, a good system will occasionally direct you to do something stupid. In such cases, your own judgment is vital.

Generally speaking, however, if your system is any good, don’t override it, except when it’s clearly violating the intentions of its design. Don’t get into the habit of finagling the system day in and day out. Save your ingenuity and creativity for research.

Can you give me an example of a system violating the intentions of its design?

On the day of the stock market crash [October 19, 1987], I was short S&Ps, and I was also short Eurodollars. At the close, the S&Ps were down 8,000 points, but the Eurodollars were down only 5 points. My trader mentality told me that the Eurodollars should have been down at least 40 or 50 points in sympathy with the S&P collapse. Even though my system was still short Eurodollars, I covered my position because I didn’t like the market action.

Was that the right thing to do?

Yes. The market opened nearly 300 points higher the next day.

When you discover that your system does something that is not optimal for reasons you can verbalize, as in the Eurodollar example you just cited, do you then modify your system to incorporate a new rule to address such situations?

If you find yourself repeatedly running into a certain kind of problem, or if you find a structural flaw in the system, then it’s time to change the system. But you shouldn’t change it every time it does something you don’t like. No system of reasonable algorithmic complexity is going to behave according to the intentions of the designer under all constellations of circumstances. A designer cannot anticipate all possible situations. Even if he could, it would be unwise to add a degree of freedom to the system for something that happens less than once a year.

Any other examples of overriding your system that stick in your mind?

Yes, around the time of the Gulf War. This was a completely unprecedented situation. We had never before had a war by deadline. My instinct was to not trade, but I had other concerns. I take the point of view that missing an important trade is a much more serious error than making a bad trade. In any worthwhile system, you have all kinds of backups to protect you (that is, to assure that you get out) when you take a bad trade. On the other hand, typically, if you miss a good trade, you have nothing to protect you—that is, nothing in the system will assure that you eventually get in. Also, missing a good trade can be demoralizing and destabilizing, especially if you’ve been in the midst of a losing period. And like so many bad trading decisions, it ends up costing you more than just the money lost or not made on the trade. Missing a major trade tends to have a reverberating effect throughout your whole trading strategy. Sometimes it can be weeks before you get back on track. For all these reasons, I felt that it was inappropriate to not trade.

But I thought you said this was an instance when you overrode the system?

I took the trades, but I cut my normal position size in half.

What happened?

I got clobbered, or, more accurately, half-clobbered.

So, once again, your intervention seemed to help your performance. Were there situations when overriding the system blew up in your face?

Many. One that stands out occurred several years ago after I had suffered a longer-than-usual string of losses. At the time, I happened to be long currencies. Some international situation developed over the weekend that caused the currencies to move sharply higher. By Monday morning I had what appeared to be a windfall profit. On the alleged basis that I was reducing my exposure because of the increased volatility, I took profits on half of my position. In fact, my exposure across all markets at that time was light, and I could easily have afforded the extra risk in the currency position. It was simply that coming after a period of much losing, I couldn’t stand the idea of giving back all that profit. In effect, I reasoned that the currencies had gone up enough—the call of the countertrend. Shortly thereafter, the currencies underwent another upside explosion that exceeded the first. Such willfully missed opportunities hurt more than losses.

On balance, have you found that your intervention has helped or hindered your performance?

I had the experience of simultaneously trading for myself, which is what I’ve done for most of my career, and also managing an account for an associate, which I traded exclusively on a mechanical system. Although the performance in my account was good, the account trading entirely on the mechanical system definitely did better.

I had known that a good system would outperform me in a windfall year, but I thought I could outperform the system in a mediocre year. (Maybe I could have once, but my systems have improved over the years.) This experience indicated otherwise.

Yet, I take it that until this unintentional experiment, you must have thought that your overrides were helping performance.

That’s because the times when you do something that appears to outsmart the system are the ones that stay with you. The day-in, day-out slippage is the sort of thing you forget. Clearly, my overriding was costing me money, even though I thought otherwise.

Have you then changed your viewpoints on overriding?

Certainly, I now feel that it should be a far more selective process than I did years ago. You should try to express your enthusiasm and ingenuity by doing research at night, not by overriding your system during the day. Overriding is something that you should do only in unexpected circumstances—and then only with great forethought. If you find yourself overriding routinely, it’s a sure sign that there’s something that you want in the system that hasn’t been included.

Is there anything that you can say about how you pick your trades other than off the system?

I don’t like to buy retracements. If the market is going up and I think I should be long, I’d rather buy when the market is strong than wait for a retracement. Buying on a retracement is psychologically seductive because you feel you’re getting a bargain versus the price you saw a while ago. However, I feel that approach contains more than a drop of poison. If the market has retraced enough to make a significant difference to your purchase price, then the trade is not nearly as good as it once was. Although the trade may still work, there’s an enhanced chance that the trend is turning. Perhaps even more critical, a strategy of trying to buy on retracements will often result in your missing the trade entirely or being forced to buy at an even higher price. Buying on retracements is one of those ploys that gives psychological satisfaction rather than providing any benefits in terms of increased profits. As a general rule, avoid those things that give you comfort; it’s usually false comfort.

Do you have any rational explanation for why trend-following systems work?

People tend to focus on the few broad outcomes that appear most probable and ignore the low-probability scenarios. As various possible outcomes become less and more likely, certain neglected ones of small probability pop into view—a threshold phenomenon. The market has to discount these “new” possibilities somewhat discontinuously. Evidently, the success of trend-following means that moves of a characteristic size are more than randomly likely to be the beginnings of such discontinuous adjustments. Of course, the inference problem facing the trend follower is to distinguish the initial parts of such adjustments from random swings.

Do you have any familiarity with the systems that are sold to the public?

I used to try to keep abreast of them, but, given the preponderance of garbage out there, I found it an exasperating experience. You have to sift through so much that’s both complicated and worthless that I think time is better spent brainstorming.

Why do you categorize these systems as “worthless”?

Because they tend to overfit the past data.

Do you think the overfitting is a consequence of naïveté? Or an unbridled desire to sell more systems?

At this late date, it’s probably predominantly disingenuous.

Have you looked at a lot of outside systems?

I’ve looked at about fifty.

Out of those fifty, how many had value?

One. And I don’t think it had a value as a system, but it had an element that I was able to use later.

Do you then feel that purchasing systems is a waste of money?

For the most part, I feel that’s true. I would hate to think how much money a person would have to spend to chance on something good. If you have the resources to evaluate systems, your time is better spent developing your own ideas. I wouldn’t recommend buying systems.

Is the idea that if a system really worked—by that I mean a combination of good profitability, low volatility, and durability—it wouldn’t make any monetary sense for someone to sell it?

Occasionally, it might happen that somebody comes up with something really good and sells it because he needs the money. But in my experience, something good isn’t discovered on a Greyhound bus while leafing through the charts; it’s something developed over a period of years. Typically, if a person has invested sufficient time and money into developing a system, he or she will want to use the system, not sell it.

What is your opinion about contrary opinion?

Contrary opinion attempts to push the idea of trading against the majority in individual trades. Although theoretically this approach might work given the right kind of information about market composition, in practice the information available to contrary opinion traders is of questionable significance.

For instance, consider the consensus numbers. These are based on recommendations from market newsletters, advisory services, and so on. Therefore, these numbers model a very nonrepresentative group of traders—those who trade on market-letter advice. I don’t know even one. In any case, this is an empirical question: Do the consensus figures work? Our research indicates that it’s marginally profitable to buy—not to sell—a market with an extremely high bullish consensus.

Do you have any opinion about popular technical overbought/oversold-type indicators, such as RSI and stochastics?

I think these indicators are nearly worthless. I’m not implying that you shouldn’t do research on these approaches—you can be very promiscuous in your research, but not in your trading.

Having done the research, would you term these approaches “bogus indicators”?

Yes, they’re close to zero in terms of their profit expectations. What these patterns make during market consolidations, they lose during trends.

Why do you believe these approaches are so popular if they’re ineffective for trading purposes?

For one thing, when you look at these indicators superimposed on a price chart, they look much better than they really are. The human eye tends to pick up the times these indicators accurately called minor tops and bottoms, but it misses all the false signals and the extent to which they were wrong during trends.

Formally, the mistake is the confusion between prior and posterior probabilities. For example, it’s true that a lot of extremes have reversal days. [A reversal day is one in which the market reaches a new high (low) and then reverses direction, closing below (above) one or more immediately preceding daily closes.] All that’s telling you is the probability of having a reversal day given a price extreme. What you really want to know is what the probability is of having an extreme—that is, a sustained change in market trend—given that you have a reversal day. That is a very different probability. Just because one probability is high, it in no way implies that the other one is high as well. If 85 percent of all tops and bottoms have property X, but property X also occurs often enough in other places, using that indicator as a signal will rip you to shreds.