The New Market Wizards: Conversations with America's Top Traders (19 page)

Since most small to moderate profits tend to vanish, the market teaches you to cash them in before they get away. Since the market spends more time in consolidations than in trends, it teaches you to buy dips and sell rallies. Since the market trades through the same prices again and again and seems, if only you wait long enough, to return to prices it has visited before, it teaches you to hold on to bad trades. The market likes to lull you into the false security of high success rate techniques, which often lose disastrously in the long run. The general idea is that what works most of the time is nearly the opposite of what works in the long run.

A basic theme that runs through Eckhardt’s comments is that what feels good is usually the wrong thing to do. As one example, decision theorists have demonstrated that people consistently prefer to lock in a sure win rather than accept a gamble with a higher expected payoff. They also prefer to gamble with a loss, even when the bet has a worse expected outcome than a sure loss alternative. These instinctive preferences run counter to perhaps the most fundamental principle of successful trading: Cut your losses short and let your profits run. Just because this aphorism has become a cliché makes it no less valid.

Another example of counterproductive instincts is what Eckhardt terms “the call of the countertrend.” Selling on strength and buying on weakness appeals to people’s desire to buy cheap and sell dear. While such trades may feel better at the moment of implementation, following a countertrend strategy is almost inevitably doomed to failure. (This contention does not, however, imply that the reverse strategy—trend following—is assured success, since both approaches incur transaction costs.)

Traders’ excessive concern regarding their current positions involves yet another example of the detrimental impact of gravitating toward comfortable actions. Taking profits before intended objectives are reached so that the market won’t take away the gains, holding positions beyond intended loss liquidation points in the hopes that the market is only witnessing a retracement, and liquidating positions before stop-loss points are reached because of the fear of losing are all examples of actions intended to make current positions feel better. However, all of these actions are likely to negatively impact long-term performance.

People’s natural inclinations also lead them astray in systems trading. The more closely a system is fit to past price behavior, the more impressive the historical simulations will appear and the better the trader will feel about using the system. Yet, ironically, beyond a very limited point, the more effort expended to make a system fit past price behavior more closely, the worse actual future performance is likely to be. The desire to design a system that looks great also leads people to accept favorable simulated results without sufficient scrutiny. Very often, great results are simply the consequence of error or naive methodology. Eckhardt’s advice is that system designers should believe their results only after they have done everything possible to disprove them.

Eckhardt proposes that the tendency to do what is comfortable will actually lead most people to experience even worse than random results in the markets. In effect, he is saying that most people don’t lose simply because they lack the skill to do better than random but also because natural human traits entice them into behavioral patterns that will actually lead to worse than random results—a particularly compelling observation. If Eckhardt is right—and I believe he is—the critical implication is that our natural instincts will mislead us in trading. Therefore, the first step in succeeding as a trader is reprogramming behavior to do what is correct rather than what feels comfortable.

P
icture an oak-paneled English drawing room. Two obviously wealthy gentlemen sit in their armchairs facing a roaring fire, puffing on their pipes and discussing their philosophy of trading.

“It is my proposition, Colin, that anyone can be taught to be a superior trader. There is nothing magical about it. There is no rare talent involved. It is simply a matter of being taught the appropriate rules and following those rules. There is no question in my mind that I could train virtually anyone to make a fortune trading.”

“That is nonsense, Duncan. You just think your trading success is due to your system. What you do not realize is that you have a special talent. You could print out your rules in twelve-inch-high letters and have people read them every day for a year, and they still would not be able to do what you do in the markets. Your success is a function of your talent. It cannot be taught!”

“Well, Colin, this must be the hundredth time we’ve had this discussion. Let’s settle it once and for all. Why don’t we just pick ten people, teach them my system, give them each £1 million to trade and see what happens.”

“That’s an excellent idea, Duncan. Pick your ten people, train them, and if by the end of one year they are not ahead, on average, by at least 25 percent—a modest figure considering that you normally make two to three times that per year—you pay me £1 million. If they are up by more than 25 percent, I will pay you the same amount.”

Duncan and Colin then proceed to the window, watching the passersby for potential candidates for their experiment. Each time they agree on an individual, they send their butler out to summon the person.

The above may sound like a fanciful plot for a story or movie. (Actually, it is a very loose adaptation inspired by the delightful Mark Twain story, “The £1,000,000 Bank-Note.”) However, change the setting from London to Chicago, eliminate the monetary element of the bet, and substitute a more sophisticated method for screening candidates, and you actually have a true story. The legendary trader Richard Dennis, who reputedly transformed an initial stake of several thousand dollars into a fortune estimated at $200 million, essentially had the same argument with his partner, William Eckhardt (interviewed in the previous chapter). It was Dennis’s contention that trading success could be taught, while Eckhardt scoffed at the idea.

To settle their ongoing argument, Dennis and Eckhardt decided to run a version of the above experiment. They placed an ad in the
Wall Street Journal
seeking persons interested in being trained as traders. Through a process of reviewing written applications, evaluating the results of an exam, and interviewing selected finalists, approximately one thousand respondents were eventually whittled down to a group of thirteen. Over a period of about two weeks, Dennis and Eckhardt taught this fortunate group some of their systems. No holds barred, they gave the group all the specifics. After the training, Dennis then funded this group and sent them off to trade on their own.

The first group performed so well during the initial year that Dennis repeated the experiment the following year with a second group of ten. These two groups of traders collectively became known in the industry as the Turtles. This rather curious name had its origins in a trip Richard Dennis took to the Orient during this period of time. At one point, he visited a turtle farm, in which turtles were raised in huge vats. In Dennis’s mind, the image of growing thousands of squirming turtles in a huge vat was a perfect analogy for training traders. The name stuck.

Was Richard Dennis right? Could people actually be trained to be exceptionally successful traders? To answer this question, let’s pick up the scene six years later, when I am preparing to do this book. My first job is to research possible candidates to be interviewed. In the area of futures traders, one reference source I used was the quarterly summary provided by
Managed Accounts Reports.
This report summarizes the performance of a large number of commodity trading advisors (CTAs), providing a single synopsis sheet for each advisor. At the bottom of each sheet is a summary table with key statistics, such as average annual percentage return, largest drawdown, Sharpe ratio (a return/risk measure), percentage of winning months, and the probabilities of witnessing a 50 percent, 30 percent, and 20 percent loss with the given CTA. To be objective, I flipped through the pages, glancing only at the tables (not the names at the top of the sheets) and checking off the names of those advisors whose exceptional performance seemed to jump off the page. By the end of this process, I had checked off eighteen of the more than one hundred CTAs surveyed. Eight of these eighteen names (44 percent) turned out to be Turtles. Absolutely astounding! Richard Dennis was obviously right. (Admittedly, the results would have been less dramatic a year later, as 1991 proved to be a tough year for many of the Turtles.)

It seemed clear to me that if I were going to pursue the quest for the ingredients in trading success, I should be talking to the Turtles. The uniqueness of Dennis’s experiment seemed to provide an unusual opportunity to see how different individuals exposed to the same training differed in the way they approached the markets.

Although the idea looked good on paper, the execution proved to be very difficult. First of all, I found that a number of the Turtles simply refused to talk. “Look,” I would say, “I understand your reticence. However, I assure you that I will not print anything until you have seen it, and if you feel that you have inadvertently divulged any trade secrets, I promise not to use that material. The risk is all mine. I can go through the entire interview and editing process, only in the end to have you refuse to grant me permission to use the copy. What do you have to lose?” Despite these assurances, a number of the Turtles simply refused even to consider participating.

Those who refused to talk at all were only part of the problem. The major problem was that the remainder of the group was largely tight-lipped about anything of interest. I was well aware that the group had signed agreements not to divulge any parts of the system, and I hardly expected them to share these secrets with the world, let alone betray a trust. Therefore, in the interviews, I avoided any specific questions regarding the system. Unfortunately, the Turtles’ caution was so extreme that they avoided talking about anything even remotely connected with the system. (I couldn’t help but be reminded of the World War II movies where the downed American pilot responds to all the interrogator’s questions by repeating his rank, file, and serial number.) The following is a representative segment intended to provide a flavor of the typical interview.

How do you pick your trades?

I basically use the system, but I can’t say much more than that.

I know we can’t discuss the specifics of the system, but can you just tell me in general terms why this system tends to do so much better than the vast majority of trend-following systems that are out there?

I really don’t know the other systems.

Well, for purposes of comparison, let’s just use the typical moving average system, which is essentially a trend-following approach. Without divulging any specific trade secrets, in a general conceptual sense, how do the systems that Dennis taught you differ from these more standard approaches?

I’d rather not answer that.

What are the trading rules you live by?

The same general rules I’m sure you’ve heard everywhere. I don’t think there’s anything new I could add.

Let’s talk about a specific trading situation. The recent start of the U.S. air war against Iraq resulted in a number of huge overnight price moves. Were you in any of those markets? Were you watching those markets during the nighttime session?

I was lucky—I was out of the crude oil market at the time.

How about a market like gold, which also had a huge price reversal at the time?

Yes, I had a position in gold.

It’s no secret that Dennis’s approach was trend-following in nature. Obviously then, since the market had been rising for a while prior to the outbreak of the air war, you must have been long at the time. The war started at night, and although gold prices initially rose, by the next morning they were down over $30. Were you watching the market during the night session? And if so, how did you react?

I got out.

Was this because the market received news that should have been bullish—that is, the outbreak of war—moved slightly higher, and then started trading lower?

I can’t say.

I’m hardly talking trade secrets here. The concept that a market’s failure to respond appropriately to important news is a significant price action clue is something that I put in a book six years ago. And I’m sure I was not the first or last person to talk about this idea. All I’m asking is whether this was the reasoning behind taking the loss quickly or whether there was more to it.

There was more, but I can’t talk about it.

Is there anything that we haven’t discussed concerning the concepts and philosophy of successful trading that you would care to comment on?

[Long pause.] No, not really. I can’t think of anything.

OK, you get the idea. Applying the appropriate trading principle, I decided to cut my losses short and stop requesting additional Turtle interviews after the first few. Obviously, the extraordinary sensitivity of the Turtles to the possibility of revealing anything about what Richard Dennis had taught them, even inadvertently, provided a seemingly insurmountable impediment to achieving the type of relatively open discussions I had enjoyed with other traders.

I have, however, selected short excerpts from two of the Turtle interviews I conducted. The following material offers some feel for the Turtle experience and provides a few insights in terms of useful trading lessons or advice.

MICHAEL CARR

After the near paranoia, and even rudeness, I encountered in some of my preliminary interview requests among the Turtles, Michael Carr’s attitude came as a pleasant relief. (He not only graciously accepted the interview request but, upon learning that I was a hiking enthusiast, was thoughtful enough to send me a brochure on the Ice Age Trail, which passes near his house.)

Carr was in the first group of Turtles trained by Richard Dennis. He began trading in 1984, and in his four years of trading for Dennis, Carr averaged 57 percent annually (he was down moderately for the first third of 1988, when Dennis terminated the program). Carr did not begin trading again until August 1989, when he launched his own CTA company. As of late 1991, Carr was up 89 percent from that starting point.

I interviewed Carr at his Wisconsin home, which virtually sits in a lake and is connected to the mainland by a very long driveway. I arrived just as it began to storm. Carr’s office, which has windows all around, offers views of the water in every direction. The combination of the all-encompassing water views and the storm provided a spectacular backdrop. Unfortunately, the setting was far more dramatic than our conversation. Although Carr was quite friendly, our interchange was stymied by the same cautiousness that characterized all the Turtle interviews.

How did you become a Turtle?

I was on the creative management staff of TSR, the game company of Dungeons and Dragons fame. I started with TSR when there were only a few employees. In the ensuing years, the company went through a spectacular growth phase, which culminated with over three hundred people on the payroll. The company then hit hard times and made drastic cutbacks in order to survive. I lost my job along with two hundred other workers. It was around this time that I picked up a copy of the
Wall Street Journal.
Ironically, that was the same day that Richard Dennis ran his ad seeking trading trainees.

Did you have any prior experience in the commodity markets at the time?

Certainly no trading experience. However, while I was working for TSR, I came up with the idea of creating a commodity game. I thought that the commodity markets had all the necessary ingredients for making a successful game. To get the background information, I had sent away for lots of exchange publications. I also took an extension course, which involved six evening sessions taught by a commodity broker. So I had a rudimentary understanding of the commodity markets, but nothing more.

As I understand it, there were over a thousand applicants and only thirteen candidates were selected. Why do you believe you were chosen?

To my knowledge, I was the only candidate that had worked for a game company. I believe the fact that my background was different from the others helped me get noticed. Also, a lot of commodity trading is based on game theory and probability. Therefore, it’s not much of a jump to believe that someone with experience in that area might bring something to the table.