The New Market Wizards: Conversations with America's Top Traders (22 page)

There’s so much information flowing in here that I can’t possibly follow and analyze it all. My traders are under instructions to alert me anytime something important happens. They also keep me posted as to when markets are likely to be particularly volatile based on fundamentals or news announcements. A recent example of that type of an announcement was Jim Baker’s statement to the press on January 9. We were set up for a more peaceful type of an announcement. [January 9, 1991, was the day that Secretary of State James Baker met with the Iraqi ambassador in an effort to avert a war. At the time, there was a reasonable degree of optimism going into the meeting because a continued hard-line stance seemed such folly for Iraq. Addressing the press after the meeting, Baker began his statement, “Regrettably….” Traders didn’t wait to hear the second word, and a wave of selling hit the stock and bond markets.]

Did you sell as soon as you heard the word “Regrettably”?

It was too late for us. With the type of size we trade, it was all over. For example, we lost 1,200 points in the S&P in a half-hour, and most of that was in the first ten seconds. We were long about seven hundred contracts. If we had tried to sell into that type of market, we would have amplified the decline and probably would have ended up selling at the low of the day.

When some sudden news comes out, how do you decide when you should just get out immediately and when you should wait for the initial selling panic to subside?

There’s a big difference between small size and big size. If I were trading small size—for example, ten lots in the S&P—then I probably would have gotten out right away. That is, I would have sold as soon as I heard the word “Regrettably.”

But obviously you’re not in that position anymore. Now that you’re always trading larger size, do you just have to grit your teeth and wait when a surprise hits the market?

I wait until the market stabilizes a bit and then I start getting out—particularly if it’s past my pain threshold in terms of dollar loss.

What eventually happened on that day? Did you get out of your entire S&P position?

Yes. We basically phased out of the position over the rest of the day. There was no question about what to do because one of my risk management rules is that if we lose more than 1.5 percent of our total equity on a given trade we get out.

What are your other risk management rules?

If we’re down 4 percent on a single day, we close out all positions and wait until the next day to get into anything again. This rule has been activated only twice in the last two years, one of those days being January 9. I dumped my whole portfolio because I was down 4 percent.

What was your dollar loss that day?

About $9.5 million.

And you lost that amount in a very short period of time?

From all practical standpoints, I lost most of it in about ten seconds.

Talk about your emotions when you’re losing a million dollars a second.

In this instance, it happened so quickly that I was a bit speechless. Normally when I lose money, I get angry. That’s usually the first emotion that comes into play.

Angry at the market, or angry at yourself?

I guess more at the market, but, of course, that’s not really rational because the market is not a personal thing; it is not trying to get me. I try to keep my anger in check as much as possible because I believe that to be a good trader it’s very important to be rational and have your emotions under control. I’ve been trying for years to get rid of anger completely when I lose money, and I’ve come to the conclusion that it is impossible. I can work toward that goal, but until the day I die, I don’t think I’m ever going to be able to look a big loss in the face and not get angry.

Does anger affect your trading?

No. I’d say that I’m pretty good about that.

Going back to January 9, after you got past your speechless reaction, what did you do?

Once I realized that we were down over 4 percent, I devised an orderly plan to exit all markets by the close. In that type of situation I try to devise an exit plan and then get out of the trading room because I want the liquidation done in a rational manner. I leave it to my traders to handle the execution.

Did the loss keep you awake that night or did you sleep well?

In general, I don’t sleep well at any time. Unfortunately, that’s one of the prices you have to pay for being a trader. I wish I didn’t have to, but that’s the way it is.

Do you sleep better on days when you win than on days when you lose?

Not necessarily. In fact, I probably sleep worse when I’m doing well, because I get too excited.

How long was it until you fully absorbed the impact of that day and were on to the next thing?

I started forgetting a bit about it the next day. It took me a few days.

When a loss like this happens, do you think it’s going to bother you for a while? Are you surprised that you’re completely over it a week later?

I guess I know that I’m going to be over it in a week. I never want to get into a situation where it’s so bad that I can’t get over it. That’s one of the reasons I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow.

Once you get out, even though you’ve taken a loss, do you feel better because you’re out?

Yes, because the pain is over, and I know exactly what I’ve lost. There’s a bit of a feeling of relief.

Is it meaningfully tougher to lose 4 percent when you’re trading $100 million than when you’re trading $1 million?

It is tougher. Dollars have a lot to do with it, too. There are plenty of traders I know who show track records with an amazing cumulative winning percentage. I’ve seen situations where they might be up 1,000 percent over a five-year period, but if you examine their track record in terms of net dollars made or lost, you discover they are actually down.

Because they made the large percentage returns with small capital and then lost money when they were managing large sums?

Exactly. I’m not in the business of picking CTAs. But if I were, one of the first screens I would use would be a person’s total dollar profit—how many dollars did the CTA pull out of the market. If that number were negative, I would eliminate the CTA from consideration, regardless of the percentage return.

Did your 4 percent maximum daily loss rule help you on January 9?

On that particular occasion, no. We actually would have been better off gritting our teeth and holding on for a while longer.

But doesn’t that change your faith in the rule?

No, because if you don’t have that type of rule, you can end up being long the S&P on a day like October 19, 1987, when procrastinating in getting out would have been a disaster.

So far you’ve mentioned a 1.5 percent maximum loss limit on a single position and 4 percent on the entire portfolio for any given day. Are there any other risk management rules you use?

We have a maximum loss point of 10 percent per month. If we ever lost that amount, we’d exit all our positions and wait until the start of the next month to begin trading again. Thankfully, that has never happened.

We also have a fourth risk management rule: At the beginning of each month, I determine the maximum position size that I’m willing to take in each market, and I don’t exceed that limit, regardless of how bullish or bearish I get. This rule keeps me in check.

Do you use charts?

I look at charts primarily to figure out where traders are going to get interested in a market. I know the types of patterns they like to look at.

You use both discretionary and system trading. Do you have anything to say about the merits or drawbacks of each approach?

The bottom line is that you need an edge. One of the ways you can get an edge is to find a successful system. However, if you’re just a pure systems player and you start managing large amounts of money, you’re going to find that your transaction costs start to eliminate a good deal of your profits. In general, it’s probably best to be somewhere between a pure discretionary trader and a pure system trader. As I mentioned before, you can help your systems by using some discretion in the entry and exit of positions.

Have you looked at commercial systems at all?

Sure, we’ve bought lots of them. I used to evaluate the systems myself, but now I have other people in the office do it. We have never used any of these systems as is; we use them to give us ideas in constructing our own systems.

Do you have any advice for the public about systems offered for sale?

Join Club 3000. [This organization issues a newsletter composed of members’ letters that discuss systems and other aspects of trading. The name derives from its origins. Club 3000 was formed in frustration by members who had paid approximately $3,000 for a system they felt was essentially worthless and decided to get together to share information about various systems.] I would also subscribe to such publications as
Futures, Technical Analysis of Stocks and Commodities
, and
Commodity Traders Consumers Report
for their reviews on systems. Also, once you buy a system, make sure you test it on your own data.

In other words, don’t take the vendor’s word for it. Do you think that many of the claims for systems are overblown?

Yes.

Is that because of deliberate misrepresentation or are most of the vendors actually fooling themselves?

Some of the system claims may actually be partially legitimate. However, I usually find these systems don’t have enough observations to be statistically significant. Also, frequently, the systems base their percentage return claims on the minimum exchange margin requirements.

I understand. Doing that gives the systems extraordinary leverage and the ads only talk about the return side; they don’t discuss the risk side.

Right. I made the same mistake in my senior thesis. I based my percentage returns on the assumption of an account size equal to double the exchange minimum margin requirement, which was a grossly inadequate sum. In reality, if you ever tried to trade that way, you would go broke, because the drawdowns are too big.

Do you basically believe that if somebody developed a really good system they wouldn’t be selling it?

To some degree, I believe that. Sure, it’s possible that a system developer may not have any money, but if the system is that good, he should be able to convince friends, family, anybody to put some money into the system and trade it.

Are there any technical indicators in the public domain that you find useful?

Moving averages are useful. They’ll work if you watch your risk management. I believe you can make an above-average return by using moving averages, if you’re smart about it.

Any indicators that you consider overrated?

Most of the common ones: Fibonacci retracements, Gann angles, RSI, and stochastics. I haven’t found anything there for any of these indicators.

If you have a streak when you’re doing very well, day after day, do you get to the point where you say, “This just can’t keep on”? And do you start reducing your position because of that?

Actually, the better I’m doing, the bigger I play, and the worse I’m doing, the smaller I play.

So you believe in streaks?

Yes, not just in trading, but in most things in life. If a team has won eight games in a row, you don’t best against them winning their ninth game.