Read The New Market Wizards: Conversations with America's Top Traders Online
Authors: Jack D. Schwager
Trout’s basic message is twofold. First, you have to have an edge to beat the markets. Everything else is secondary. You can have great money management, but if you don’t have an approach that gives you an edge, then you can’t win. This may seem obvious, but many traders enter the markets without any evidence that they have an edge.
Second, assuming you have an edge, you must exercise rigid risk control to protect against those infrequent events that cause enormous, abrupt price moves that can quickly decimate overleveraged accounts. And, as demonstrated in Trout’s own thesis, the probability of sharp price moves is far greater than suggested by standard statistical assumptions. Hence, risk control is essential. The trader who gets wiped out by a sudden, large, adverse price move is not simply unlucky, since such events occur often enough that they must be planned for.
It is instructive to compare Monroe Trout’s message with that of Blair Hull (see Part VI). Although their trading methods are completely different—Trout is a directional trader, whereas Hull is an arbitrageur—their assessments of the key to successful trading are virtually identical: a combination of having an edge and using rigid money management controls.
I
n terms of return/risk ratio, Al Weiss may well have the single best long-term track record for a commodity trading advisor. Since he began trading in 1982 as AZF Commodity Management, Weiss has averaged 52 percent annually. One thousand dollars invested with Weiss in 1982 would have been worth almost $53,000 at the end of 1991. However, returns are only half the story. The truly impressive element in Weiss’s track record is that these high gains were achieved with extremely small equity drawdowns. During this entire period, the largest single equity drawdown witnessed by Weiss was 17 percent in 1986. In the past four years (1988–91), Weiss has honed his risk control to truly astounding standards: during this period, his worst annual drawdown averaged under 5 percent, while his average annual return exceeded 29 percent.
Despite his exemplary track record, Weiss has kept a very low profile. Until 1991, Weiss repeatedly refused to grant any interviews. He explains this by saying, “I didn’t feel my methods were proven until I had realized at least a decade of superior performance.” He also felt that interviews would attract the wrong type of investors. At this point, that consideration is no longer a concern, as Weiss is handling as much money as he feels he can manage without negatively affecting his performance (approximately $100 million).
Although Weiss now regularly turns away new investors, he will occasionally make an exception. As he explains, “Sometimes I take on a small account [$100,000] if I feel the person is truly sincere. I still get a kick out of taking on a small account and making it compound. Just recently, I accepted a new investor because I was impressed that he had gone through the track records of five hundred CTAs before making a selection. Ironically, at the same time I was talking to this person, I also received a call from a French bank that wanted to invest $30 million. I turned down the bank, but I accepted the small account’s $100,000 investment.”
Weiss has also shunned publicity because he is naturally reclusive. He admits that, during the decade he has been managing investor funds, he has met only five of his clients. Although Weiss comes across as an extrovert over the phone, in person his shy side dominates.
One of Weiss’s hobbies is investing with other traders. He devotes one or two days per month to this endeavor. He estimates that, over the years, he has reviewed the track records of approximately eight hundred traders. Out of this large group, he has selected about twenty traders for personal investment. His goal is not to pick any individual supertraders but rather to blend traders together in a group whose composite performance reflects both good returns and very low equity drawdowns. Interestingly, the performance characteristics of this group of traders as a whole has the appearance of a Weiss clone. During the period 1988–91, the group realized an average annual return of 19 percent, with an extraordinarily low average maximum annual drawdown under 3 percent. The ratio of these two numbers (19/3 = 6.3) is nearly identical to the ratio of Weiss’s corresponding figures for the same period (29/5 = 5.8).
My interview of Weiss proved to be one of the most difficult I have conducted. Quite frankly, had I been less impressed with his track record, I would have given up on this chapter. After virtually every question I posed, Weiss would go off on elaborate tangents and ultimately catch himself, stop talking, and glance at me with a look that seemed to say, “stop me before I digress any further.” The interview was such an obvious flop to both of us that we decided to break and go for dinner. In other interviews, I have taken my tape recorder along in such situations, and sections of past interviews have, in fact, transpired over meals. However, in this instance, the prospects seemed so unencouraging that I deliberately left the recorder in my room. I also felt that some casual conversation might help break the ice.
After dinner, we decided to give it another shot by trying to continue the interview on an evening walk. The atmosphere was conducive to conversation, as we strolled along the quiet streets of a small island just off the coast of Florida, on a mild, winter evening. Nevertheless, the interview still proceeded in very jagged fashion. I found myself constantly turning the tape recorder on and off.
Following are excerpts gleaned from our conversations and some additional material from follow-up correspondence.
How did you end up becoming a trader?
It was not an overnight process. I spent four years of solid research before doing any serious trading. After literally thousands of hours of poring over charts, going back as far in history as I could, I began to recognize certain patterns that became the basis of my trading approach.
You spent four years doing research before you even started trading?
Yes. I’m a risk-averse person. I wanted to have confidence in my approach before I started.
Precisely how far back did you go in your chart studies?
It varied with the individual market and the available charts. In the case of the grain markets, I was able to go back as far as the 1840s.
Was it really necessary to go back that far?
Absolutely. One of the keys in long-term chart analysis is realizing that markets behave differently in different economic cycles. Recognizing these repeating and shifting long-term patterns requires lots of history. Identifying where you are in an economic cycle—say, an inflationary phase versus a deflationary phase—is critical to interpreting the chart patterns evolving at that time.
How did you support yourself during the four years you devoted to researching the markets?
In my early twenties, I had pioneered the development of the urethane skateboard wheel, which was a great financial success. I invested the money I made on this venture into the real estate market, which also proved to be very profitable. As a result, I had all the money I needed and was able to devote my full time to research.
I understand that you’re basically a technical systems trader. Why do you believe your track record is so much better than those of other commodity trading advisors using similar methods? In particular, I’m interested in how you have managed to avoid the large drawdowns that seem to be almost intrinsic to this approach.
Although I employ technical analysis to make my trading decisions, there are a few important differences between my method and the approaches of most other traders in this group. First, I think very few other technical traders have gone back more than thirty years in their chart studies, let alone more than a hundred years. Second, I don’t always interpret the same pattern in the same way. I also factor in where I believe we are at in terms of long-term economic cycles. This factor alone can lead to very substantial differences between the conclusions I might draw from the charts versus those reached by traders not incorporating such a perspective. Finally, I don’t simply look at the classical chart patterns (head and shoulders, triangle, and so on) as independent formations. Rather, I tend to look for certain combinations of patterns or, in other words, patterns within patterns within patterns. These more complex, multiple-pattern combinations can signal much higher probability trades.
What popular chart patterns are accurate only 50 percent of the time?
Most of them. But that’s not a drawback. A pattern that works 50 percent of the time can be quite profitable if you employ it with a good risk control plan.
Is technical analysis an art or a science?
It’s both an art and a science. It’s an art in the sense that if you asked ten different traders to define a head-and-shoulders pattern, you’d come up with ten different answers. However, for any individual trader, the definition can be made mathematically precise. In other words, chart traders are artists until they mathematically define their patterns—say, as part of a system structure—at which time they become scientists.
Why have you chosen a purely technical approach in favor of one that also employs fundamentals?
Many economists have tried to trade the commodity markets fundamentally and have usually ended up losing. The problem is that the markets operate more on psychology than on fundamentals. For example, you may determine that silver should be priced at, say, $8, and that may well be an accurate evaluation. However, under certain conditions—for example, a major inflationary environment—the price could temporarily go much higher. In the commodity inflation boom that peaked in 1980, silver reached a high of $50—a price level that was out of all proportion to any true fundamental value. Of course, eventually the market returned to its base value—in fact, in the history of markets, I can’t think of a single commodity that didn’t eventually move back to its base value—but in the interim, anyone trading purely on the fundamentals would have been wiped out.
Do any particularly memorable trades come to mind?
Whenever I’m on vacation, I continue to chart the markets. In the summer of 1990, while on vacation in the Bahamas, I was updating my charts on a picnic table beneath the palm trees. I noticed patterns that indicated buy signals in all the energy markets. These signals seemed particularly odd because it’s very unusual to get a buy signal in heating oil during the summer. However, I didn’t question the trade and simply phoned in the orders. Three days later, Iraq invaded Kuwait and oil prices exploded.
Do you follow your system absolutely, or do you sometimes override the trading signals?
I follow the system well over 90 percent of the time, but occasionally I try to do better than the system. Since I employ such deviations from the pure system very selectively, they have improved performance overall.
Give me an example of a situation in which you overrode the system.
In October 1987 when the stock market was in the midst of its crash, I started receiving anxious calls from my clients who wanted to know if they had suffered a large loss. I calmly explained that we were still up 37 percent for the year and that the total risk on all our open positions was only 4 percent. I had a feeling that people would be very insecure in the markets and that there would be a resulting flight to T-bills. I decided to take off my entire short position in T-bills, even though my system had not yet provided any reversal signal. That proved to be the right action, as the T-bill market took off on the upside almost immediately afterwards.
It’s obvious from your earlier comments that you consider cycles important. Could you please elaborate?
There are cycles in everything—the weather, ocean waves, and the markets. One of the most important long-term cycles is the cycle from inflation to deflation. About every two generations—roughly every forty-seven to sixty years—there’s a deflationary market. For example, in respect to the commodity markets, we’re currently in a deflationary phase that began in 1980. Over the past two hundred years, these deflationary phases have typically lasted between eight and twelve years. Since we’re currently in the twelfth year of commodity price deflation, I think we’re very close to a major bottom in commodity prices.
Another important consideration in regard to cycles is that their lengths vary greatly from market to market. For example, in the grain markets, which are heavily weather dependent, you may get major bull markets about five times every twenty years. In the gold market, however, a major bull cycle may occur only three to five times in a century. This consideration could make a market such as gold very frustrating for traders trying to play for the next bullish wave.
What is the single most important statement you could make about the markets?
The essential element is that the markets are ultimately based on human psychology, and by charting the markets you’re merely converting human psychology into graphic representations. I believe that the human mind is more powerful than any computer in analyzing the implications of these price graphs.
Weiss’s highly individualistic approach doesn’t lend itself readily to generalizations. Certainly his comments should inspire those inclined to cyclical analysis, but I would add that other expert traders, such as Eckhardt, argue the opposite viewpoint rather persuasively. Perhaps his most significant input is that the reliability of chart analysis can be greatly enhanced by viewing classic chart patterns as parts of more complex combinations, rather than in isolation, as is typically done. Weiss also emphasizes that students of chart analysis need to conduct their research much further back in history than is usually the case. In markets in which he was able to obtain the data, Weiss has extended his chart studies as far back as 150 years ago.
In essence, I think Weiss is successful because of the combination of a vast amount of research in analyzing charts and a knack for seeing relatively complex patterns. Ultimately, that line of reasoning leads to the conclusion that you, too, can be successful if you can read a chart with the same skill as Weiss. Not very helpful information, is it? However, Weiss’s consistent streak of high annual returns and low maximum drawdowns provides compelling proof that pure chart analysis can yield an extraordinarily effective trading approach.