The New Market Wizards: Conversations with America's Top Traders (36 page)

Do you use chart analysis?

Yes, but I like to keep it simple. My primary methodology is a three-step process to define important trend changes. Let me take the example of trying to identify a top in a rising market. The first step is waiting for the uptrend line to be broken.

In my experience, I have not found trend lines to be particularly reliable.

It is essential that you draw the trend line correctly. Most people draw trend lines incorrectly.

What is the correct way of drawing a trend line?

In the case of an uptrend line, you draw the line from the lowest low to the highest low immediately preceding the highest high, making sure that the connecting point you select does not result in the trend line passing through any prices between the two points.

I interrupted you. You said you used a three-step process of chart analysis. What are the remaining two steps?

Once the trend line is broken, I then look for an unsuccessful test of the recent high. This failure may take the form of prices reversing below the previous high or, in some instances, prices might actually penetrate the previous high by a modest amount and then break. In the case where prices penetrate the previous high, a pullback below that high would serve as confirmation of a failed test of the high. The third and final confirmation of a trend change would be the downside penetration of the most recent relative low.

In the second criterion you mentioned—the failed test of the previous high—you indicated that sometimes the rebound will fall short of the high and sometimes it will penetrate the high before prices break. Is the pattern more reliable if the previous high is penetrated before prices pull back?

As a matter of fact, yes. In fact, this one pattern alone can sometimes catch the virtual exact high or low. In my view, these types of price failures are probably the most reliable and important chart patterns.

The reason these types of failures often mark major turning points is related to the mechanics of the trading floor. Many traders tend to set their stops at or near the previous high or low. This behavioral pattern holds true for both major and minor price moves. When there is a heavy concentration of such stops, you can be reasonably sure that the locals on the floor are aware of this information. There will be a tendency for the locals to buy as prices approach a concentration of buy stops above the market (or to sell if the market approaches heavy sell stops below the market). The locals try to profit by anticipating that the activation of a large pocket of stops will cause a minor extension of the price move. They will then use such a price extension as an opportunity to liquidate their positions for a quick profit. Thus, it’s in the interest of the locals to try to trigger heavy concentrations of stop orders.

In cases where there are valid fundamental reasons for the continuation of a price move beyond the previous high (or low), the move will tend to extend. However, if the move to a new high (or low) was largely caused by local trading activity, once the stop orders are filled, prices will tend to reverse, falling back below the prior high (or rebounding above the prior low). In effect, the triggering of the stops represents the market’s last gasp.

The process I have just described applies to an open outcry type of market, such as futures. However, a similar process also operates in specialist-type markets, such as the stock exchange. The specialist trades one stock or several stocks. It’s the specialist’s job to make a market in these stocks. For providing this service, the specialist is paid a flat fee per hundred shares traded. Obviously, it’s in his interest to have prices move to the levels that will result in the execution of the largest amount of orders. These points will normally be prices just above the prior high or just below the prior low. Also, keep in mind that the specialist has the advantage of knowing ahead of time the location of all the orders for his stock. In addition, the locals on the stock exchange floor will have a similar type of interest in triggering stops as do the locals on, say, the futures market exchanges.

The primary point I’m trying to make is that key chart patterns are often based on the activity of the professionals on the floors.

Do you use any technical indicators?

I use them as a secondary type of input. In the stock market, the one indicator I give the greatest weight is the two-hundred-day moving average. I wouldn’t recommend this indicator as a sole input for making trading decisions, but it does add a bit of useful information to supplement other methods and forms of analysis. In fact, one study I saw demonstrated that by simply using the two-hundred-day moving average on the Dow Jones stocks, an investor could have earned an average annual return of 18 percent over the fifty-year survey period—approximately double the return that would have been realized by a straight buy-and-hold method.

I know that you’re a self-taught student in economics, having read scores or possibly even hundreds of books on the subject. Has this study been a purely intellectual endeavor, or does it yield some practical benefits in terms of trading?

There have been a number of incidents in which I believe my knowledge of economics and economic history helped me profit from the markets. A classic example occurred when François Mitterrand, a self-proclaimed socialist, won a surprise victory in the 1981 French presidential election. In his campaign, Mitterrand had promised to nationalize segments of industry and to introduce massive social welfare programs. I understood that the economic implications of Mitterrand’s programs would spell disaster for the French franc. I immediately sold the franc, which was then trading at approximately a four-to-one exchange rate to the dollar. I covered that position a mere three weeks later when the franc was trading at six to one to the dollar. In my view, that trade was about as close as you can get to a sure thing. Incidentally, the franc eventually sank to a ten-to-one rate against the dollar.

Probably your best-publicized market call was a prediction for a major top in the stock market, which you made in
Barron’s
in September 1987—one month before the crash. What made you so confident about an impending collapse in stock prices?

At the August 1987 high, the stock market had gained nearly 23 percent in ninety-six days. These figures were almost exactly in line with the historical medians for the magnitude and duration of intermediate bull market moves. This consideration was only a cautionary note. If all the other factors were positive, then fine. However, to recall an analogy I used earlier, this market was no Jack LaLanne. In August, the Dow Jones Industrial index made a new high, but the advance/decline ratio did not—a bearish divergence. The price/earnings ratio at the time was at its highest level in twenty-five years. Government, corporate, and consumer debt were at record levels. Virtually any indicator you looked at was screaming caution against the possibility of an impending collapse.

Were you short going into the October 19 crash? If so, what considerations did you use to actually time your entry into the market?

The first major timing signal came on October 5, when I read Fed Chairman Greenspan’s comment in the
Wall Street Journal
, in which he was quoted as saying that interest rates could become “dangerously high” if inflation fears were to “mushroom” in the financial markets. Although Greenspan indicated that he felt such concerns were unwarranted, he also hinted that the discount rate might have to be raised to alleviate such worries. On October 15, Dow Theory gave a sell signal, and I initiated my short position.

The straw that broke the camel’s back was Secretary of State James Baker’s dispute with Germany, in which he urged Germany to stimulate its economy. When Germany refused to cooperate, Baker made a weekend announcement that the United States was prepared to “let the dollar slide.” In my opinion, there’s no doubt that this statement was the trigger for the October 19 stock market collapse. An unknown devaluation of a currency is not something that any foreign investor wants to live with. What does “slide” mean? Five percent? Ten percent? Twenty percent? How much are you going to let it slide? Investors who hold dollar-denominated securities are going to sell until they know what “slide” means.

At that point, I was absolutely convinced that the stock market was going to collapse because of this unknown dollar devaluation. On Monday morning, I immediately added to my short position, even though the Dow Jones index opened over 200 points lower.

I know that you also caught the October 1989 minicrash. Was the analysis process similar to that in October 1987?

Very much so. In October 1989, the market had been up for 200 days without an intermediate downtrend [by Sperandeo’s definition, a decline of fifteen days or longer], versus a historical median of 107 days. Moreover, the market was up over 24 percent, and my historical studies had shown that seven out of eight times when the market was up by that amount, a correction eventually occurred that carried prices back below that point. In other words, the odds for the market continuing to move higher were very low. Consequently, I was out of longs and very attuned to signs that the market was ready to die. Statistically, this market was like an eighty-seven-year-old.

Any final words?

Being involved in this business requires tremendous dedication and desire. However, you shouldn’t make trading your whole life. You have to take time off. You need to spend time with loved ones. You need to balance your life.

When I did my exhaustive study on historical stock trends, my daughter, Jennifer, was in her preschool years. That’s a critical age for the child in terms of development and a wonderful age for parents to enjoy their children. Unfortunately, I was so involved with my project that when I came home from work, I would eat and immediately head for my study. When my daughter wandered into my office, I had no time to share with her. It was a mistake that I regret to this day.

Some traders make this business their entire life and, as a result, they may make more money, but at the expense of living a more rounded, balanced, and satisfying life.

One way or another, it all comes down to odds. Unless you can find some way to get the odds in your favor, trading, like any other 50/50 game with a cost to play (commissions and execution slippage in this case), will eventually be a losing proposition. Sperandeo has taken the definition of odds to an actuarial-like extreme. Just as insurance companies guarantee that the odds are in their favor by classifying policyholders according to risk, Sperandeo categorizes the stock market by risk. When it comes to the stock market, he can tell the difference between a twenty-year-old and an eighty-year-old.

Another somewhat related element behind Sperandeo’s success is that he varies his bet size considerably. When he implements a position in a market that he perceives to be in the beginning stages of a new trend and various indicators confirm the trade, he will tend to trade much larger than in situations where these conditions are lacking. In this way, Sperandeo places his largest bet when he estimates that the odds are most favorable. (Incidentally, this strategy is essentially the key to success in games such as blackjack; see the Hull interview.) Sperandeo emphasizes, however, that when trading large, it is essential that the market go immediately in your favor; otherwise, the position should be pared down quickly. This measure is essential to ensure financial survival when you are wrong in a situation that you thought was highly favorable.

While his view is hardly universal, Sperandeo downplays the significance of intelligence to trading success. Based on his experience in training thirty-eight traders, Sperandeo concluded that intelligence was virtually irrelevant in predicting success. A far more important trait to winning as a trader, he says, is the ability to admit mistakes. He points out that people who tie their self-esteem to being right in the markets will find it very difficult to take losses when the market action indicates that they are wrong.

One sacred cow that Sperandeo believes is really a bum steer is the standard advice to use a buy-and-hold strategy in the stock market. Sperandeo provides some examples of very extended periods in which such a strategy would have been disastrous.

MR. SERENITY

T
o be frank, Tom Basso was not on my list of interview subjects for this book. Although his track record is solid, it is by no means striking. As a stock account manager, he has averaged 16 percent annually since 1980, approximately 5 percent above the S&P 500 return. Quite respectable, considering that the majority of managers underperform the index, but still not the stuff of legends. As a futures fund manager, Basso has averaged 20 percent annually since 1987 with only moderate volatility. Here, too, the results are significantly better than the industry average, but hardly extraordinary. And yet, in an important sense, Basso is perhaps the most successful trader I have interviewed. To paraphrase a recent commercial, how do you spell success? If your answer is M-O-S-T B-U-C-K-S, then Basso doesn’t make the grade. If, however, your answer is G-O-O-D B-U-C-K-S, G-R-E-A-T L-I-F-E, then Basso has few peers.

When I first met Basso, I was immediately struck by his incredible ease about trading. He has learned to accept losses in trading not only in an intellectual sense but on an emotional level as well. Moreover, his feelings of exuberance about trading (or, for that matter, about life) bubble right out of him. Basso has managed to be a profitable trader while apparently maintaining complete peace of mind and experiencing great joy. In this sense, I can’t think of a more worthy role model for a trader. I knew within minutes of meeting Basso that he was someone I wanted to include in this book. I also realized that my method of selecting interview subjects strictly on the basis of numbers was a somewhat myopic approach.

Basso started out as an engineer for Monsanto Company. He found that this job didn’t fully absorb his energies, and he began dabbling in the investment field. His first foray into the financial markets was a commodity (futures) account, which proved to be an immediate disaster. Although it took many years before Basso was able to trade futures profitably, he persisted until he finally succeeded.

In 1980, he began managing equity accounts as an outgrowth of an involvement in an investment club. In 1984 he expanded his management scope to include futures accounts as well. The small size of most of these futures accounts (many as small as $25,000) resulted in excessive volatility. Basso realized that in order to reduce volatility to a reasonable level while still maintaining adequate diversification, he would have to drastically raise his minimum account size. In 1987, he raised his minimum to $1 million and returned the funds of all clients with smaller accounts. Today, he continues to manage both stock and futures accounts.

Basso and I met at a psychology investment seminar run by Dr. Van Tharp and Adrienne Toghraie. The seminar was held in the somewhat unlikely locale of Newark, New Jersey. The interview was conducted over lunch at a local diner.

One of the things that immediately struck me about you is that you have this aura of incredible relaxation—almost bliss—about your trading. It’s the antithesis of the mental state people typically associate with traders. Have you always had this attitude about trading?

Not at all. I still remember my first trade. In 1975, I opened a commodity account for $2,000. I bought two corn contracts and immediately lost $600. My stomach was turning. I couldn’t concentrate on my work. (I was an engineer in those days.) I called my broker every hour.

Do you remember your motivation for that trade?

I put on the trade because of a rather naive study I did in which I found that a certain very infrequent chart pattern had been followed by a price advance 100 percent of the time. Several years ago I heard you give a speech in which you talked about “the well-chosen example.” I laughed to myself when I heard you use that phrase because it reminded me of my first trade, which was the epitome of the well-chosen example.

[The well-chosen example Basso is referring to represents one of my pet peeves. The basic contention is that virtually any system ever invented can be made to look great if one simply illustrates the approach by selecting the historical market that proved most favorable for the particular method. I first became aware of this concept in the mid-1980s, when I read an article on a simple, fully disclosed trading system. At that time I was working on a rather complex system of my own. To my shock and dismay, this very simple system seemed to have outperformed the far more complicated system I had spent so much time developing—at least for the one illustration provided.

I reread the article with greater scrutiny. The proposed system consisted of only two conditions. I and Norman Strahm, my partner in system development at the time who did all our programming, had tested one of the conditions before. We knew it to be a net winning, albeit only moderately performing, trading rule. The other condition was a rule that we considered to have such a poor prospect of success that we never even bothered testing it. However, if the system described in the article were really that good, its superiority had to come from including this second condition—a trading rule we had dismissed out of hand.

Naturally, we tested this second condition. Its performance for the market illustrated in the article was exactly as indicated. However, the time period selected for the example just happened to be the single best year in a ten-year test period for that market. In fact, it was the single best year for any of the twenty-five markets we tested for that ten-year period. No wonder the system had appeared to be that good—we were looking at the single best case out of the 250 possible market and year combinations we tested. What a coincidence! I’m sure hindsight had nothing to do with it.

But that’s not the end of the story. The system did dismally in the remainder of the test sample. In fact, for the ten-year period tested, seventeen out of twenty-five markets actually lost money once transaction costs were taken into account. Ever since that time, I have had an ingrained sense of skepticism regarding the illustrations used in trading system articles and advertisements.]

Do you believe that most of the people who sell trading systems using these well-chosen examples know better? Or are they really fooling themselves—as you admittedly did in your first trade?

I think it’s probably a bit of both. Some people are just selling garbage and they know it, while others are kidding themselves—they believe they have something that’s worthwhile, but they really don’t. This type of self-delusion occurs frequently, because it’s psychologically comforting to construct a system that looks very good in its past performance. In their desire to achieve superior past performance, system developers often define system conditions that are unrealistically restrictive. The problem is that the future never looks exactly like the past. As a result, these well-chosen models fall apart when they’re traded in the future.

After my years of experience in the markets, I now try to keep my models as flexible as I possibly can. I try to imagine scenarios that would almost make good movie plots. As an example, the U.S. government falls, causing the Treasury to default on its T-bill obligations and the U.S. dollar to drop by 50 percent overnight.

How can you possibly design systems that can cope with those types of extreme situations?

I don’t necessarily design systems that will cope with those situations, but I mentally live through what will happen to my positions, given one of these scenarios.

How does that help?

It helps prepare me for all the different market conditions that can arise. Therefore, I know what I’ll do in any given situation.

In your description of your first trade, you come across as being filled with tension and anxiety. How did you go from that mind-set to your current extraordinarily relaxed attitude?

I realized that every time I had a loss, I needed to learn something from the experience and view the loss as tuition at the College of Trading. As long as you learn something from a loss, it’s not really a loss.

When did you adopt that mental attitude?

Very early; probably right after the corn trade.

Did it help?

Definitely. By adopting that perspective, I stopped looking at the losses as problems and started viewing them as opportunities to elevate myself to the next plateau. Over the next five years, I gradually improved and lost less each year.

After losing money for five consecutive years from your start in trading, didn’t you ever think that you might not be cut out for this endeavor?

No, never.

What gave you the confidence? You obviously weren’t getting any reinforcement from the market.

My reinforcement came when my losses gradually became smaller and smaller. I was getting very close to the breakeven point. I also kept my losses at a manageable level. I always traded a very small account—an amount that I could afford to lose without affecting my life-style.

Did you stop trading when you lost whatever amount of money you had set aside to risk in a given year?

That never happened. I had developed the concept of never taking a trade that would jeopardize my ability to continue trading. I always limited the risk on any trade to a level that I knew would permit me to come in and play the game again if I were wrong.

What lessons stand out most vividly from the period during which you attended your so-called College of Trading?

An absolutely pivotal experience occurred in 1979, about four years after I had started trading. My parents, who lived in Syracuse, New York, came in for a week-long visit. I was busy playing tour guide and fell behind in my work. Unbeknownst to me, that same week, silver broke out violently on the upside. The next week, I updated my work and discovered I had missed a buy signal in silver.

Were you trading a system at the time?

Yes. I was following a specific system and had taken every trade for nine months straight. In other words, there’s no question that I would have taken the trade had I updated my work. Over the next few months, silver skyrocketed. The end of the story is that missing that single trade meant an opportunity loss of $30,000 profit per contract.

What was your trading account size at the time?

It was very small—about $5,000. So that trade would have meant an approximate sixfold increase in the account size. From that point on, no matter what system I was using, I always made certain that I would take all the trading signals.

Were any other trades pivotal in shaping your overall trading approach?

In 1987 my wife and I had an account that, at the time, had an equity level of about $130,000. We were long several contracts of silver when the market exploded. We watched the account go up by about $500,000 in one month and then surrender 80 percent of that profit in only a week.

That trade taught me a lot about my own stomach lining. When your account has these massive swings up and down, there’s a tendency to feel a rush when the market is going your way and devastation when it’s going against you. These emotions do absolutely nothing to make you a good trader. It’s far better to keep the equity swings manageable and strive for a sense of balance each day, no matter what happens. That trade was the catalyst for my adopting a formula that limited both my profits and drawdowns by notching back the number of contracts traded in each market to a tolerable level. The key is that the number of contracts traded fluctuates in accordance with each market’s volatility.

Getting back to my first question, can you explain how you manage such a composed attitude in trading the markets?

When I come to work each day, I know that the risk and volatility in my portfolio is exactly the same as it was yesterday, last week, and last month. So why should I let my emotions go up and down if I’m in exactly the same exposure all the time?

I assume that being able to have that attitude requires great confidence in your system.

It’s a matter of both having confidence and being comfortable in the approach you’re using. For example, if I gave you my exact system, I’m sure that within a month you would be making changes to fit your own ideas. For one reason or another, you probably wouldn’t be comfortable with what I gave you. It would be even worse if I gave you the system as a black box [a computer program that generates buy and sell signals based on undisclosed rules]. That would drive you crazy. Since you wouldn’t have any idea what went into the program, the first time the system had a losing streak, you would probably abandon it altogether. You would say, “Tom may be a nice guy, but how do I know he just didn’t develop this system off of some well-chosen examples?”

That is precisely the reason why I believe people almost invariably fail to make money on trading systems they buy. Even if they are lucky enough to purchase a system that works, they almost never have the confidence to stay with the system when it hits its first major drawdown period—and every system in the world will have a drawdown.