The New Market Wizards: Conversations with America's Top Traders (59 page)

An unwavering confidence in their ability to continue to win in the markets was a nearly universal characteristic among the traders I interviewed. Dr. Van Tharp, a psychologist who has done a great deal of research on traders and was interviewed in
Market Wizards
, claims that one of the basic traits of winning traders is that they believe “they’ve won the game before the start.”

15. LOSING IS PART OF THE GAME

The great traders fully realize that losing is an intrinsic element in the game of trading. This attitude seems linked to confidence. Because exceptional traders are confident that they will win over the long run, individual losing trades no longer seem horrible; they simply appear inevitable—which is what they are. As Linda Raschke explained, “It never bothered me to lose, because I always knew that I would make it right back.”

There is no more certain recipe for losing than having a fear of losing. If you can’t stand taking losses, you will either end up taking large losses or missing great trading opportunities—either flaw is sufficient to sink any chance for success.

16. LACK OF CONFIDENCE AND TIME-OUTS

Trade only when you feel confident and optimistic. I have often heard traders say: “I just can’t seem to do anything right.” Or, “I bet I get stopped out right near the low again.” if you find yourself thinking in such negative terms, it is a sure sign that it is time to take a break from trading. Get back into trading slowly. Think of trading as a cold ocean. Test the water before plunging in.

17. THE URGE TO SEEK ADVICE

The urge to seek advice betrays a lack of confidence. As Linda Raschke said, “If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.”

18. THE VIRTUE OF PATIENCE

Waiting for the right opportunity increases the probability of success. You don’t always have to be in the market. As Edwin Lefevre put it in his classic
Reminiscences of a Stock Operator
, “There is the plain fool who does the wrong thing at all times anywhere, but there is the Wall Street fool who thinks he must trade all the time.”

One of the more colorful descriptions of patience in trading was offered by Jim Rogers in
Market Wizards:
“I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up.” In other words, until he is so sure of a trade that it seems as easy as picking money off the floor, he does nothing.

Mark Weinstein (also interviewed in
Market Wizards
) provided the following apt analogy: “Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but preferably one that is also sick or lame. Only then, when there is no chance it can lose its prey, does it attack. That, to me, is the epitome of professional trading.”

As a final bit of advice on the subject of patience, guard particularly against being overeager to trade in order to win back prior losses. Vengeance trading is a sure recipe for failure.

19. THE IMPORTANCE OF SITTING

Patience is important not only in waiting for the right trades, but also in staying with trades that are working. The failure to adequately profit from correct trades is a key profit-limiting factor. Quoting again from Lefevre in
Reminiscences
, “It never was my thinking that made big money for me. It was always my sitting. Got that? My sitting tight!” Also, recall Eckhardt’s comment on the subject: “One common adage … that is completely wrongheaded is: You can’t go broke taking profits. That’s precisely how many traders
do
go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits.”

20. DEVELOPING A LOW-RISK IDEA

One of the exercises Dr. Van Tharp uses in his seminars is having the participants take the time to write down their ideas on low-risk trades. The merit of a low-risk idea is that it combines two essential elements: patience (because only a small portion of ideas will qualify) and risk control (inherent in the definition). Taking the time to think through low-risk strategies is a useful exercise for all traders. The specific ideas will vary greatly from trader to trader, depending on the markets traded and methodologies used. At the seminar I attended, the participants came up with a long list of descriptions of low-risk ideas. As one example: a trade in which the market movement required to provide convincing proof that you are wrong is small. Although it had nothing to do with trading, my personal favorite of the low-risk ideas mentioned was: “Open a doughnut shop next door to a police station.”

21. THE IMPORTANCE OF VARYING BET SIZE

All traders who win consistently over the long run have an edge. However, that edge may vary significantly from trade to trade. It can be mathematically demonstrated that in any wager game with varying probabilities, winnings are maximized by adjusting the bet size in accordance with the perceived chance for a successful outcome. Optimal blackjack betting strategy provides a perfect illustration of this concept (see Hull chapter).

If the trader has some idea as to which trades have a greater edge—say, for example, based on a higher confidence level (assuming that is a reliable indicator)—then it makes sense to be more aggressive in these situations. As Druckenmiller expresses it, “The way to build [superior] long-term returns is through preservation of capital and home runs…. When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig.” For a number of Market Wizards, keen judgment as to when to really step on the accelerator and the courage to do so have been instrumental to their achieving exceptional (as opposed to merely good) returns.

Some of the traders interviewed mentioned that they varied their trading size in accordance with how they were doing. For example, McKay indicated that it was not uncommon for him to vary his position size by as much as a factor of one hundred to one. He finds this approach helps him reduce risk during losing periods while enhancing profits during the winning periods.

22. SCALING IN AND OUT OF TRADES

You don’t have to get in or out of a position all at once. Scaling in and out of positions provides the flexibility of fine-tuning trades and broadens the set of alternative choices. Most traders sacrifice this flexibility without a second thought because of the innate human desire to be completely right. (By definition, a scaling approach means that some portions of a trade will be entered or exited at worse prices than other portions.) As one example of the potential benefits of scaling, Lipschutz noted that it has enabled him to stay with long-term winners much longer than he has seen most traders stay with their positions.

23. BEING RIGHT IS MORE IMPORTANT THAN BEING A GENIUS

I think one reason why so many people try to pick tops and bottoms is that they want to prove to the world how smart they are. Think about winning rather than being a hero. Forget trying to judge trading success by how close you can come to picking major tops and bottoms, but rather by how well you can pick individual trades with merit based on favorable risk/return situations and a good percentage of winners. Go for consistency on a trade-to-trade basis, not perfect trades.

24. DON’T WORRY ABOUT LOOKING STUPID

Last week you told everyone at the office, “My analysis has just given me a great buy signal in the S&P. The market is going to a new high.” Now as you examine the market action since then, something appears to be wrong. Instead of rallying, the market is breaking down. Your gut tells you that the market is vulnerable. Whether you realize it or not, your announced prognostications are going to color your objectivity. Why? Because you don’t want to look stupid after telling the world that the market was going to a new high. Consequently, you are likely to view the market’s action in the most favorable light possible. “The market isn’t breaking down, it’s just a pullback to knock out the weak longs.” As a result of this type of rationalization, you end up holding a losing position far too long. There is an easy solution to this problem: Don’t talk about your position.

What if your job requires talking about your market opinions (as mine does)? Here the rule is: Whenever you start worrying about contradicting your previous opinion, view that concern as reinforcement to reverse your market stance. As a personal example, in early 1991 I came to the conclusion that the dollar had formed a major bottom. I specifically remember one talk in which an audience member asked me about my outlook for currencies. I responded by boldly predicting that the dollar would head higher for years. Several months later, when the dollar surrendered the entire gain it had realized following the news of the August 1991 Soviet coup before the coup’s failure was confirmed, I sensed that something was wrong. I recalled my many predictions over the preceding months in which I had stated that the dollar would go up for years. The discomfort and embarrassment I felt about these previous forecasts told me it was time to change my opinion.

In my earlier years in the business, I invariably tried to rationalize my original market opinion in such situations. I was burned enough times that I eventually learned a lesson. In the above example, the abandonment of my original projection was fortunate, because the dollar collapsed in the ensuing months.

25. SOMETIMES ACTION IS MORE IMPORTANT THAN PRUDENCE

Waiting for a price correction to enter the market may sound prudent, but it is often the wrong thing to do. When your analysis, methodology, or gut tells you to get into a trade at the market instead of waiting for a correction—do so. Caution against the influence of knowing that you could have gotten in at a better price in recent sessions, particularly in those situations when the market witnesses a sudden, large move (often due to an important surprise news item). If you don’t feel the market is going to correct, that consideration is irrelevant. These types of trades often work because they are so hard to do. As a perfect example, recall the willingness of the trader in Lipschutz’s group to aggressively sell the dollar into a collapsing market following the G-7 meeting. Another example of this principle is Driehaus’s willingness to buy a stock heavily after it is already up very sharply on a bullish earnings report if he feels the new information implies the stock will go still higher.

26. CATCHING PART OF THE MOVE IS JUST FINE

Just because you missed the first major portion of a new trend, don’t let that keep you from trading with that trend (as long as you can define a reasonable stop-loss point). Recall McKay’s observation that the easiest part of a trend is the middle portion, which implies always missing part of the trend prior to entry.

27. MAXIMIZE GAINS, NOT THE NUMBER OF WINS

Eckhardt explains that human nature does not operate to maximize gain but rather the chance of a gain. The problem with this is that it implies a lack of focus on the magnitudes of gains (and losses)—a flaw that leads to nonoptimal performance results. Eckhardt bluntly concludes: “The success rate of trades is the least important performance statistic and may even be inversely related to performance.” Yass echoes a similar theme: “The basic concept that applies to both poker and option trading is that the primary object is not winning the most hands, but rather maximizing your gains.”

28. LEARN TO BE DISLOYAL

Loyalty may be a virtue in family, friends, and pets, but it is a fatal flaw for a trader. Never have loyalty to a position. The novice trader will have lots of loyalty to his original position. He will ignore signs that he is on the wrong side of the market, riding his trade into a large loss while hoping for the best. The more experienced trader, having learned the importance of money management, will exit quickly once it is apparent he has made a bad trade. However, the truly skilled trader will be able to do a 180-degree turn,
reversing
his position at a loss if market behavior points to such a course of action. Recall Druckenmiller’s ill-timed reversal from short to long on the very day before the October 19, 1987 crash. His ability to quickly recognize his error and, more important, to unhesitatingly act on that realization by reversing back to short at a large loss helped transform a potentially disastrous month into a net profitable one.

29. PULL OUT PARTIAL PROFITS

Pull a portion of winnings out of the market to prevent trading discipline from deteriorating into complacency. It is far too easy to rationalize overtrading and procrastination in liquidating losing trades by saying, “It’s only profits.” Profits withdrawn from an account are much more likely to be viewed as real money.

30. HOPE IS A FOUR-LETTER WORD

Hope is a dirty word for a trader, not only in regards to procrastinating in a losing position, hoping the market will come back, but also in terms of hoping for a reaction that will allow for a better entry in a missed trade. if such trades are good, the hoped-for reaction will not materialize until it is too late. Often the only way to enter such trades is to do so as soon as a reasonable stop-loss point can he identified.

31. DON’T DO THE COMFORTABLE THING