The New Market Wizards: Conversations with America's Top Traders (7 page)

Any other traumatic trading experiences?

You never asked me about what happened to my own account.

All right, what happened? As I remember, you started out with about $12,000.

That’s right, and the peak was about $250,000.

Really? You had built it up that much!

Well, this was over a period of about four to five years.

Still…

Yes, I had a lot of success. Anyway, I ended up blowing out virtually the entire account in a few days.

What happened?

On September 23, 1982, the Dow went from down 30 points to closing up 20. This was the famous Granville reversal, which was the bottom of the bear market.

Does “Granville reversal” refer to the rally occurring just after Joe Granville [an extraordinarily popular market advisor at the time] had put out a sell recommendation?

Exactly. I was very bearish and heavily long puts. I kept pyramiding all the way down. I was really pressing. I lost most of the money that Monday, and by Wednesday the account was virtually all gone.

You took over four years to turn $12,000 into $250,000 and lost it all in a matter of days. Did you have a moment of self-questioning?

No, I just saw it as one major mistake. I’ve always had a lot of confidence as a trader. My feeling was that I had developed and practiced the basic trading skills that had landed me at Salomon Brothers and that I had a tremendous amount of fun in the process. I was devastated by the way I had traded, but the money never had a major effect on me.

Did you change anything because of this experience?

I decided that since I was going to work for Salomon Brothers, all my attention should go into doing that very well, not trading my own account. After that point, I never again traded my own account—not because I had lost money but because I didn’t want to split my focus, as I saw some other people do over the years. I basically took my paycheck every two weeks and put it in a money market account—a government-securities-only money market account because I wanted the extra protection.

How did the sudden demise of your personal account change you as a trader?

I probably became more risk-control oriented. I was never particularly risk averse.

What do you mean by “risk control”?

There are a lot of elements to risk control: Always know exactly where you stand. Don’t concentrate too much of your money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it
now
stands, not as it existed when you put the position on. Some people say, “I was only playing with the market’s money.” That’s the most ridiculous thing I ever heard. I’m not saying that all these concepts crystallized in one day, but I think that experience with my own account set me off on the track of considering these aspects much more seriously.

On the subject of risk control, how do you handle a losing streak?

When you’re in a losing streak, your ability to properly assimilate and analyze information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.

With all the loyalty you had to Salomon, why did you eventually leave?

Gil, who started the department, left in 1988, and I ended up running the department for a year and a half. I would find myself talking on the phone a lot—not about trading, but rather about a lot of personnel problems. I was also not crazy about traveling all over. I didn’t like managing people in Tokyo, London, and New York.

I wanted to bring someone in as a comanager for the department. I wanted to run trading and let someone else run the administrative side. That’s not the style of Salomon Brothers, however. Instead they brought in someone from above me. Initially, I thought that it might work out, but the person they picked had no foreign exchange background at all. He came from the fixed-income department and saw everything in the eyes of the bond world. He would frequently ask, “Gee, isn’t that just like the government bond market?” The answer in my mind was, “No, it’s nothing like the government bond market. Forget the government bond market.”

How does your current trading for your own management firm differ from your trading at Salomon?

At the moment, I’m trading a lot smaller than at Salomon, which is a disadvantage.

How is large size an advantage?

You’re kidding.

No, I’m serious.

If a big buyer comes in and pushes the market 4 percent, that’s an advantage.

He still has to get out of that position. Unless he’s right about the market, it doesn’t seem like large size would be an advantage.

He doesn’t have to get out of the position all at once. Foreign exchange is a very psychological market. You’re assuming that the market is going to move back to equilibrium very quickly—more quickly than he can cover his position. That’s not necessarily the case. If you move the market 4 percent, for example, you’re probably going to change the market psychology for the next few days.

So you’re saying size is an advantage?

It’s a huge advantage in foreign exchange.

How large an account were you trading at Salomon?

That question really has no direct meaning. For a company like Salomon, there are no assets directly underlying the trading activity. Rather, over time, the traders and treasurer built up greater and greater amounts of credit facilities at the banks. The banks were eager to extend these credit lines because we were Salomon Brothers. This is an example of another way in which size was an advantage. By 1990, our department probably had $80 billion in credit lines. However, no specific assets were segregated or pledged to the foreign exchange activities.

I would like to get some feeling for how you reach your price directional decisions. Strictly for purposes of illustration, let’s use the current outlook for the Deutsche mark. I know that you expect the dollar to gain on the Deutsche mark. What is your reasoning behind the trade?

First of all, I’m very concerned about the effects of unification on the German economy. There are tremendous infrastructure problems in East Germany that may take a decade or longer to solve. Also, the plans to restructure the Bundesbank [the German central bank] to include representatives of the former East German central bank create a lot of uncertainty. Finally, Kohl’s government currently appears to be on a much weaker footing. All of these factors should operate to provide disincentives for capital flowing into Germany.

At the same time, a combination of low U.S. interest rates, an apparent desire by the Federal Reserve to continue to stimulate the economy, and preliminary signs of favorable economic data suggest that the United States may be coming out of its recession. Therefore, people are starting to think that the United States may not be a bad place in which to invest their money.

Having established a long-term philosophy about which way the currency is going—in this case, the dollar going higher against the D-mark—how would you then recognize if that analysis were wrong?

Events that would change my mind would include evidence that the German government was dealing effectively with some of the problems I listed before and economic statistics suggesting that my assumption of an end to the U.S. recession was premature—essentially, the converse of the situation I described for making me bullish on the dollar.

For argument’s sake, let’s say that the fundamentals ostensibly don’t change but the dollar starts going down. How would you decide that you’re wrong? What would prevent you from taking an open-ended loss?

I believe in this scenario very strongly—but if the price action fails to confirm my expectations, will I be hugely long? No, I’m going to be flat and buying a little bit on the dips. You have to trade at a size such that if you’re not exactly right in your timing, you won’t be blown out of your position. My approach is to build to a larger size as the market is going my way. I don’t put on a trade by saying, “My God, this is the level; the market is taking off right from here.” I am definitely a scale-in type of trader.

I do the same thing getting out of positions. I don’t say, “Fine, I’ve made enough money. This is it. I’m out.” Instead, I start to lighten up as I see the fundamentals or price action changing.”

Do you believe your scaling type of approach in entering and exiting positions is an essential element in your overall trading success?

I think it has enabled me to stay with long-term winners much longer than I’ve seen most traders stay with their positions. I don’t have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don’t think you can consistently be a winning trader if you’re banking on being right more than 50 percent of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.

Let me ask you the converse of the question I asked you before: Let’s say that the dollar started to go up—that is, in favor of the direction of your trade—but the fundamentals that provided your original premise for the trade had changed. Do you still hold the position because the market is moving in your favor, or do you get out because your fundamental analysis has changed?

I would definitely get out. If my perception that the fundamentals have changed is not the market’s perception, then there’s something going on that I don’t understand. You don’t want to hold a position when you don’t understand what’s going on. That doesn’t make any sense.

I’ve always been puzzled by the multitude of banks in the United States and worldwide that have large rooms filled with traders. How can all these trading operations make money? Trading is just not that easy. I’ve been involved in the markets for nearly twenty years and know that the vast majority of traders lose money. How are the banks able to find all these young trainees who make money as traders?

Actually, some of the large banks have as many as seventy trading rooms worldwide. First of all, not all banks are profitable in their trading every year.

Still, I assume that the majority are profitable for most years. Is this profitability due to the advantage of earning the bid/ask spread on customer transactions, or is it primarily due to successful directional trading?

There have been a lot of studies done on that question. A couple of years ago, I read a study on the trading operations of Citibank, which is the largest and probably the most profitable currency trading bank in the world. They usually make about $300 million to $400 million a year in their trading operations. There is always some debate as to how they make that kind of money. Some people argue that Citibank has such a franchise in currency trading that many of the marginal traders and hedgers in the currency market immediately think of Citibank when they need to do a transaction—and Citibank can earn a wide spread on those unsophisticated trades. Also, Citibank has operations in many countries that don’t have their own central bank. In these countries, much or even all of the foreign currency transactions go through Citibank. The study concluded that if Citibank traded only for the bid/ask spread and never took any position trades, they probably would make $600 million a year.

That would imply that they probably lose a couple of hundred million dollars a year on their actual directional trading. Of course, that would help explain the apparent paradox posed by my question—that is, how can all those traders make money? Am I interpreting you correctly?

Personally, that’s what I believe. However, the argument within Citibank would probably be: “We doubt that’s true, but even if it were, if we weren’t in the market doing all that proprietary trading and developing information, we wouldn’t be able to service our customers in the same way.”

That sounds like rationalization.

Assume you’re a trader for a bank and you’re expected to make $2.5 million a year in revenues. If you break that down into approximately 250 trading days, that means you have to make an average of $10,000 a day. Let’s say an unsophisticated customer who trades once a year and doesn’t have a screen comes in to do a hedge. You do the trade at a wide spread, and right off the bat you’re up $110,000. You know what you do? You spec your buns off for the rest of the day. That’s what almost every currency trader in New York does, and it’s virtually impossible to change that mentality. Because if you are lucky, you’ll make $300,000 that day, and you’ll be a fucking hero at the bar that night. And if you give it all back—“Ah, the market screwed me today.”