The New Market Wizards: Conversations with America's Top Traders (23 page)

Are there trading errors that you’ve learned to avoid?

In general, I don’t like placing stops. If you’re a big player, you really have to be careful about putting stops into the market.

Did you learn that by getting burned in placing stops?

I never placed a lot of stops throughout my entire career, but I used to place more than I do now.

If you did place the stop, did you find there was a higher tendency of getting hit?

If I put a large stop order in the market, not only is it going to have a tendency to get hit, but when it does get activated, prices are likely to run. So I will not only get stopped out, but I will get filled at an average price significantly worse than my stop.

At your current trading size, I would assume that you probably avoid entering explicit stop orders altogether.

Right. Sometimes, if I want the price to move toward a certain level, I may put in a stop and then cancel the order once the market gets close. I do stuff like that frequently. Actually, I did it today. It worked today, but sometimes it backfires, and you find yourself the proud owner of some bonds you don’t want.

You seem very confident about your ability to trade the markets profitably. Have you always had that confidence in trading?

Probably for about four years.

Not speaking about yourself now, but in general, would you say there is a strong correlation between the degree of confidence and success in trading?

There is some correlation, but it’s nowhere near 100 percent. Some people are just confident, but if they don’t have an edge in the market, it doesn’t matter; they’re still going to lose money.

What you’re saying is that not all confident people are going to be good traders. However, are nearly all good traders confident?

Yes, I would think that virtually all good traders are probably confident in their trading ability.

Do you remember when you really became confident as a trader? Is there some transition point that you can recall?

I guess by the time I decided to go off on my own I was fairly confident. I knew I had to make money just to pay my rent.

Was that confidence derived from the consistency of your returns?

Yes, I knew I was getting statistically significant results.

You come from an academic background and even did your thesis on a subject related to the markets. I’m sure you’re quite aware that most of the academic community still holds to the efficient market hypothesis. Obviously, what you’re doing couldn’t be done if that theory were right.

The markets are clearly not a random walk. The markets are not even efficient because that assumption implies you can’t make an above-average return. Since some people can do that, I disagree with the assumption.

But still, I’m sure a lot of your professors believe in the efficient market hypothesis.

Right, and that’s probably why they’re professors and why I’m making money doing what I’m doing. Also, I think it’s amazing what you can do when you have real money on the line. A person in an academic setting might think that they have tested all possible types of systems. However, when you have real money on the line, you can start to think pretty creatively. There is always something else to test. I think that the academic community just hasn’t tested many of the approaches that are viable. Certainly, if you just spend a short time doing an academic study, you’re not going to find anything significant. It can’t be any other way. If it were, everyone would be rich. But if you spend every day of your life researching the markets and have adequate computer support, you can find stuff that works.

What are the traits of a successful trader?

A successful trader is rational, analytical, able to control emotions, practical, and profit oriented.

What advice would you give to a friend who wants to be a trader?

Learn a lot of statistics. Learn how to use a computer. Find some systems that work. Develop some simple risk management rules.

Are there any books on the markets that you would recommend to other people?

We give our new traders three books when they start: your first book,
The Complete Guide to the Futures Markets
[Jack D. Schwager, John Wiley & Sons, 1984],
The Handbook of Futures Markets
, by Perry Kaufman [John Wiley & Sons, 1984], and
The Commodity Futures Game: Who Wins? Who Loses? Why?
by Richard J. Tewles and Frank J. Jones [McGraw-Hill, 1987]. Then there are some fun books I recommend, like your
Market Wizards
, which is a good motivational work. We also have loads of other books in our library, and we let traders choose which other ones they wish to read.

What kinds of misconceptions do people have about the markets?

They believe you can make tons of money with little work. They think you can make 100 percent a year doing a little bit of research on the weekends. That’s ridiculous.

They underestimate the difficulty of the game and overestimate the payoff?

Exactly. Also, some people blame everyone except themselves when they lose money. It galled me to read in a recent
Wall Street Journal
article that some guy actually won a lawsuit against his brokerage firm because he lost all the money in his account. The point is that it wasn’t even a matter of his broker giving him bad advice; he was calling his own trades! He sued the brokerage firm, saying that they shouldn’t have allowed him to trade his account the way he did. I believe it’s a free country, and if you want to trade, you should have every right to do so, but if you lose money, it’s your own responsibility.

What mistakes do most people make in the markets? I’m talking about actual trading mistakes rather than misconceptions.

First, many people get involved in the markets without any edge. They get in the market because their broker told them that the market is bullish. That is not an edge. However, to tell the truth, most small speculators will never be around long enough to find out whether their system could have worked, because they bet too much on their trades, or their account is too small to start.

So there are people out there who actually might have a good idea that could make money, but they’ll never find out because when they first try to do it, they bet too much and they’re knocked out of the game.

Exactly.

Do you trade overnight sometimes?

We have a twenty-four-hour operation. I also have a hand-held quotation device that I use to check the markets when I’m home.

Isn’t that kind of overbearing?

Yes, it is. Although I check the quotes every night, I try not to overdo it, because I do have a tendency to become compulsive.

Are your night people under instructions to call and wake you in the middle of the night if something important happens?

Yes.

How often does that happen?

Not that often. Maybe four times a year.

What do you do for recreation?

I go to a lot of sporting events, and I do a fair amount of reading. I’m interested in psychology and philosophy. I also read lots of self-improvement books. I probably overdo it, though. I notice that the more memory books I read, the worse my memory becomes.

Do you still play basketball yourself? [Trout was captain of his college team.] Don’t you miss it? I mean, at one time it was obviously pretty important in your life.

No, because I’m on to the next big thing: trading.

Did you ever entertain the possibility of making the pros?

Coming out of my senior year in high school, I had hoped to play for the pros, and I thought that maybe I could. However, after playing my first year in college, I realized that the people were too good. I could have played in Europe. In fact, a lot of my former teammates are playing professionally in Europe, but some of them make just $10,000 a year, I didn’t want to do that.

Do you take any vacation time?

I have only had three days off in a year and a half.

Is that because when you go on vacation you’re thinking that every day you are away is costing you X amount of dollars?

To some degree I do that. Also, I feel I need to be around to supervise my staff and make sure that the trading is going properly.

Do you sometimes feel that you’ve become a captive to your own creation? Wouldn’t you like to be able to just go away for a few weeks somewhere and forget everything?

I would, but to trade successfully you have to do it full-time. I allot myself ten vacation days a year, but I never take them. I firmly believe that for every good thing in life, there’s a price you have to pay.

What are the trading rules you live by?

Make sure you have the edge. Know what your edge is. Have rigid risk control rules like the ones we talked about earlier. Basically, when you get down to it, to make money, you need to have an edge and employ good money management. Good money management alone isn’t going to increase your edge at all. If your system isn’t any good, you’re still going to lose money, no matter how effective your money management rules are. But if you have an approach that makes money, then money management can make the difference between success and failure.

What are your current goals?

To make a 30 percent return each year, with no peak-to-valley drawdown greater than 10 percent.

Any other final words?

Just that I’m excited and confident about the future. If I ever don’t feel that way, I will stop trading.

I had found Trout’s track record—a combination of very high annualized returns and extremely low drawdowns—almost mystifying. Of course, although a combination of high return and low risk is rare, it is not unique; in fact, a number of the other traders I interviewed in this book (and in
Market Wizards
) also exhibited this profile. Why then do I say “mystifying”? Because from what I had heard about Trout, I knew that his trades were based largely on signals generated by computerized technical trading systems.

I have spent many years developing and evaluating technical trading systems. Although I have found systems that make nearly as much as Trout does (based on average annualized return), these systems invariably exhibit much greater volatility. Drawdowns of 25 percent in these systems are commonplace, with worst-case drawdowns even exceeding 50 percent. Certainly, the volatility of these systems could be reduced by cutting back the leverage (i.e., the number of contracts traded per $100,000). Doing so, however, would lower the returns down to mediocre levels.

I have never found any systems that could even remotely approach Trout’s performance in terms of return/risk measurements. In fact, every trader I interviewed who displayed a combination of high return and very low risk invariably proved to be a discretionary trader (i.e., a trader who relies on his own internal synthesis of market information to make trading decisions, as opposed to using computer-generated trading signals). How, then, does Trout do it?

I got the answer to that question in this interview. Part of it has to do with his reliance on systems that are based primarily on statistical analysis as opposed to more standard, trend-following approaches. However, perhaps the major factor is that Trout’s exceptional skill in timing the entry and exit of his positions, by his own estimate, accounts for fully half of his return. “I could give ten CTAs the exact systems we use, and some of them still wouldn’t make any money,” he says. Thus, once again, we’re talking about synthesis of information that can’t be computerized (e.g., the noise level on the floors) accounting for the superior performance. In other words, Trout may reach his trading decisions in a similar fashion to that of system traders, but he executes these decisions like a discretionary trader.