The New Market Wizards: Conversations with America's Top Traders (48 page)

When I joined, there were eight members, but it eventually grew to about twenty.

Does this type of operation depend on a great deal of trust and honesty? If you combined banks and played independently, how did players know how the other members were really doing?

In the later stages, we actually started using polygraphs. I have both taken and administered them. In the early days, there weren’t any polygraphs; people just trusted each other.

At what point did people start becoming suspicious of other members of the team?

[
He laughs.
] It became obvious that one of the players was skimming off the top.

Because there’s a lot of controversy about polygraphs, I’m curious about whether you believe that the tests actually work.

Generally speaking, I believe they’re about 85 percent accurate. I’ve taken four and administered about six. There’s no question that the process of getting ready for the polygraph and administering the test can get information from people. In one case, I literally saw the blood drain from a person’s face when I asked a question. I’ve had admissions before, during, and after polygraphs. Sometimes the information you turn up is minor—for example, a person not accounting for expenses accurately. Sometimes there are bigger issues involved. For example, one fellow was playing for another team at the same time he was playing for us, which involved passing on proprietary information to a competitor.

Did the team operate as a team or just simply separate individuals using a common bank?

There were several versions of teams. This particular large team used a method in which there was a Big Player and several card counters. The card counters were spread out over several tables and would bet relatively small. They would then signal the Big Player when the count was very favorable.

Was this done to be less obvious?

Right. If this guy isn’t looking at the cards, how could he be counting them?

How long did it take for the casinos to learn of the team’s existence?

A little over six months. We started playing very big. We just kept building and building, and pretty soon we were playing limit, and they knew who we were.

Did they know you were all part of the same team, or did they just know you individually?

They knew each of us, but then they slowly started to pick up the associations. There was a detective agency the casinos employed that specialized in finding card counters. The agency classified card counters in the same category as dice cheats or slot machine drillers. Essentially, the casinos don’t want to have skillful players. And I understand that. I wouldn’t either if I owned a casino.

Is it easy to spot a card counter because he’s not playing every hand?

It’s easy to spot him even if he
is
playing every hand.

Because of the variation of bet size—betting low on low-probability hands?

Yes. If I stood behind someone playing with a large amount of money, I could tell very quickly at what level of advantage or disadvantage he was playing.

Did you originally think the team would last longer before the casinos caught on?

I think if we had been a little more discreet, the team could have lasted longer. One of the problems was that one of the members of the team was more interested in writing a book than in the continued success of the team. [The book Hull is referring to is
The Big Player
, by Ken Uston; Holt, Rinehart and Winston, 1977.] Ironically, I was the one who talked the other partners into allowing him to be a Big Player. It proved to he the start of the team’s downfall. People have a basic need to be recognized. He had a need to be recognized—even by the casinos. Until you get barred, the casinos haven’t recognized that you’re a good player. There are direct parallels to trading in the markets.

Let’s talk about that connection.

It’s the same thing. The people who want to be recognized as the greatest traders are probably not the greatest traders. Egos get in the way of the process. In my opinion, you never want to be the largest player in the pit.

Before I get to the connection between blackjack and trading, I’m just curious: Is it still possible to beat the casinos using the card counting method today?

Absolutely. If I didn’t have any money, there’s no doubt in my mind about where I would go.

Then why don’t the casinos use larger decks or reshuffle more frequently so as to make card counting unfeasible?

First of all, the prevalence of blackjack strategy books actually helps the casinos by giving people the hope of winning. Also, it’s not the mathematical skill that’s critical to winning, it’s the discipline of being able to stick to the system. There are very few people who can develop the skills to get the edge, and far fewer still who can withstand the losses emotionally and still stick with the system. Probably only one in five hundred people has the necessary discipline to be successful.

Did the teams on which you played help enforce the necessary discipline?

To some extent, the team helps you to develop discipline. It’s almost like the army—you have to do things under certain conditions and you have to have a certain skill level. The discipline is imposed by the team as a self-regulatory process. It’s very difficult for an individual to have the same level of discipline.

So the casinos leave it feasible to win in blackjack by card counting because there are more people who misapply the strategies for winning.

Absolutely.

What element of the blackjack playing experience do you believe contributed to your success as a trader?

The experience of going through extensive losing periods and having the faith to stick with the system because I knew that I had the edge was something that helped me a great deal when I went into the pit. Also, the risk control experience was very beneficial. In blackjack, even if you have the edge, there are going to be periods of significant losses. When that happens, you have to cut back your bet size in order to avoid the possibility of ruin. If you lose half your stake, you have to cut your bet size in half. That’s a difficult thing to do when you’re down significantly, but it’s essential to surviving.

The way you express it, blackjack and trading are very similar.

That’s right. All you need is a mathematical advantage and the money management controls to assure that you stay in the game. Everything else takes care of itself.

What happened after the team was uncovered?

For a while, I used the same principles to organize smaller teams. I kept a low profile by being a counter instead of the Big Player and playing in other locations, like Atlantic City. When I got tired of traveling so much, I tried to find other ways of applying probability theory. For a while, I tried poker, but I found that, although I had all the mathematics down pat, I didn’t have the appropriate skills. Every time I had the hand and bet large, everybody folded, and every time I bluffed, everybody stayed in.

Now correct me if I’m wrong. In blackjack, the rules are absolutely dictated. The dealer has to draw another card or he has to stick, depending on his card count, whereas in poker, people have more choice, and reading your opponent becomes a factor. Therefore, even if you have the edge mathematically, if people can read your emotions correctly or you can’t read theirs, you lose the edge.

Right, you lose the edge in a major way. Bluffing is an essential element of the game. There’s a mathematician who has written some very good books on poker strategy, but he’s never been able to make any money playing poker.

Do you believe that some of the successful floor traders are successful because they’re good at reading people?

Absolutely. To some extent, you can sense when another market participant is in trouble. In other words, he’s offering at a quarter and you can just read that he needs to get out. So even if you want to buy at a quarter, you’ll wait, because you know he’s eventually going to reduce his offer to an eighth. This approach was never an important element in my own trading, however. Most of the money I’ve made has been the result of being on the right side of the theoretical value.

When did you actually get involved in trading?

During the period when I was winding down my involvement in blackjack, I started to work on some option valuation models.

Was your model similar to the standard models, such as Black-Scholes?

Actually, the paper on this model was published in 1973. I was unfamiliar with the literature, so in 1975 I was busy constructing this model, which in fact had already been developed. In late 1976, I applied to be a market maker on the Pacific Stock Exchange.

What was your trading method?

Each day, I ran a computer program that generated theoretical value sheets, which told me what each option was worth at a certain stock price. Essentially, I walked around the pits with these sheets, and any time an option was out of line with my theoretical model, I bought or sold it.

So when you first started in option trading, you were looking for options that were out of line with their theoretical value.

That’s right.

That raises an interesting question. Since theoretical values are based on historical volatility, doesn’t that approach imply that historical volatility is a better predictor of future volatility than implied volatility? [For a detailed discussion of the concepts underlying this question, see the Joe Ritchie interview, pages 356-574.]

No. Actually, empirical studies have shown that implied volatility is better than historical volatility in predicting the actual future volatility.

Then how could you make money by trading based on mispricings relative to your model?

The real key is relative value. It doesn’t matter what model you use, as long as you apply it consistently across all option prices. What I was really concerned about was the price of options relative to each other. I would adjust the model-implied prices so that the at-the-money implied price was in line with the market price. For example, if the model said the at-the-money option was worth 3 but the option was actually trading at 3 1/2, then I would raise the volatility assumption in the model so the at-the-money option would also be priced at 3 1/2. Once you make that adjustment, all the other option values should be in line with the market. Then I would merely buy those options that were trading cheaper and sell those that were more expensive.

In other words, we’re not talking about looking at whether the market is out of line with the model, but rather whether the individual options in a specific market are out of line relative to each other.

Yes. I would say that in the early periods, most of my money was made in those types of trades.

Besides the fact that the mathematical models are forced to estimate the unknown future volatility by using past volatility, are there any other potential pitfalls in using these models?

Most of the models assume that stock options follow a log-normal distribution. In fact, I found out that the actual price distributions of virtually all financial markets tend to have fatter tails than suggested by the log-normal distribution.

To put that in lay terms, you’re saying that the standard mathematical models do not provide an accurate reflection of how options should be priced in the real world because of the tendency of extreme price moves to occur far more frequently than implied by the standard assumptions in these models.

Correct.

This would imply that it makes more sense to be a buyer of deep out-of-the-money options than might be assumed based on a model.

That’s true—especially in potential takeover situations.