The New Market Wizards: Conversations with America's Top Traders (60 page)
Read The New Market Wizards: Conversations with America's Top Traders Online
Authors: Jack D. Schwager
Eckhardt offers the rather provocative proposition that the human tendency to select comfortable choices will lead most people to experience worse than random results. In effect, he is saying that natural human traits lead to such poor trading decisions that most people would be better off flipping coins or throwing darts. Some of the examples Eckhardt cites of the comfortable choices people tend to make that run counter to sound trading principles include: gambling with losses, locking in sure winners, selling on strength and buying on weakness, and designing (or buying) trading systems that have been overfitted to past price behavior. The implied message to the trader is: Do what is right, not what feels comfortable.
32. YOU CAN’T WIN IF YOU HAVE TO WIN
There is an old Wall Street adage: “Scared money never wins.” The reason is quite simple: If you are risking money you can’t afford to lose, all the emotional pitfalls of trading will be magnified. Druckenmiller’s “betting the ranch” on one trade, in a last-ditch effort to save his firm, is a perfect example of the above aphorism. Even though he came within one week of picking the absolute bottom in the T-bill market, he still lost all his money. The need to win fosters trading errors (e.g., excessive leverage and a lack of planning in the example just cited). The market seldom tolerates the carelessness associated with trades born of desperation.
33. THINK TWICE WHEN THE MARKET LETS YOU OFF THE HOOK EASILY
Don’t be too eager to get out of a position you have been worried about if the market allows you to exit at a much better price than anticipated. If you had been worried about an adverse overnight (or over-the-weekend) price move because of a news event or a technical price failure on the previous close, it is likely that many other traders shared this concern. The fact that the market does not follow through much on these fears strongly suggests that there must be some very powerful underlying forces in favor of the direction of the original position. This concept, which was first proposed by Marty Schwartz in
Market Wizards,
was illustrated in this volume by the manner in which Lipschutz exited the one trade he admitted had scared him. In that instance, he held an enormous short dollar position in the midst of a strongly rallying market and had to wait for the Tokyo opening to find sufficient liquidity to exit his position. When the dollar opened weaker than expected in Tokyo, he didn’t just dump his position in relief; rather, his trader’s instincts told him to delay liquidation—a decision that resulted in a far better exit price.
34. A MIND IS A TERRIBLE THING TO CLOSE
Open-mindedness seems to be a common trait among those who excel at trading. For example, Blake’s entry into trading was actually an attempt to demonstrate to a friend that prices were random. When he realized he was wrong, he became a trader. Driehaus says that the mind is like a parachute; it’s good only when it’s open.
35. THE MARKETS ARE AN EXPENSIVE PLACE TO LOOK FOR EXCITEMENT
Excitement has a lot to do with the image of trading but nothing to do with success in trading (except in an inverse sense). In
Market Wizards,
Larry Hite described his conversation with a friend who couldn’t understand his absolute adherence to a computerized trading system. His friend asked, “Larry, how can you trade the way you do. Isn’t it boring?” Larry replied, “I don’t trade for excitement; I trade to win.” This passage came to mind when Faulkner described the trader who blew out because he found it too boring to be trading in the way that produced profits.
36. THE CALM STATE OF A TRADER
If there is an emotional state associated with successful trading, it is the antithesis of excitement. Based on his observations, Faulkner stated that exceptional traders are able to remain calm and detached regardless of what the markets are doing. He describes Peter Steidlmayer’s response to a position that is going against him as being typified by the thought, “Hmmm, look at that.” Basso also talks directly about the benefits of a detached perspective in trading: “If instead of saying, ’I’m going to do this trade,’ you say, ’I’m going to watch myself do this trade,’ all of a sudden you find that the process is a lot easier.”
37. IDENTIFY AND ELIMINATE STRESS
Stress in trading is a sign that something is wrong. If you feel stress, think about the cause, and then act to eliminate the problem. For example, let’s say you determine that the greatest source of stress is indecision in getting out of a losing position. One way to solve this problem is simply to enter a protective stop order every time you put on a position.
I will give you a personal example. One of the elements of my job is providing trading recommendations to brokers in my company. This task is very similar to trading, and, having done both, I believe it’s actually more difficult than trading. At one point, after years of net profitable recommendations, I hit a bad streak. I just couldn’t do anything right. When I was right about the direction of the market, my buy recommendation was just a bit too low (or my sell price too high). When I got in and the direction was right, I got stopped out—frequently within a few ticks of the extreme of the reaction.
I responded by developing a range of computerized trading programs and technical indicators, thereby widely diversifying the trading advice I provided to the firm. I still made my day-to-day subjective calls on the market, but everything was no longer riding on the accuracy of these recommendations. By widely diversifying the trading-related advice and information, and transferring much of this load to mechanical approaches, I was able to greatly diminish a source of personal stress—and improve the quality of the research product in the process.
38. PAY ATTENTION TO INTUITION
As I see it. intuition is simply experience that resides in the subconscious mind. The objectivity of the market analysis done by the conscious mind can be compromised by all sorts of extraneous considerations (e.g., one’s current market position, a resistance to change a previous forecast). The subconscious, however, is not inhibited by such constraints. Unfortunately, we can’t readily tap into our subconscious thoughts. However, when they come through as intuition, the trader needs to pay attention. As the anonymous trader in
Zen and the Art of Trading
expressed it, “The trick is to differentiate between what you
want
to happen and what you
know
will happen.”
39. LIFE’S MISSION AND LOVE OF THE ENDEAVOR
In talking to the traders interviewed in this book, I had the definite sense that many of them felt that trading was what they were meant to do—in essence, their mission in life. Recall Charles Faulkner’s quote of John Grinder’s description of mission: “What do you love so much that you would pay to do it?” Throughout my interviews, I was struck by the exuberance and love the Market Wizards had for trading. Many used gamelike analogies to describe trading. This type of love for the endeavor may indeed be an essential element for success.
40. THE ELEMENTS OF ACHIEVEMENT
Faulkner’s list of the six key steps to achievement based on Gary Faris’s study of successfully rehabilitated athletes appears to apply equally well to the goal of achieving trading success. These strategies include the following:
- using both “Toward” and “Away From” motivation;
- having a goal of full capability plus, with anything less being unacceptable;
- breaking down potentially overwhelming goals into chunks, with satisfaction garnered from the completion of each individual step;
- keeping full concentration on the present moment—that is, the single task at hand rather than the long-term goal;
- being personally involved in achieving goals (as opposed to depending on others); and
- making self-to-self comparisons to measure progress.
41. PRICES ARE NON RANDOM = THE MARKETS CAN BE BEAT
In reference to academicians who believe market prices are random, Trout says, “That’s probably why they’re professors and why Fin making money doing what I’m doing.” The debate over whether prices are random is not yet over. However, my experience with the interviews conducted for this book and its predecessor leaves me with little doubt that the random walk theory is wrong. It is not the magnitude of the winnings registered by the Market Wizards but the consistency of these winnings in some cases that underpin my belief. As a particularly compelling example, consider Blake’s 25:1 ratio of winning to losing months and his average annual return of 45 percent compared with a worst drawdown of only 5 percent. It is hard to imagine that results this lopsided could occur purely by chance—perhaps in a universe filled with traders, but not in their more finite numbers. Certainly, winning at the markets is not easy—and, in fact, it is getting more difficult as professionals account for a constantly growing proportion of the activity—but it can be done!
42. KEEP TRADING IN PERSPECTIVE
There is more to life than trading.
I
am frequently asked whether writing this volume and the first
Market Wizards
helped me become a better trader. The answer is yes, but not in the way people expect when they ask the question. No trader revealed to me any great market secrets or master plan unlocking the grand design of the markets. (If this is what you seek, don’t despair, the answer is readily available—just check the ads in any financial periodical.) For me, the single most important lesson provided by the interviews is that it is absolutely necessary to adopt a trading approach precisely suited to one’s own personality.
Over the years, I have come to clearly realize that what I really like about this business is trying to solve this master puzzle: How do you win in the markets? You have all these pieces, and you can put them together in a limitless number of ways, bounded only by your creativity. Moreover, to keep the game interesting, there are lots of pitfalls to lead you astray, and some of the rules keep changing in subtle ways. There is even a group of very intelligent people telling you that the game can’t be won at all. The really fascinating thing is that, as complex as this puzzle is, there are a multitude of totally different solutions, and there are always better solutions. Trying to solve this wonderful puzzle is what I enjoy.
On the other hand, I have also come to realize that I do not like the trading aspect at all. I do not enjoy the emotionality of making intraday trading decisions. When I am losing, I am upset, and when I am on a hot streak, I am anxious because I know I can’t keep it up. In short, it is not my style. In contrast, there are people who thrive on and excel at the actual trading. One person who in my mind epitomizes this type of approach is Paul Tudor Jones, whom I interviewed in
Market Wizards
. When you watch Paul trade, you can see he’s really charged by the activity. He bubbles over with energy, taking in information from a hundred different directions and making instantaneous trading decisions. He seems to love it, as if it were some challenging sport. And loving it is probably why he is so good at it.
For many years, I participated in both descretionary trading and system trading. It is, perhaps, no coincidence that in the course of working on this book, I came to the conclusion that it was system trading that suited my personality. Once I increased my efforts and commitment to system trading, my progress accelerated and I felt that the approach fit like a glove.
It took me over a decade to figure out my natural direction. I’d suggest that you take the time to seriously ponder whether the path you are on is the one you want to be on. Perhaps your journey will then be shortened.
T
here are two basic types of options: calls and puts. The purchase of a
call option
provides the buyer with the right—but not the obligation—to purchase the underlying item at a specified price, called the
strike price or exercise price
, at any time up to and including the
expiration date
. A
put option
provides the buyer with the right—but not the obligation—to sell the underlying item at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a
bearish
trade, whereas selling a put is a
bullish
trade.) The price of an option is called a
premium
. As an example of an option, an IBM April 130 call gives the purchaser the right to buy 100 shares of IBM at $130 per share at any time during the life of the option.
The buyer of a call seeks to profit from an anticipated price rise by locking in a specified purchase price. The call buyer’s maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price were above the prevailing market price. For example, if IBM were trading at $125 when the 130 option expired, the option would expire worthless. If at expiration the price of the underlying market was above the strike price, the option would have some value and would hence be exercised. However, if the difference between the market price and the strike price were less than the premium paid for the option, the net result of the trade would still be a loss. In order for a call buyer to realize a net profit, the difference between the market price and the strike price would have to exceed the premium paid when the call was purchased (after adjusting for commission cost). The higher the market price, the greater the resulting profit.
The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Like the call buyer, his maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the market price by an amount greater than the premium of the put at purchase (after adjusting for commission cost).
Whereas the buyer of a call or put has limited risk and unlimited potential gain, the reverse is true for the seller. The option seller (often called the
writer
) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position
at the strike price
if an option is exercised. For example, if a call is exercised, the seller must assume a short position in the underlying market at the strike price (because, by exercising the call, the buyer assumes a long position at that price).
The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call provides the most attractive trading opportunity. However, if the trader expected a large price decline, he would usually be better off going short the underlying market or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market.
Some novices have trouble understanding why a trader would not always prefer the buy side of the option (call or put, depending on market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurrence (i.e., prices in the vicinity of the market price when the option trade occurs) would result in a net gain to the option seller. Roughly speaking, the option buyer accepts a large probability of a small loss in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain. In an efficient market, neither the consistent option buyer nor the consistent option seller should have any significant advantage over the long run.
The option premium consists of two components: intrinsic value plus time value. The
intrinsic value
of a call option is the amount by which the current market price is above the strike price. (The intrinsic value of a put option is the amount by which the current market price is below the strike price.) In effect, the intrinsic value is that part of the premium that could be realized if the option were exercised at the current market price. The intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic value, a trader could buy and exercise the option and immediately offset the resulting market position, thereby realizing a net gain (assuming that the trader covers at least transaction costs).
Options that have intrinsic value (i.e., calls with strike prices below the market price and puts with strike prices above the market price) are said to be
in the money
. Options that have no intrinsic value are called
out-of-the-money
options. Options with a strike price closest to the market price are called
at-the-money
options.
An out-of-the-money option, which by definition has an intrinsic value equal to zero, will still have some value because of the possibility that the market price will move beyond the strike price prior to the expiration date. An in-the-money option will have a value greater than the intrinsic value because a position in the option will be preferred to a position in the underlying market. Why? Because both the option and the market position will gain equally in the event of a favorable price movement, but the option’s maximum loss is limited. The portion of the premium that exceeds the intrinsic value is called the
time value
.
The three most important factors that influence an option’s time value are the following:
1.
Relationship between the strike price and market price
—Deeply out-of-the-money options will have little time value since it is unlikely that the market price will move to the strike price—or beyond—prior to expiration. Deeply in-the-money options have little time value because these options offer positions very similar to the underlying market—both will gain and lose equivalent amounts for all but an extremely adverse price move. In other words, for a deeply in-the-money option, risk being limited is not worth very much because the strike price is so far from the prevailing market price.
2.
Time remaining until expiration
—The more time remaining until expiration, the greater the value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specified amount prior to expiration.
3.
Volatility
—Time value will vary directly with the estimated
volatility
(a measure of the degree of price variability) of the underlying market for the remaining life span of the option. This relationship results because greater volatility raises the probability of the intrinsic value increasing by any specified amount prior to expiration. In other words, the greater the volatility, the greater the probable price range of the market.
Although volatility is an extremely important factor in the determination of option premium values, it should be stressed that the future volatility of a market is never precisely known until after the fact. (In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of
historical volatility
data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the
implied volatility.
