The New Market Wizards: Conversations with America's Top Traders (43 page)

In other words, you failed to act decisively, a trait you cited earlier as one of the key ingredients to being a successful trader.

Exactly. I eventually ended up buying gold at just under $500 an ounce. And as you might guess, it went down the limit the day I bought it. Locked limit-down, in fact.

Did you think of getting out?

No. The hostage situation was still completely unresolved. Also, around the same time, the Soviet Union had invaded Afghanistan. I still felt the market would eventually continue to go higher. So I stuck with it. Of course, as you know, the market did go sharply higher.

Did you have a plan for getting out?

Yes, my plan was to get out whenever the market dropped 10 percent from its high.

Basically, your plan was to let the market run until there was some sign of meaningful weakness.

Right. Unfortunately, when the market dropped, it lost 25 percent of its value in one day. Needless to say, that was a particularly painful loss. But the point is that I still ended up with a large profit on the trade.

In fact, this trade raises the whole question of how you view drawdowns. Most people don’t distinguish between drawdowns in open equity and drawdowns in closed equity. [The distinction is that
open equity
refers to unrealized profits on an existing position. In effect, what Ritchie is implying is that he views a given loss differently if it is a partial surrender of profits on a winning trade as opposed to if it is a drawdown in a losing trade.] If I protected open equity [i.e., open profits] with the same care I protected closed equity, I would never be able to participate in a long-term move. Any sensible overall risk control measure could not withstand the normal volatility in such a move.

In other words, in order to score the really large gains, you have to be willing to see those gains erode significantly before getting out of the market.

I can’t see any other way. If you get too careful about not risking your gains, you’re not going to be able to extract a large profit.

How much do you risk on any single trade or idea (measured from trade initiation, not peak equity)?

About one-half of I percent. I think it’s generally a good idea that when you put on a trade, it should be so small that it seems almost a waste of your time. Always trade at a level that seems too small.

You spent approximately the first ten years of your trading career on the floor and then made a transition to trading from an office. Since you were very successful as a floor trader, I’d like to understand your motivation for making the switch. First, tell me, would I be safe in assuming that while you were a floor trader, virtually every month was profitable?

Yes.

Let’s take it one step further. What percentage of your weeks would you estimate were profitable during that period?

Ninety percent.

Most people would say, “My God, 90 percent of the weeks this guy makes a profit!” Why would you ever leave that type of an edge?

First I’ll give you my short answer: old age. Also, the soybean market had lost much of its volatility, which reduced trading opportunities. It seemed like the right time to try trading off the floor.

Did you have a plan on how you would approach trading from upstairs?

I had no idea. I checked out lots of things. I tried a number of advisory services but found that they were often not worth the time it took to listen to the phone tape. I eventually gravitated toward trying to develop my own systems. One of the things that amazed me was the unreliability of information by the so-called pros of the industry. For example, when I started working on testing and developing systems, I purchased price data from a company that marketed what they called a “perpetual” contract. [The perpetual price is derived by interpolating between the nearest two actual futures contracts to obtain a hypothetical price series that is always a constant amount of time forward from the current date (e.g., ninety days). The resulting price is a theoretical concept that will be a hybrid of two different contracts and cannot be replicated by any real-world trading instrument(s).]

I used this data for over six months before I realized that it was not a reflection of the real market. For example, the perpetual series could show a large price move that implied a profit that you could not have realized in the real market. When l discovered this, I almost fell off my chair. I couldn’t understand how anyone who had ever traded anything could have constructed this type of series.

I asked myself, “How can all these professionals who obviously know what they’re doing be following data that’s fundamentally foolish?” The question was easy enough to answer. After all, I had used it myself for six months. I had to go back to square one and start over. I never again trusted anyone else’s work.

Did you buy any commercial trading systems at the time?

Yes, I did buy a couple. One of them—I don’t want to mention the name—was essentially a simulation package. I had assumed that if I could get a tool that would allow me to develop optimized trading systems, it would be a thousand times more effective than trying to approach the market by using charts. [Optimization refers to the process of testing a particular system, using many different values for the key inputs, and then choosing the single combination of values that worked best for past history. Although this procedure can yield wonderful performance for the past, it usually wildly overinflates the implied performance for the future.] Instead, I found the software was worthless. There again, I was amazed at the magnitude of ignorance of the people who had developed this system.

In what way was it worthless?

The software was a system that allowed you to optimize the market to death. In fact, this organization even recommended reoptimizing the system every week. In other words, curve-fit the program to last week so the trades this week will match what should have been done the previous week. I just got the overwhelming impression that whoever had developed the ideas for this system had never traded himself.

Did you ever find out if that was true?

[A long sigh] I asked that question, but they just dodged it. In fact, I remember the company salesman showing me how to enter the data manually. Personally, I prefer to get the data by computer, because manual entry just seems like too much work. Anyway, this fellow, who was himself a trader, said, “I don’t even pay for the price of the
Wall Street Journal.
I have a friend photocopy the price page for me.” I thought to myself. “Here’s a guy who’s marketing a program that’s being represented as the premiere trading system software on the market, and he doesn’t even have enough money to buy the
Wall Street Journal.
”

Did you actually try trading the system?

Yes, but the results were just spasmodic. Moreover, I was extremely uncomfortable with the idea of trading a black box [trading system computer software that generates buy and sell signals without revealing the rules of how the signals are generated]. I swore to myself that I would never purchase a black box system again.

Is your advice to people then: Forget what’s out there and do your own work?

My advice to people has always been: Stay out of the business; stay completely away from the market. For novices to come in and try to generate profit in this incredibly complex industry is like me trying to do brain surgery on the weekends to pick up a little extra cash.

I have a friend who knows three doctors who got together to invest in a stud race horse. When they took delivery of the horse, they found that it was a gelding. My friend was teasing them about this and asked if they had ever thought of inspecting the horse. You won’t believe this, but it turns out that they had thought of it, but they didn’t go any further. So he said, “Well, you guys are all doctors; did you ever bend over and take a look under there to make sure he had the necessary tools?”

If you asked those three doctors today what their mistake was, I’m sure they would tell you that they should have inspected the horse’s valuables. They still wouldn’t have learned the lesson: DON’T INVEST WHERE YOU DON’T KNOW WHAT YOU’RE DOING. If they invest in another horse, they won’t get a gelding, but they’ll make some other mistake just as laughable.

Do you mean to imply that people should just put their money in T-bills?

I think they can go with some of the managed funds or trading advisors that have proven track records. But I would take very seriously the standard disclaimer that says, “Past performance is no guarantee of future results.” Also, I don’t think you can make money unless you’re willing to lose it. Unless you have money that you can afford to lose and still sleep at night, you don’t belong in the market. My willingness to lose is fundamental to my ability to make money in the markets.

And that’s not true of most people?

That’s right. Most people come into this business without a willingness to lose money. They also enter the market with unrealistic expectations. Even if they’re lucky enough to pick a successful trading advisor, they’re likely to pull their money out the first quarter he has a drawdown. So they end up losing even though they may have been in a winning situation.

Actually, my empirical research has demonstrated the exact same conclusion. Several years ago, part of my job was evaluating outside trading advisors. In the process, I found out something particularly interesting. There was a handful of advisors who had made money every year. Yet even for this select group, less than 50 percent of their closed client accounts showed a net profit. That really brought home to me how poor most people are in deciding when to enter and exit investments. I think the natural tendency is to invest money with a manager after he has had a hot streak and to withdraw it after a losing streak.

Although you discourage people from getting into this business, let’s say that somebody comes to you with a serious interest in becoming a trader. What do you tell them?

I know this is going to sound patronizing, but honestly, I tell them to read your first book
[The Complete Guide to the Futures Markets].
I slow them down by telling them to come back to me after they have digested half of that book, knowing full well that most of them will never do that.

So that’s the way you turn people away from the business. Now
there’s
a ringing compliment on my work if I ever heard one.

Actually, just picking the book up is a threatening experience. Seriously, I think your book gives people a good idea of the amount of work it takes to become competent in this business.

Is one of your motivations for trading having the ability to give a portion of your profits to charity?

Precisely, although I hate to put it that simply. In my youth, I was so idealistic that I thought the dollar was that unholy Mammon that one must resist in order to do humanity some higher good. I eventually learned that wealth has a great deal of inherent value. When you see somebody starving, what he needs is money.

I assume that you probably long ago passed the point where your trading profits took care of any personal needs or financial security you might envision. In your own case, if the charity aspect were not there, do you think you would still be trading?

I’m not sure that I would be. I just don’t know. Incidentally, let me correct your use of the term
charity
. I don’t think in terms of charity. I think in terms of investing in the poor. If someone is starving and you hand him a buck, you’ve taught him that what he needs is for someone to give him a handout. I prefer to
invest
in the poor—to provide capital so they can enhance their own productivity. What the poor need are cottage industries that allow them to become self-sufficient. That’s the type of funding I believe in, and it may not fit the conventional view of charity.

I know what I’m going to say can be easily misconstrued, but if I could set up a system where I could make money off the poor, then I would have achieved my goal. I know that sounds crass. Of course, my objective is not to make money off the poor, but the point is that charity tends to spawn dependency. That’s why the Great Society war on poverty was such a failure. In contrast, if I can establish someone in a business where he can return my money, then I know his situation is stable.