The New Market Wizards: Conversations with America's Top Traders (9 page)

What do you believe are the characteristics of the truly superior traders?

Let me start with an analogy. When I was in college, my impression was that people who were really smart could do very well, even if they didn’t work that hard, and people who really worked hard could also do very well, even if they weren’t outstandingly bright. In contrast, in trading, I think you need both elements. The best traders I know are really quite brilliant, and they all work very hard—much harder than anyone else.

By the way, when I talk about working hard, I mean commitment and focus; it has nothing to do with how many hours you spend in the office. These traders have tremendous commitment to the markets—to their craft, so to speak. They develop scenarios, reevaluate scenarios, collect information, and reevaluate that information. They constantly ask themselves: What am I doing right? What am I doing wrong? How can I do what I am doing better? How can I get more information? It’s obsessive.

Is this type of analysis something that’s ongoing during all your waking hours?

Absolutely. Some professional traders may claim that they separate their personal life from their business life and are able to completely turn off on the weekends. I don’t believe that for a second. I think that when they’re relaxing in their sailboats, at some level they’re still focused on the market.

I know you like to play golf. When you’re out on the course, are you still thinking about the markets?

Probably so. The really best traders around don’t think twice about how many hours they’re working or whether they come in on a weekend. There’s no substitute for that level of commitment.

When you’re interviewing someone for a job as a trader, how do you determine whether they have that type of commitment?

Sometimes it’s obvious. For example, in an interview someone might ask you, “What time do I have to come to work in the morning?” In my opinion that’s a very bizarre question. Come in whatever time you believe is appropriate. “How late do I have to stay in the afternoon?” Leave whenever you want. I’m not going to tell someone when to come in and when to leave.

Besides intelligence and extreme commitment, are there any other qualities that you believe are important to excel as a trader?

Courage. It’s not enough to simply have the insight to see something apart from the rest of the crowd, you also need to have the courage to act on it and to stay with it. It’s very difficult to be different from the rest of the crowd the majority of the time, which by definition is what you’re doing if you’re a successful trader.

Many people think that trading can be reduced to a few rules. Always do this or always do that. To me, trading isn’t about
always
at all; it is about each situation.

So many people want the positive rewards of being a successful trader without being willing to go through the commitment and pain. And there’s a lot of pain.

The pain being what?

You give up a lot of things. It’s all tradeoffs. It’s the middle of the night, everyone else is asleep, and you’re sitting in front of a machine with glowing green numbers, with a pain in your psyche because the market is going against you and you don’t know whether the fundamentals have changed or whether it’s just a meaningless short-term move. Those are very trying times.

Trading is such a pervasive element in your life, including being up half the night on a regular basis. Does this obsession, as you yourself termed it a little earlier, create a source of friction in your married life?

Not at all. My wife was a bond salesman at Goldman Sachs for many years. Personally, I think she would make a very good trader—she has many of the right qualities—but she doesn’t want to trade. I wouldn’t lessen it by saying simply that she is understanding, because that sounds so docile. She’s more than understanding; she’s fully cognizant, supportive, and I think she gets a big thrill out of what I do.

Why do you trade?

I like the game. I think it’s a great challenge. It’s also an easy game to keep score of.

With trading consuming most of your day, not to mention night, is it still fun?

It’s tremendous fun! It’s fascinating as hell because it’s different every day.

Would you still trade if there were no monetary remuneration?

Absolutely. Without question, I would do this for free. I’m thirty-six years old, and I almost feel like I have never worked. I sometimes can’t believe I’m making all this money to essentially play an elaborate game. On the other hand, when you look at all the money I’ve produced over the years, I’ve been vastly underpaid.

The more supertraders I interview, the more convinced I become that, at least to some degree, their success can be attributed to an innate talent. Bill Lipschutz provides an excellent example. His first encounter with trading actually involved paper trading in a college investment course. Lipschutz ended up running a hypothetical $100,000 into an incredible $29 million by the end of the course. Although this accomplishment has to be taken with a grain of salt because it didn’t involve real money and the rules of the experiment were flawed by the lack of realistic limitations on leverage, the results were striking nonetheless.

Lipschutz’s first experience in actual trading was prompted by a $12,000 inheritance that he steadily built up to $250,000 over a four-year period. Although he ended up blowing the entire account because of one drastic mistake of wildly overleveraging his position, that does not take away from the skill that was needed to produce the steady equity growth in the first place.

Finally, and most important, despite having had no previous experience whatsoever in the currency markets, Lipschutz was significantly profitable in his very first year of trading these markets and extraordinarily profitable over the next seven years. Although he declines to quote any specific figures, it has been estimated that his trading alone accounted for an excess of one-half billion dollars in profits for Salomon Brothers over his eight-year stay with the firm.

Lipschutz himself cites hard work and an all-consuming commitment to the markets as the principal ingredients for his success. Although hard work by itself is not sufficient to make one a great trader, it does appear to be an important ingredient in the success of many of the world’s best traders. Lipschutz also believes that superior intelligence is an important ingredient to trading success. However, it should be noted that others whom I have interviewed (e.g., Victor Sperandeo) do not share this view.

One theme that seems to recur in many of my conversations with the world’s top traders is their view of the markets as a wonderful game rather than as work. Lipschutz emphatically claims that, for him, trading is such an engaging game that he would do it for free if he had to.

One lesson that could be drawn from Lipschutz’s trading style is that you don’t have to get in or out of a position all at once. Lipschutz scales in and out of virtually all his trades. One sensible piece of advice for most traders is this: Avoid the temptation of wanting to be completely right. For example, let’s say you become convinced that a market should be bought, but prices have already had a sizable run-up. In many instances, if the trade is really good, by waiting for a significant reaction before putting on the entire position you are apt to miss the move completely. However, by adopting a scale-in plan—putting on part of the intended total position at the market and the remainder on a scale-down basis—you assure that you will at least have a partial position if the market keeps on going, without the excessive risk that would be implied by putting on the entire position after a large, uninterrupted advance.

As another example, assume that you are long with a large profit and are concerned about a market top. If you get out of the entire position and the market advance continues, you can miss a large part of the total move. On the other hand, if you keep the entire position and the market does indeed top, you can end up giving back a very large portion of the gain. By using a scale-out approach, you may never get the best outcome, but at the same time you will never get the worst outcome either. Also, by using a scale-in and scale-out approach, you can restrict full positions to those instances in which your confidence in a trade is greatest.

Another lesson to be learned from this interview is that if you have a strong conviction about a trade and the market has a large move because of a news event, the best decision may well be to bite the bullet and buy on extreme strength (or sell on extreme weakness). A perfect example of this concept was provided by the way the trader in Lipschutz’s group handled trading the market following the G-7 meeting.

In
Market Wizards,
Marty Schwartz made the observation that if a trade that you are very worried about does not turn out as badly as feared, don’t get out. The rationale is that if there is no follow-through in a direction adverse to your position, then there must be some very strong underlying forces in favor of the direction of the original position (since the reasons—fundamental or technical—for your own fears are probably shared by many others in the marketplace). A prime example of this rule in action was provided by the one trade that Bill Lipschutz admitted scared him. In that instance, he was short a very large dollar position against the D-mark in the midst of a sharp dollar rally and had to wait for the Tokyo opening to find sufficient liquidity to exit the position. However, by the time Tokyo opened, the dollar was weaker, letting him off the hook easily and therefore implying that he shouldn’t get out. Lipschutz, being a highly skilled trader, responded exactly right and delayed liquidating his position, thereby recouping most of his loss.

One item I found particularly curious was that, after more than four years of steady trading gains in his stock option account, Lipschutz lost virtually the entire amount in a few days’ time. Ironically, this loss coincided with his start of full employment at Salomon Brothers. Interestingly, as expressed in the interview, he had strong feelings against simultaneously trading personal and company accounts. The demise of his own account, therefore, played neatly into avoiding any potential source of conflict. In our conversation, Lipschutz insisted that the loss was probably coincidental since he was only in the training class and not yet aware of any potential conflict.

Despite Lipschutz’s denial, I couldn’t help but be reminded of the provocative aphorism: “Everybody gets what they want out of the market.”
^*
I wondered whether Lipschutz’s subconscious was perhaps a bit more foresightful than he realized. In any case, the timing of this large loss and its relative uniqueness in Lipschutz’s trading career does seem somewhat ironic. Whether this interpretation is strained conjecture or fact, one thing is certain: Lipschutz did indeed get what he wanted—a perfect job, huge trading profits, and an absence of conflict between his personal and company trading.

T
oday’s futures markets encompass all the world’s major market groups: interest rates (e.g., T-bonds), stock indexes (e.g., the S&P 500), currencies (e.g., Japanese yen), precious metals (e.g., gold), energy (e.g., crude oil), and agricultural commodities (e.g., corn). Although the futures markets had their origins in agricultural commodities, this sector now accounts for only about one-fifth of total futures trading. During the past two decades, the introduction and spectacular growth of many new contracts have resulted in the financial markets (currencies, interest rate instruments, and stock indexes) accounting for approximately 60 percent of all futures trading. (Energy and metal markets account for nearly half of the remaining 40 percent.) Thus, while the term
commodities
is often used to refer to the futures markets, it has increasingly become a misnomer. Many of the most actively traded futures markets, such as those in the financial instruments, are not true commodities, and many commodity markets have no corresponding futures markets.

Trading volume in futures has expanded tremendously during the past generation. In 1991 total volume of all futures traded in the United States alone exceeded 263,000,000. Conservatively assuming an average contact value of at least $40,000, the total dollar value of these contracts exceeded $10 trillion! (Yes, trillion, not billion.)

The essence of a futures market is in its name. Trading involves a standardized contract for a commodity, such as gold, or a financial instrument, such as T-bonds, for a future delivery date, as opposed to the present time. For example, if an automobile manufacturer needs copper for current operations, it will buy its materials directly from a producer. If, however, the same manufacturer were concerned that copper prices would be much higher in six months, it could approximately lock in its costs at that time by buying copper futures now. (This offset of future price risk is called a hedge.) If copper prices climbed during the interim, the profit on the futures hedge would approximately offset the higher cost of copper at the time of actual purchase. Of course, if copper prices declined instead, the futures hedge would result in a loss, but the manufacturer would end up buying its copper at lower levels than it was willing to lock in.

While hedgers, such as the above automobile manufacturer, participate in futures markets to reduce the risk of an adverse price move, traders participate in an effort to profit from anticipated price changes. In fact, many traders will prefer the futures markets over their cash counterparts as trading vehicles for a variety of reasons:

1.
Standardized contracts
—Futures contracts are standardized (in terms of quantity and quality); thus, the trader does not have to find a specific buyer or seller in order to initiate or liquidate a position.

2.
Liquidity
—All of the major markets provide excellent liquidity.

3.
Ease of going short
—The futures markets allow equal ease of going short as well as long. For example, the short seller in the stock market (who is actually borrowing stock to sell) must wait for an uptick before initiating a position; no such restriction exits in the futures markets.

4.
Leverage
—The futures markets offer tremendous leverage. Roughly speaking, initial margin requirements are usually equal to 5 to 10 percent of the contract value. (The use of the term
margin
in the futures market is unfortunate because it leads to tremendous confusion with the concept of margins in stocks. In the futures markets, margins do not imply partial payments, since no actual physical transaction occurs until the expiration date; rather, margins are basically good-faith deposits.) Although high leverage is one of the attributes of futures markets for traders, it should be emphasized that leverage is a two-edged sword. The undisciplined use of leverage is the single most important reason why most traders lose money in the futures markets. In generals, futures prices are no more volatile than the underlying cash prices or, for that matter, many stocks. The high-risk reputation of futures is largely a consequence of the leverage factor.

5.
Low transaction costs
—Futures markets provide very low transaction costs. For example, it is far less expensive for a stock portfolio manager to reduce market exposure by selling the equivalent dollar amount of stock index futures contracts than by selling individual stocks.

6.
Ease of offset
—A futures position can be offset at any time during market hours, providing prices are not locked at limit-up or limit-down. (Some futures markets specify daily maximum price changes. In cases in which free market forces would normally seek an equilibrium price outside the range of boundaries implied by price limits, the market will simply move to the limit and virtually cease to trade.)

7.
Guaranteed by exchange
—The futures trader does not have to be concerned about the financial stability of the person on the other side of the trade. All futures transactions are guaranteed by the clearinghouse of the exchange.

Since, by their very structure, futures are closely tied to their underlying markets (the activity of arbitrageurs assures that deviations are relatively minor and short-lived), price moves in futures will very closely parallel those in the corresponding cash markets. Keeping in mind that the majority of futures trading activity is concentrated in financial instruments, many futures traders are, in reality, traders in stocks, bonds, and currencies. In this context, the comments of futures traders interviewed in the following chapters have direct relevance even to investors who have never ventured beyond stocks and bonds.