The new market wizards 9780887305870, 0887305873

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THE NEW MARKET WIZARDS CONVERSATIONS WITH AMERICA'S TOP TRADERS

JACK D. SCHWAGER

HarperBusiness 1

2 This book was originally published in 1992 by HarperBusiness, a division of Harper-Coltins Publishers. THE NEW MARKET WIZARDS.

Copyright © 1992 by Jack D. Schwager. All rights reserved. Printed in the United States of America. No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information address Harper-Collins Publishers, Inc., 10 East 53rd Street, New York, NY 10022. HarperCollins books may be purchased for educational, business, or sales promotional use. For information please write: Special Markets Department, HarpeiCollins Publishers, Inc., 10 East 53rd Street, New York, NY 10022. First paperback edition published 1994. Designed by Alma Hochhauser Orenstein

The Library of Congress has catalogued the hardcover edition as follows: Schwager, Jack D., 1948The new market wizards : conversations with America's top traders / Jack D. Schwager.- Isted-p. cm. Sequel to: Market wizards. ISBN 0-88730-587-3 1. Floor traders (Finance)-United States-Interviews. 2. Futures market-United States. 3. Financial futuresUnited States. 1. Schwager, Jack D., 1948- Market Wizards. H. Title-HG4621.S283 1992 332.64'0973dc20 92-52612 ISBN 0-88730-667-5 (pbk.) 984-/RRD-H 20191817

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3 Contents Pr e fa ce _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4 Ack n ow le dgm e n t s_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 5 Pr ologu e _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6 PART I Tr a din g Pe r spe ct ive s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 M isa dve n t u r e s in Tr a din g _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 8 H u sse in M a k e s a Ba d Tr a de _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 1 PART I I Th e W or ld's Bigge st M a r k e t _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 2 Bill Lipsch u t z: Th e Su lt a n of Cu r r e n cie s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 3 PART I I I Fu t u r e s- Th e Va r ie t y- Pa ck M a r k e t _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 3 3 Fu t u r e s- Unde r st a n din g t h e Ba sics _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 3 4 Ra n dy M cKa y: Ve t e r a n Tr a de r _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 3 5 W illia m Eck h a r dt : Th e M a t h e m a t icia n _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4 5 Th e Sile n ce of t h e Tu r t le s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 5 7 = = = Michael Carr = = = __________________________________________________________________ 58 = = = Howard Seidler = = = ________________________________________________________________ 59 M on r oe Tr ou t : Th e Be st Re t u r n Th a t Low Risk Ca n Bu y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6 1 AlW e iss: Th e H u m a n Cha r t En cyclope dia _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 1 PART I V Fu n d M a n a ge r s a n d Tim e r s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 4 St a n le y D r uck e n m ille r : Th e Ar t of Top- D ow n I nve st in g _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 5 Rich a r d D r ie h a u s: Th e Ar t of Bot t om - Up I n ve st in g _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 8 4 Gil Bla k e : Th e M a st e r of Con sist e n cy _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 9 1 Vict or Spe r a n de o: M a r k e t s Gr ow Old Too _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 9 8 PART V M u lt iple - M a r k e t Pla ye r s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 0 7 Tom Ba sso: M r . Se r e n it y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 0 8 Lin da Br a dfor d Ra sch k e : Re a din g t h e M u sic of t h e M a r k e t s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 1 3 PART VI Th e M on e y M a ch in e s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 1 9 CRT: Th e Tr a din g M a ch in e _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 2 0 M a r k Rit ch ie : God in t h e Pit s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 2 2 Joe Rit ch ie : Th e I n t u it ive Th e or e t icia n _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 3 0 Bla ir H u ll: Ge t t in g t h e Edge _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 3 8 Je ff Ya ss: Th e M a t h e m a t ics of St r a t e gy _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 4 7 PART VI I Th e Psych ology of Tr a din g _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 5 4 Ze n a n d t h e Ar t of Tr a din g _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 5 5 Ch a r le s Fa ulk n e r : Th e M in d of a n Ach ie ve r _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 5 6 Robe r t Kr a usz: Th e Role of t h e Su bcon sciou s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 6 5 PART VI I I Closin g Be ll _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 2 M a r k e t W iz( a r ) dom _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 3 A Pe r son a l Re fle ct ion _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 1 Appe n dix : Opt ion s - Un de r st a n ding t h e Ba sics _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 2 Glossa r y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 4

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4 Preface TO

MY FAMI LY Joe Ann Daniel Zachary Sam ant ha Who are all very special t o m e Wit h love

Here's what I believe: 1. The m arket s are not random . I don't care if t he num ber of academ icians who have argued t he efficient m arket hypot hesis would st ret ch t o t he m oon and back if laid end t o end; t hey are sim ply wrong. 2. The m ark et s are not random , because t hey ar e based on hum an behavior, and hum an behavior, especially m ass behavior, is not random . I t never has been, and it probably never will be. 3. There is no holy grail or grand secret t o t he m arket s, but t here are m any pat t erns t hat can lead t o profit s. 4. There are a m illion ways t o m ake m oney in m arket s. The irony is t hat t hey are all very difficult t o find. 5. The m arket s are always changing, and t hey are always t he sam e. 6. The secret t o success in t he m ar ket s lies not in discovering som e incredible indicat or or elaborat e t heory; rat her, it lies wit hin each individual. 7. To excel in t rading requires a com binat ion of t alent and ext rem ely hard work- ( surprise! ) t he sam e com binat ion required for excellence in any field. Those seeking success by buying t he lat est $300 or even $3,000 syst em , or by following t he lat est hot t ip, will never find t he answer because t hey haven't yet underst ood t he quest ion. 8. Success in t rading is a w ort hy goal, but it w ill be w ort hless if it is not accom panied by success in your life ( and I use t he word success here wit hout m onet ary connot at ion) . I n conduct ing t he int erview s for t his book and it s predecessor. Market Wizards, I becam e absolut ely convinced t hat winning in t he m arket s is a m at t er of skill and discipline, not luck. The m agnit ude and consist ency of t he winning t rack records com piled by m any of t hose I int erviewed sim ply defy chance. I believe t he Market Wizards provide role m odels for what it t akes t o win in t he m arket s. Those seeking quick fort unes should be discouraged at t he onset . I have st rived t o r each t wo audiences: t he professionals who have st aked careers in t he m arket s or are serious, st udent s of t he m arket s, and t he lay readers who hav e a general int erest in t he financial m arket s and a curiosit y about t hose who have won dram at ically in an arena where t he vast m aj orit y loses. I n order t o keep t he book accessible t o t he layperson, I have t ried t o avoid part icularly esot eric t opics and have included explanat ions wherever appropriat e. At t he sam e rim e, I have st rived t o m aint ain all core ideas so t hat t here would be no loss of m eaningful inform at ion t o t hose wit h a good working knowledge of t he m arket s. I t hink t his book should be as m eaningful t o t he layperson as t o t he professional sim ply because t he elem ent s t hat det erm ine success in t rading are t ot ally applicable t o success in virt ually any field or t o achieving any m eaningful goal.

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5 Acknowledgments My t hanks t o t hose who graciously agreed t o be int erviewed for t his volum e, freely sharing t heir t hought s and experiences while refraining from request s for cosm et ic changes w hen present ed wit h t he finished m anuscript for review. ( Not all t hose I int erviewed proved as accom m odat ing; t he except ions do not appear in t his book.) I n a num ber of cases, t he t raders I int erview ed had not hing t o gain from part icipat ing, at least not m onet arily, as t hey eit her do not m anage any public funds or are not open t o furt her invest m ent . I am part icularly appreciat ive of t heir cooperat ion. I would like t o t hank m y wife, Jo Ann, for reading t he original m anuscript and providing som e welldirect ed suggest ions, all of which were t aken. Most ly, I m ust t hank Jo Ann for enduring yet anot her year as a " book widow," not t o m ent ion keeping t he kids quiet so t hat I could sleep in t he m ornings aft er t hose allnight writ ing sessions. My t hree wonder ful children- Daniel, Zachary, and Sam ant ha- were as underst anding as could possibly be expect ed for any group aged eight , seven, and t hree in accept ing all t hose hours st olen from our t im e t oget her and act ivit ies foregone as a result of m y involvem ent in t his work. Finally, I would like t o t hank t he following friends for t heir suggest ions and advice regarding pot ent ial int erview candidat es: Norm Zadeh, Audrey Gale, Douglas Makepeace, St anley Angrist , Tony Saliba, and JeffGrable.

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6 Prologue Th e Ja de m a st e r One cold wint er m orning a young m an walks five m iles t hrough t he snow. He knocks on t he Jadem ast er 's door. The Jadem ast er answers wit h a broom in his hand. " Yes?" " I want t o learn about Jade." " Very well t hen, com e in out of t he cold." They sit by t he fire sipping hot green t ea. The Jadem ast er pr esses a gr een st one deeply int o t he young m an's hand and begins t o t alk about t ree frogs. Aft er a few m inut es, t he young m an int errupt s. " Excuse m e, I am here t o leam about Jade, not t ree frogs." The Jadem ast er t akes t he st one and t ells t he young m an t o go hom e and ret urn in a week. The following week t he young m an ret urns. The Jadem ast er presses anot her green st one int o t he young m an's hand and cont inues t he st ory. Again, t he young m an int errupt s. Again, t he Jade- m ast er sends him hom e. Weeks pass. The young m an int errupt s less and less. The young m an also learns t o brew t he hot green t ea, clean up t he kit chen and sweep t he floors. Spring com es. One day, t he young m an observes, " The st one I hold is not genuine Jade." I lean back in m y chair, savoring t he st ory. My st udent int errupt s. " OK. OK. That 's a great st ory. I don't see what it has t o do wit h m aking m oney. I com e t o you t o find out about t he m arket s. I want t o learn about t he bulls and t he bears, com m odit ies, st ocks, bonds, calls and opt ions. I want t o m ake big m oney. You t ell m e a fable about Jade. What is t his? You ..." " That 's all for now. Leave t hose price chart s on t he t able. Com e back next week." Mont hs pass. My st udent int errupt s less and less as I cont inue t he st ory of The Trader 's Window. - from The Trader's Window, ED SEYKOTA

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7 PART I Trading Perspectives

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8 Misadventures in Trading On t he lect ur e t our following t he com plet ion of t his book's predecessor, Mark et Wizards, cert ain quest ions cam e up wit h reliable frequency. One com m on quest ion was: " Has your own t rading im proved dr am at ically now t hat you've j ust finished int erviewing som e of t he world's best t raders?" Alt hough I had t he advant age of having plent y of room for dram at ic im provem ent in m y t rading, m y response was a bit of a copout . " Well," I would answer, " I don't know. You see, at t he m om ent , I 'm not t rading." While it m ay seem a bit heret ical for t he aut hor of Market Wizards not t o be t rading, t here was a perfect ly good reason for m y inact ion. One of t he cardinal rules about t rading is ( or should be) : Don't t rade when you can't afford t o lose. I n fact , t here ar e few m ore cert ain ways of guarant eeing t hat you will lose t han by t rading m oney you can't afford t o lose. I f your t rading capit al is t oo im port ant , you will be doom ed t o a num ber of fat al errors. You will m iss out on som e of t he best t rading oppor t unit ies because t hese ar e oft en t he m ost risky. You will j um p out of perfect ly good posit ions prem at urely on t he first sign of adverse price m ovem ent only t o t hen see t he m arket go in t he ant icipat ed direct ion. You will be t oo quick t o t ake t he first bit of profit because of concern t hat t he m arket will t ake it away from you. I ronically, overconcem about losing m ay even lead t o st aying wit h losing t rades as fear t riggers indeci- siveness, m uch like a deer frozen in t he glare of a car's headlight s. I n shor t , t rading wit h " scared m oney" will lead t o a host of negat ive em ot ions t hat will cloud decision m aking and virt ually guarant ee failure. The com plet ion of Market Wizards coincided wit h m y having a house built . Perhaps som ewhere out in t his great count r y, t here is som eone who has act ually built a house for what t hey t hought it would cost . But I doubt it . When financing t he building of a house, you find yourself repeat edly ut t ering t hat seem ingly innocuous phrase, " Oh, it 's only anot her $2,000." All t hose $2,000` s add up, not t o m ent ion t he m uch larger sum s. One of our ext ravagances was an indoor swim m ing pool, and t o help pay for t his it em I liquidat ed m y com m odit y account - in t he t ruest sense of t he word. I t was m y sincerest int ent ion not t o resum e t rading unt il I felt I had adequat e risk capit al available, and an unending st ream of im provem ent s on t he house kept pushing t hat dat e furt her int o t he fut ure. I n addit ion, working at a dem anding full- t im e j ob and sim ult aneously writ ing a book is a draining experience. Trading requires ener gy, and I felt I needed t im e t o recuperat e wit hout any addit ional st rains. I n short , I didn't want t o t rade. This was t he sit uat ion one day when, in reviewing m y chart s in t he aft ernoon, I found m yself wit h t he firm convict ion t hat t he Brit ish pound was about t o collapse. I n t he previous t wo weeks, t he pound had m oved st raight dow n wit hout even a hint of a t echnical rebound. Aft er t his sharp br eak, in t he m ost recent week, t he pound had set t led int o a narrow, sideways pat t er n. I n m y experience, t his t ype of com bined price act ion oft en leads t o anot her price decline. Market s will oft en do what ever confounds t he m ost t r aders. I n t his t ype of sit uat ion, m any t raders who have been long realize t hey have been wrong and are reconciled t o liquidat ing a bad posit ion- not right away, of course, but on t he first rebound. Ot her t raders who have been wait ing t o go short realize t hat t he t rain m ay have left wit hout t hem . They t oo are wait ing for any m inor rebound as an opport unit y t o sell. The sim ple t rut h is t hat m ost t raders cannot st and t he t hought of selling near a recent low, especially soon aft er a sharp break. Consequent ly, wit h everyone wait ing t o sell t he first rally, t he m arket never rallies. I n any case, one look at t he chart and I felt convinced t his was one of t hose sit uat ions in which t he m arket would never lift it s head. Alt hough m y st rong convict ion t em pt ed m e t o im plem ent a short posit ion, I also felt it was an inappropriat e t im e t o resum e t rading. I looked at m y wat ch. There were exact ly t en m inut es left t o t he close. I procrast inat ed. The m arket closed. That night before leaving work, I felt I had m ade a m ist ake. I f I was so sure t he m arket was going dow n, I reasoned, I should have gone short , ev en if I didn't want t o t rade. So I walked over t o t he t ewnt y- four- hour t rading desk and placed an order t o go short t he Br it ish pound in t he overnight m arket . The next m orning I cam e in and t he pound w as down over 200 point s on t he opening. I placed a t oken am ount of m oney int o t he account and ent ered a st op order t o liquidat e t he t rade if t he m arket ret urned t o m y ent ry level. I rat ionalized t hat I was only t rading wit h t he m arket 's m oney, and since m y plan was t o cease t rading on a ret urn t o breakeven, I was not really violat ing m y beliefs against t rading wit h inadequat e capit al. Thus, I found m yself t rading once again, despit e a desire not t o do so. This part icular t rade provides a good illust rat ion of one of t he pr inciples t hat em erged from m y int erviews for Market Wizards. Pat ience was an elem ent t hat a num ber of t he supert r aders st r essed as being crit ical t o success. Jam es Rogers said it perhaps m ost colorfully, " I j ust wait unt il t h'ere is m oney lying in t he com er, and all I have t o do is go over t her e and pick it up. I do not hing in t he m eant im e." I n essence, by not want ing t o t rade, I had inadvert ent ly t ransform ed m yself int o a m ast er of pat ience. By forcing m yself t o wait unt il t here was a t rade t hat appeared so com pelling t hat I could not st and t he t hought of not t aking it , I had vast ly im proved t he odds. During t he next few m ont hs, I cont inued t o t rade and m y equit y st eadily increased, as I seem ed t o be m aking m ost ly correct t rading decisions. My account grew from $0 ( not count ing an init ial $4,000 deposit t hat was quickly wit hdrawn once profit s m ore t han covered m argin requirem ent s) t o over $25,000. I t was at t his j unct ure, while t raveling on a business t rip, t hat nearly all m y posit ions t urned sour sim ult aneously. I m ade som e hast y decisions bet ween m eet ings, virt ually all of which proved wrong. Wit hin about a week, I had lost about one- t hird of m y gains. Norm ally, w hen I surr ender a m eaningful percent age of m y pr ofit s, I put on t he br akes, eit her t rading only m inim ally or ceasing t o t r ade alt oget her. I nst inct ively, I seem ed t o be following t he sam e script on t his occasion, as m y posit ions were reduced t o m inim al levels. At t his t im e, I received a call from m y friend Harvey ( not his real nam e) . Harvey is a pract it ioner of Elliot t Wave analysis ( a com plex t heory t hat at t em pt s t o explain all m arket behavior as part of a grand st ruct ure of

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9 price waves) .' Harvey oft en calls m e for m y m arket opinion and in t he process can't r esist t elling m e his. Alt hough I have usually found it t o be a m ist ake t o list en t o anyone else's opinions on specific t rades, in m y experience Harvey had m ade som e very good calls. This t im e he caught m y ear. " List en, Jack," he said, " you have t o sell t he British pound! " At t he t im e, t he Brit ish pound had gone virt ually st raight up for four m ont hs, m oving t o a one- and- a- half- year high. " Act ually," I replied, " m y own proj ect ion suggest s t hat we m ay be only a few cent s away from a m aj or t op, but I would never sell int o a m naway m arket like t his. I 'm going t o wait unt il t here are som e signs of t he m arket t opping." " I t will never happen," Harvey shot back. " This is t he fift h of a fift h." ( This is a rerference t o t he wave st ruct ure of prices t hat will m ean som et hing t o Elliot t icians, as ent husiast s of t his m et hodology are known. As for ot her readers, any at t em pt at an explanat ion is m ore likely t o confuse t han enlight en- t ake m y word for it .) " This is t he m arket 's last gasp, it will probably j ust gap lower on Monday m orning and never look back." ( This conversat ion was t aking place on a Friday aft ernoon wit h t he pound near it s highs for t he week.) " I really feel sure about t his one." I paused, t hinking: I 've j ust t aken a hit in t he m arket s. Harvey is usually pret t y good in his analysis, and t his t im e he seem s part icularly confident about his call. Maybe I 'll coat t ail him on j ust t his one t rade, and if he's right , it will be an easy way for m e t o get back on a winning t rack. So I said ( I st ill cringe at t he recollect ion) , " OK Harvey, I 'll follow you on t his t rade. But I m ust t ell you t hat from past experience I 've found list ening t o ot her opinions disast rous. I f I get in on your opinion, I 'll have no basis for deciding when t o get out of t he t rade. So underst and t hat m y plan is t o follow you all t he way. I 'll get out when you get out , and you need t o let m e know when you change your opinion." Harvey readily agreed. I went short at t he m arket about a half- hour before t he close and t hen wat ched as prices cont inued t o edge higher, wit h t he pound closing near it s high for t he week. The following Monday m orning, t he Brit ish pound opened 220 point s higher. One of m y t rading rules is: Never hold a posit ion t hat gaps shar ply against you right aft er you have put it on. ( A gap refers t o t he m arket opening shaiply higher or lower t han t he previous close.) The t rade seem ed wrong. My own inst inct s were t o j ust get out . However, since I had ent ered t his t r ade on Harvey's analysis, I t hought it was im port ant t o rem ain consist ent . So I called Harvey and said, " This short pound t rade doesn't look so good t o m e, but since I don't t hink it 's a good idea t o m ix analysis on a t rade, m y plan is t o follow you on t he exit of t he posit ion. So what do you t hink?" " I t 's gone a lit t le higher t han I t hought . But t his is j ust a wave ext ension. I t hink we're very close t o t he t op. I 'm st aying short ." The m arket cont inued t o edge higher during t he week. On Friday, t he release of som e negat ive econom ic news for t he pound caused t he currency t o t rade briefly lower during t he m orning, but by t he aft ernoon prices were up for t he day once again. This cont rarian response t o t he news set off warning bells. Again, m y inst inct s were t o get out . But I didn't want t o deviat e from t he gam e plan at t his lat e j unct ure, so I called Harvey again. Well, as you m ight have guessed, t he wave was st ill ext ending and he was st ill as bearish as ever. And yes, I st ayed short . On t he next Monday m orning, it was no gr eat surprise t hat t he m ar ket was up anot her few hundred point s. A day lat er, wit h t he m arket st ill edging higher, Harvey called. His confidence unshaken, he t rium phant ly announced, " Good news, I 've redone m y analysis and we're very close t o t he t op." I groaned t o m yself. Som ehow t his ent husiasm over an event t hat had not yet occurred seem ed om inous. My own confidence in t he t rade reached a new low. No need t o cont inue t he gruesom e det ails. About one week lat er, I decided t o t hrow in t he t owel, Harvey or no Harvey. By t he way, t he m arket was st ill m oving higher seven m ont hs lat er. I t is am azing how one t rading sin led t o a cascade of ot hers. I t st art ed out wit h greed in want ing t o find an easy way t o recoup som e losses- by following som eone else's t rade. This act ion also violat ed m y st rong belief t hat it is unwise t o be swayed by ot her people's opinions in t rading. These errors w ere quickly followed by ignoring som e scream ing m arket clues t o liquidat e t he posit ion. Finally, by surrender ing t he decision process of t he t rade t o anot her part y, I had no m et hod for risk cont rol. Let m e be absolut ely clear t hat t he point is not t hat I followed bad advice and lost m oney, but rat her t hat t he m arket is a st em enforcer t hat unm ercifully and unfailingly ext ract s harsh fines for all ( t rading) t ransgressions. The fault for t he losses was t ot ally m y own, not Harvey's ( nor t hat of t he m et hod, Elliot t Ware Analysis, which has been wed effect ively by m any t raders) . I t raded light ly for anot her m ont h and t hen decided t o call it quit s as m y account neared t he breakeven point . I t had been a quick ride up and down, wit h lit t le t o show for it except som e m arket experience. Several m ont hs lat er I was a speaker at a sem inar at which Ed Seykot a had agreed t o m ake a rare appear ance. Ed,was one of t he phenom enal fut ures t rader s I int erviewed for Market Wizards. His views on t he m arket s provide an unusual blend of scient ific analysis, psychology, and hum or. Ed began his present at ion by asking for a volunt eer from t he audience t o point t o t he t im e periods on various chart s t hat coincided wit h t he dat es of financial m agazine covers he had brought along. He st art ed in t he early 1980s. The cover blared: " Are I nt erest Rat es Going t o 20% ?" Sure enough, t he dat e of t he m agazine cover was in near- perfect synchrony wit h t he bot t om of t he bond m arket . At anot her point , he pulled out a cover wit h an om inous pict ure of farm fields wit hering away under a blazing sun. The publicat ion dat e coincided wit h t he price peak of t he grain m arket s during t he 1988 dr ought . Moving ahead t o t hencurrent t im es, he showed a m agazine cover t hat read: " How High Can Oil Prices Go?" This st ory was writ t en at t he t im e of skyrocket ing oil prices m t he m ont hs

9

10 following t he I raqi invasion of Kuwait . " My guess is t hat we've probably seen t he t op of t he oil m arket ," said Ed. He was right . " Now you underst and how t o get all t he im port ant inform at ion about im pending m arket t rends from news and financial m agazines. Just r ead t he covers and forget about t he art icles inside." Quint essent ial Ed Seykot a. I was eager t o speak t o Ed so t hat I could relay m y t rading experiences and glean t he benefit s of his insight s. Unfort unat ely, at every break during t he sem inar, each of us was surrounded by at t endees asking quest ions. We were st aying at t he sam e sm all hot el m San Francisco. Aft er we got back, I asked Ed if he cared t o go out and find a spot where we could relax and t alk. Alt hough he appeared a bit beat , he agreed. We walked around t he ar ea t rying t o find som et hing t hat resem bled a com fort able local bar or cafe, but all we m anaged t o find were large hot els. Finally, in desperat ion we wandered int o one. I n t he lounge, a loud band and a t ruly bad singer were belt ing out t heir version of what else- " New York, New York." ( I 'm sure if we were in New York, t he band w ould have been playing " I Left My Heart in San Francisco." ) This cert ainly w ould not do for a quiet conversat ion wit h t he m an I hoped would be m y t em por ary m ent or. We sat down in t he lobby out side, but t he st rains of t he m usic w ere st ill uncom fort ably loud ( yes, Virginia, t here are sounds worse t han Muzak) , and t he at m osphere was deadly. My hopes for an int im at e conversat ion were quickly fading. Trying t o m ake t he best of a bad sit uat ion, I relat ed m y recent t r ading experiences t o Ed. I explained how I st art ed t rading again despit e m y reluct ance t o do so and t he incredible st ring of errors I com m it t ed on t he one Brit ish pound t rade- errors t hat I t hought I had vanquished years ago. I t old him t hat , ironically, at one point before I put on t he Brit ish pound t rade, when I was st ill up about $20,000, I was in t he m arket for a new car t hat cost exact ly t hat am ount . Since m y house had virt ually drained m e of asset s, I was t em pt ed t o cash in t he account and use t he proceeds t o buy t he car. I t was a very appealing t hought since t he car would have provided an im m ediat e t angible reward for a few m ont hs of good t r ading wit hout even having risked any of m y own funds. " So why didn't you close t he account ?" Ed asked. " Well," I said, " how could I ?" Alt hough I m anaged t o t urn a few t housand dollars int o $100,000 on a couple of occasions, I had always st alled out . I had never been able t o really break t hrough and ext end it int o som e serious m oney. I f I had decided t o cash in m y chips t o m ake a purchase, I would always have wondered w het her t his would have been t he t im e t hat I would have realized m y t rading goals. Of course, wit h t he benefit of hindsight , I would have been m uch bet t er off t aking m y profit s, but at t he t im e I couldn't see giving up t he opport unit y. I rat ionally explained all m is t o Ed. " I n ot her words, t he only way you could st op t rading was by losing. I s t hat right ?" Ed didn't have t o say anyt hing m ore. I recalled t hat in m y int erview of him for Market Wizards, his m ost st riking com m ent was: " Everybody get s what t hey want out of t he m arket ." I had want ed not t o be t rading, and sure enough t hat 's what I got . The m oral here is: You don't always have t o be in t he m arket . Don't t rade if you don't feel like it or if t rading j ust doesn't feel r ight for what ever reason. To win at t he m arket s you need confidence as well as t he desire t o t rade. I believe t he except ional t raders have t hese t wo t rait s m ost of t he t im e; for t he rest of us, t hey m ay com e t oget her only on an occasional basis. I n m y own case, I had st art ed out wit h t he confidence but wit hout t he desire t o t rade, and I ended up wit h neit her. The next t im e I st art t rading, I plan t o have bot h. * The Elliot t Wave Principle, as it is for m ally called, was originally developed by R. N. Elliot t , an account ant t urned m arket st udent , Elliot t 's definit ive work on t he subj ect was published in 1946, only t wo years befors his deat h, under t he rat her im m odest t it le: Nat ur e's Law- The Secret of t he Universe. The applicat ion of t he t heory is unavoidably subj ect ive, wit h num erous int erpret at ions appearing in scores of volum es. ( SOL- RCE: JohnJ. Murphy, Technical Analysis of t he Fut ures Market s, New York I nst it ut e of Finance, 1986.)

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11 Hussein Makes a Bad Trade I n m any ways, t he elem ent s of good and bad decision m aking in t rading are very sim ilar t o t hose t hat apply t o decision m aking in general. The st art of m y work on t his book coincided wit h t he event s im m ediat ely preceding t he Persian Gulf War. I couldn't help but be st ruck by t he sim ilarit y bet ween Saddam Hussein's act ions ( or, m ore accurat ely, t he lack t hereof) and t he t ypical responses of a foundering novice t rader. Hussein's t rade was t he invasion of Kuwait . I nit ially, he had solid, fundam ent al reasons for t he t rade. ( The fundam ent at ist reasons cam e lat er, of course, as Hussein found it convenient t o discover religion.) By invading Kuwait , Hussein could drive up oil prices t o I raq's benefit by elim inat ing one of t he count ries t hat consist ent ly exceeded it s OPEC quot a and by cr eat ing t urm oil in t he w orld oil m arket s. He also st ood a perceived good chance of perm anent ly annexing part or all of Kuwait 's oil fields, as well as gaining direct access t o t he Persian Gulf. And, last but cert ainly not least , t he invasion provided a w onderful opport unit y for Hussein t o feed his m egalom aniacal am bit ions. I n exchange for all t his upside pot ent ial, t he init ial risk on t he t rade seem ed lim it ed. Alt hough forgot t en by m any because of t he event ual decisive st ance t aken by t he Unit ed St at es, t he St at e Depart m ent 's init ial response t o I raq's invasion- t hreat ening pronouncem ent s and act ions could essent ially be paraphr ased as " I t 's not our problem ." I n dealing wit h Hussein, such an am bivalent policy was alm ost t ant am ount t o offering t o lay out a red carpet for I raq's t anks. So init ially, from Hussein's perspect ive, t he invasion of Kuwait was a good t rade- large pot ent ial and lim it ed risk. However, as so oft en happens, t he m arket changed. President Bush com m it t ed t he Unit ed St at es t o t he defense of Saudi Arabia by sending in t roops and spear- headed t he passage of UN resolut ions aim ed at convincing Hussein t o leave Kuwait . At t his point , Hussein could probably have negot iat ed a deal in w hich he would have wit hdrawn from Kuwait in exchange for som e disput ed t errit orial gains and port right s- a quick profit . However, alt hough t he t rade had st art ed t o det eriorat e, Hussein decided t o st and pat . Next , Bush sent a st ronger signal by doubling U.S. forces t o four hundred t housand- an act ion indicat ing not only t hat t he Unit ed St at es was ready t o defend Saudi Arabia but t hat it w as also est ablishing t he capabilit y for ret aking Kuwait by force. Clearly t he m arket had changed. Hussein ignored t he m arket signal and st ood back. President Bush t hen set a January 15 deadline for I raq's wit hdrawal from Kuwait in com pliance wit h t he UN resolut ion- t he m arket m oved furt her against t he t rade. At t his point , t he profit pot ent ial was probably gone, but Hussein could st ill have approxim at ed a br eakeven t rade by offering t o wit hdraw from Kuwait . Once again, he decided t o hold t he posit ion. Once t he January 15 deadline had passed and t he Unit ed St at es and it s allies in t he Gulf War em barked on t he m assive bom bing of I raq, t he original t rade was clearly in losing t errit ory. Moreover, t he m arket was m oving down sharply ever y day, as each day's procrast inat ion result ed in m ore dest ruct ion in I raq. But how could Hussein give in now when so m uch had been lost ? Much like a bewildered t rader caught in a st eadily det eriorat ing posit ion, he pinned his hopes on t he long shot : I f only he held on long enough, perhaps fear of casualt ies would prom pt t he Unit ed St at es t o back down. The t rend cont inued t o go against t he t rade as t he Unit ed St at es issued anot her deadline ult im at um - t his t im e linked t o t he init iat ion of a ground war against I raq. At t his j unct ure, Hussein was readily consent ing t o condit ions cont ained in t he Soviet peace proposal, an agreem ent t hat probably would have been perfect ly sufficient earlier but was now inadequat e. Hussein's behavior was very m uch like t hat of a t rader holding a long posit ion in a st eadily declining m arket who says, " I 'll get out when I 'm even," and t hen, as t he sit uat ion grows m ore desper at e, " I 'll get out at t he last relat ive high," wit h t he relat ive high m oving st eadily down wit h t he passage of t im e. Ult im at ely, wit h t he gr ound war well under way and his arm y largely decim at ed, Hussein finally capit ulat ed. He was like a t rader who has held on t o a losing posit ion unt il his account has been virt ually dest royed, and t hen, in com plet e desperat ion, finally exclaim s t o his broker, " Get m e out of t he m arket . I don't care at what price, j ust get m e out ! " * * / / Moral: / / * * * * I f you can't t ake a sm all loss, sooner or lat er you will t ake t he m ot her of all losses.* *

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12 PART II The World's Biggest Market

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13 Bill Lipschutz: The Sultan of Currencies Quick, what is t he world's largest financial m arket ? St ocks? No, not even if you aggregat e all t he world's equit y m arket s. Of course, it m ust be bonds. Just t hink of t he huge governm ent debt t hat has been generat ed w orldwide. Good guess, but wrong again, even if you com bine all t he world's fixed- incom e m arket s. The correct answer is currencies. I n t he scope of all financial t rading, st ocks and bonds are peanut s com pared wit h currencies. I t is est im at ed t hat , on average, $1 t rillion is t raded each day in t he world currency m arket s. The vast m aj orit y of t his currency t rading does not t ake place on any organized exchange but rat her is t ransact ed in t he int erbank currency m arket . The int erbank currency m arket is a t went y- four- hour m arket , which lit erally follows t he sun around t he world, m oving from banking cent ers of t he Unit ed St at es, t o Aust ralia, t o t he Far East , t o Europe, and finally back t o t he Unit ed St at es. The m arket exist s t o fill t he needs of com panies seeking t o hedge exchange risk in a world of rapidly fluct uat ing currency v alues, but speculat ors also part icipat e in t he int erbank currency m arket in an effort t o profit from t heir expect at ions regarding shift s in exchange rat es. I n t his huge m arket , t here has been only a handful of high- st akes players. I ronically, alt hough t hese t raders som et im es t ake posit ions m easured in billions of dollars- yes, billions- t hey are virt ually unknown t o m ost of m e financial com m unit y, let alone t he public. Bill Lipschut z is one of t hese t raders. The int erviews I held wit h Lipschut z were conduct ed in t wo m arat hon sessions at his apart m ent . Lipschut z has m arket m onit or screens everywhere. Of course, t here is t he large TV m onit or in t he living room , receiving a feed of cur rency quot es. There are also quot e screens in his office, t he kit chen, and near t he side of his bed, so t hat he can roll over in his sleep and check t he quot es- as indeed he does regularly ( since som e of t he m ost act ive periods in t he m arket occur during t he U.S. night t im e hours) . I n fact , you can't even t ake a leak wit hout lit erally running int o a quot e screen ( t here is one convenient ly locat ed, som ewhat t ongue in cheek, at st anding height in t he bat hroom ) . This fellow obviously t akes his t rading very seriously. I had first cont act ed Bill Lipschut z t hrough a public relat ions agent , Tom Walek. Yes, a public relat ions agent for a t rader sounds rat her odd. I n fact , t his is part icularly t rue for Lipschut z, who had m anaged quit e deliberat ely t o m aint ain virt ually t ot al public anonym it y for his ent ire career despit e his huge t rades. However, aft er having spent eight years as Salom on Brot hers' largest and m ost successful currency t rader, Lipschut z had j ust left t he firm t o st art his own m anagem ent com pany t o t rade currencies ( init ially as a subsidiary of Merrill Lynch; lat er, t he com pany evolved int o a com plet ely independent vent ure, Rowayt on Capit al Managem ent ) . I t was t his proj ect t hat required t he public relat ions support . Anyway, aft er Walek discussed m y int erview proposal wit h Lipschut z, he called t o t ell m e t hat Bill first want ed an inform al m eet ing so t hat he could see if it " felt right ." We m et at a Soho bar, and aft er downing several French beer s ( no j oke, t he French act ually produce som e excellent beers) Lipschut z said, " I t hink you'll find t he st ory of how, in less t han a decade, Salom on Brot hers grew from a zero presence in currencies t o becom ing perhaps t he world's largest player in t he currency m arket an int erest ing t ale." Besides feeling a sense of relief, since t hat com m ent obviously reflect ed a consent t o t he int erview, his st at em ent cert ainly whet t ed m y appet it e. I n our first m eet ing at his apart m ent , wit h m y t ape recorder s whirring, I said, " OK, t ell m e t he st or y of Salom on's spect acular growt h as a m aj or t rading ent it y in t he world currency m arket s." I sat back, ant icipat ing a lengt hy response full of wonderful anecdot es and insight s. Lipschut z answered, " The currency opt ions m arket , Salom on's cur rency opt ions depar t m ent , and I all st art ed at t he sam e t im e and grew and prospered sim ult aneously." " And ...," I said, prom pt ing him t o cont inue. He rephrased t he sam e response he had j ust given. " Yes," I said, " t hat 's a very int erest ing coincidence, but could you fill in t he det ails? How about som e specific st ories?" He responded again wit h generalizat ions. My hopes for t he int erview w ent int o a rapid nosedive. I 've done int erviews t hat I knew were dead in t he wat er aft er t he first hour and have ended up dit ching t he result s aft erwards. However, t his int erview was different . Alt hough I felt t hat I was get t ing ver y lit t le useful m at erial during t he first one or t wo hours of our conversat ion, I sensed t here was som et hing t here. This was not a dry well; I j ust had t o dig deeper. Aft er t he first few hours, we st art ed t o connect belt er and Lipschut z began relat ing specific st ories regarding his t rading experiences. These m ake up t he core of t he following int erview. As m ent ioned earlier, t he large TV screen in Lipschut z's living room is norm ally t uned t o a currency quot e display, wit h a Reut er s news feed m nning across t he bot t om . Alt hough Lipschut z seem ed t o be paying full at t ent ion t o our conversat ion, on som e level he was obviously wat ching t he scr een. At one point , t he Aust ralian dollar was in t he m idst of a precipit ous decline following som e disast rously negat ive com m ent s m ade by t he Aust ralian finance m inist er. Alt hough t he m arket was in a virt ual free- fall, Lipschut z felt t he selloff w as overdone and int errupt ed our int erview t o call in som e orders. " Not hing big," he said. " I 'm j ust t rying t o buy t went y [ $20 m illion Aust ralian, t hat is] ." I m m ediat ely aft erward, t he Aust ralian dollar st art ed t o t rade higher and cont inued t o m ove up t hroughout t he rest of t he evening. Lipschut z didn't get a fill, however, because he had ent ered his order at a lim it | price j ust a hair below where t he m arket was t rading, and t he m arket " - never t raded lower. " Missing an opport unit y is as bad as being on t he wrong side of a t rade," he said. During our second int erview, Lipschut z want ed t o short t he Deut sche m ark and was wait ing for a sm all bounce t o sell. When not icing t hat t he m ark had st art ed t o m ov e lower inst ead, he said, " I t looks like I 'm going t o m iss t he t rade."

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14 'That sounds j ust like last week when you m issed get t ing long t he Aust ralian dollar by using a lim it order," I said. " I f you feel t hat st rongly," I asked, " why don't you j ust sell t he Deut sche m ark at t he m arket ?" " What ! And pay t he bid/ ask spread?" Bill exclaim ed. I wasn't sure whet her he was serious or j oking- or perhaps som e com binat ion of t he t wo. ( I ncident ally, t he Deut sche m ark kept going lower.) Our int erviews were conduct ed aft er U.S. m arket hours, but , since t he currency m arket s never close, Lipschut z, apparent ly, never st ops t rading. However, despit e his adm it t ed obsession wit h t he m arket s and t rading, Lipschut z appeared very relaxed. I wouldn't even have known t hat he was wat ching t he m arket s had he not occasionally m ade references t o price m ovem ent s and placed orders over t he phone. = = = = What happened t o archit ect ure? = = = = What happened t o archit ect ure? = = = = Well, I had heard t hat you have a degree in archit ect ure. How is it t hat you ended up as a t rader? ==== While I was enrolled in t he archit ect ural program at Com ell, m y grandm ot her died and left m e a port folio of a hundred different st ocks wit h a t ot al value of $12,000, which I liquidat ed at great cost because all t he posit ions were odd lot s. The proceeds provided m e wit h risk capit al. I found m yself using m ore and m ore of m y t im e playing around wit h t he st ock m arket . I t wasn't t hat I got less int erest ed in archit ect ure, I j ust becam e a lot m ore int erest ed in t rading. Also, archit ect ure is very m uch an Old World profession. There is a long appr ent iceship- t hree years in t his count ry- before you can t ake your licensing exam . Then you spend m any m ore years as a draft sm an. I t t akes a long t im e before you get t o m e point where you have cont rol over t he design process. = = = = Did you get your degree event ually? = = = = Yes, of course. Act ually, I got t wo degrees. The full- t im e archit ect ural program t ook five years. I t was not unusual for archit ect ural st udent s t o also enroll in ot her courses and t ake longer t o finish t heir degree. I ended up t aking a lot of business courses and also earned an M.B.A. = = = = What happened aft er you graduat ed Cornell? Did you get a j ob relat ed t o archit ect ure? = = = = No, I never pract iced as an archit ect because of t he long apprent iceship process I j ust explained. I went direct ly t o work for Salom on. = = = = How did you get t hat j ob? = = = = I t 's t ypical for st udent s in t he M.B.A. program t o get business- relat ed sum m er j obs. I n t he sum m er of 1981 I got a j ob at Salom on Brot hers. By t hat t im e, I was t rading st ock opt ions very act ively for m y own account . = = = = Was t his t he account you st art ed wit h t he $12,000 your grandm ot her left you? = = = = Yes, and by t his t im e I had built it up a bit . = = = = What did you know about st ock opt ions when you st art ed t rading? = = = = I didn't know a whole lot . = = = = Then on what basis did you m ake your t rading decisions? = = = = I t ried t o read everyt hing I could on t he subj ect . I spent a lot of t im e in t he library reading annual com pany report s. I becam e an avid reader of t he various financial periodicals such as The Econom ist , Barron 's, and Value Line. I also began t o wat ch t he st ock t ape on cable. Because I t haca, New York, is surrounded by m ount ains, it has part icularly poor t elevision recept ion. As a result , it was one of t he first places in t he count ry t o get cable TV in t he early 1970s. One of t he channels had a fift een- m inut e delayed st ock t ape. I spent m any hours wat ching t he t ape and, over t im e, I seem ed t o develop a feel for t he price act ion. = = = = Was t hat when you decided t o becom e a t rader? = = = = I can't rem em ber m aking any conscious decision, " I want t o be a t rader; I don't want t o be an archit ect ." I t was a gradual process. Trading lit erally t ook over m y life. = = = = Was t he Salom on sum m er j ob relat ed t o t rading? = = = = My wife and I m et while I was at t ending Com ell. She's very aggressive and has a very st rong econom ics background. The previous sum m er she had m anaged t o get a j ob working for Dr. Henry Kaufm an [ a worldrenowned econom ist ] in t he bond research depart m ent . I subsequent ly m et her im m ediat e superior, who also happened t o be a Com ell alum nus. He arranged for m e t o int erview wit h Henry Kaufm an for t he sam e posit ion m y wife had held ( by t his t im e, she had graduat ed and had a • full- t im e j ob) . I ronically, around t he sam e t im e, Salom on Brot hers sent a represent at ive t o Com ell t o do recruit ing. I was invit ed t o com e t o New York t o int erview for t heir sum m er sales and t rading int ern program . I was int erviewed by Sidney Gold, t he head of Salom on's propriet ary equit y opt ions desk. Sidney is a very high- st rung

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15 guy who speaks very, very fast . He t ook m e int o an office t hat had a glass wall facing out ont o a large t rading room , wit h a view of an elect ronic t ape running across t he wall. I sat wit h m y back t o t he t ape, and t he whole t im e he was int erviewing m e, he was also wat ching t he t ape. He st art ed firing quest ions at m e, one aft er die ot her. Here I am , a college kid, wearing a suit and t ie for t he first t im e in m y first form al int erview , and I had no idea w hat t o m ake of all of t his. I answered each of his quest ions slowly and deliberat ely. Aft er about t en m inut es of t his quest ion- and- answer process, he st ops abrupt ly, looks m e st raight in t he eye, and says, " OK, forget all t his bullshit . So you want t o be a t rader. Every fucking guy com es here and t ells m e he want s t o be a t rader. You said you're t rading your own account . What st ocks are you t rading?" " I 've been pr et t y involved in Exxon recent ly," I reply. He snaps back, " I don't know t hat st ock. Give m e anot her one." " I 've also been pret t y involved in 3M," I answer. " I don't know t hat one eit her," he shoot s back. " Give m e anot her one." I answer, " U.S. St eel." " U.S. St eel. I know St eel. Where is it t rading?" " I t closed last night at 30 1/ 2." " I t j ust went across t he board at 5/ 8," he says. " Where did it break out from ?" he asks. " Twent y- eight ," I answer. He fires right back, " And where did it break out from before t hat ?" " Well, t hat m ust have been over t hree years ago! " I exclaim , som ewhat st art led at t he quest ion. " I believe it broke out from about t he 18 level." At t hat point , he slows down, st ops looking at t he t ape, and say s, " I want you t o work for m e." That was t he end of t he int erview. A few weeks lat er, I received a call from t he fellow who ran Salom on's recruit ing program . He said, " We have a bit of a problem . Sidney Gold want s t o hire you, but Kaufm an also want s you t o work for him . So we worked out an arrangem ent where you'll split your t im e bet ween t he t wo." I ended up working t he first half of t he sum m er doing research for Eh- . Kaufm an and t he second half working on t he opt ions t rading desk. At t he end of t he sum m er , Sidney offered m e a j ob. Since I st ill had one sem est er left in business school and also had t o finish m y t hesis for m y archit ect ural degree, I arranged t o work for Sidney during t he fall sem est er, wit h t he underst anding t hat I would ret urn t o school in t he spring. = = = = Did t he j ob working on t he equit y opt ions desk prove valuable in t erm s of learning how t o t rade opt ions? = = = = The j ob was cert ainly helpful in t erm s of overall t rading experience, but you have t o underst and t hat , at t he t im e, equit y opt ions t rading at Salom on was highly nonquant it at ive. I n fact , when I t hink back on it now, it seem s alm ost am azing, but I don't believe anybody t here ev en knew what t he Black- Scholes m odel was [ t he st andar d opt ion pricing m odel] . Sidney would com e in on Monday m orning and say, "I went t o buy a car t his weekend and t he Chevrolet showroom was packed. Let 's buy GM calls." That t ype of st uff. I rem em ber one t rader pulling m e aside one day and saying, " Look, I don't know what Sidney is t eaching you, but let m e t ell you everyt hing you need t o k now about opt ions. You like 'em , you buy calls. You don't like 'em , you buy put s." = = = = I n ot her words, t hey were basically t rading opt ions as a leveraged out right posit ion. = = = = That 's exact ly right . But t hat whole t rading approach act ually fit very well wit h m y own t ape- reading t ype of experience. = = = = Did you ret urn t o t he equit y opt ions depart m ent when you finished Cornell? = = = = I worked t here at t he beginning of t he sum m er, but t hen I went int o t he Salom on t raining program , which is som et hing t hat every new hire does. The great t hing about t he Salom on t raining course is t hat you get exposed t o all t he key people in t he Firm . All t he big nam es at Salom on cam e in, t old t heir st ory, and in essence delivered t heir persona. You were indoct rinat ed int o Salom on Brot hers, and m e cult ure was passed on. Having spent m y ent ire career at Salom on, I feel very st rongly t hat it was im port ant for t he cult ure t o be passed on. I n t he lat er` s 1980s, a lot of t hat cult ure was lost . The program s got t oo large. When I st ar t ed at Salom on, t here was one program of 120 people each year; by t he lat e 1980s, t here wer e t wo program s wit h 250 people apiece- The t r ainees also seem ed t o com e from m ore of t he sam e m old, whereas in t he early 1980s t here appear ed t o be a great er willingness t o hire a few wild- card candidat es. = = = = What did you get out of t he Salom on t raining course besides being indoct rinat ed int o t he cult ure? ==== That was what I got out of it . = = = = I t doesn't sound like very m uch. Was t here m ore t o it ? = = = = No, t hat was a t rem endous am ount . Clearly you have never worked for Salom on. The com pany is all about t he cult ure of Salom on Brot hers.

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16 = = = = OK, t ell m e about t he cult ure of Salom on Brot hers. = = = = Salom on Brot hers was a firm t hat was alm ost solely involved in propriet ary t r ading and for years was r un by a handful of very st rong, charism at ic individuals. They wer e st reet fight ers who were bet t ing t heir own m oney and who really underst ood what it m eant t o t ake risk. I t was all about personalit ies, gut s, insight , and honest y and int egrit y beyond any shadow of a doubt .* Salom on was an inst it ut ion. There was virt ually no t urnover of key personnel at t he firm - The chairm an, John Gut freund, had a desk on t he t rading floor t hat he sat at every day. I n m y nine years at Salom on, I never sat m ore t han t went y feet away from him . I rem em ber m y first conversat ion wit h John Gut freund. I had been wit h t he firm as a full- t im e em ployee for less t han a year. You have t o pict ure t he scene. I t was t he early evening of July 3. The Salom on t rading floor is a huge, t wo- st ory space- at one t im e it was t he largest t rading floor in t he world. The t wilight colors of t he fading sunlight were flooding t hrough t he huge glass windows. Because of t he approaching holiday, t he ent ire floor was com plet ely abandoned except for John Gut freund and m yself. I heard him call, " Bill, Bill." I had no idea why he would even know m y nam e, but t hat was t he kind of place Salom on was. I was wrapped up in what I was doing, and I suddenly realized t hat he was calling m e. I walked over t o his desk and said, " Yes, Sir." He looked at m e and asked, " Where did t he fr anc close?" Racing t hrough m y m ind are all t he possible reasons he m ight be asking m e t his quest ion in t his very script ed scenario. I looked at him and asked, " Which one, Swiss franc or French franc?" John Gut freund is a m an who exudes power. He is very charism at ic and you can alm ost feel t he aura around him . He didn't hesit at e, and looked st raight at m e and said, " Bot h." So I gave him bot h quot es in a voice t hat was probably one oct ave higher t han norm al. * * Not e* * : / / This int erview was conduct ed several m ont hs prior t o t he governm ent bond- buying scandal t hat rocked Salom on. Following t his developm ent , I asked Lipschut z if he st ill wished t o m aint ain t he t erm s fwnest y and int egrit y in his descript ion of Salom on, as t he w ords now had an ironic ring in light of t he lat est revelat ions. Lipschut z, however, felt st rongly about m aint aining his original descript ion, as he believed it reflect ed his t rue feelings. Queried about how he reconciled t his im age of int egrit y w it h t he apparent et hical lapses in t he bidding procedures at several governm ent bond auct ions, he replied, " I believe it was m ore a m at t er of ego on t he part of a single individual, which ran count er t o t he qualit ies em bodied by Gut freuod and m e firm ." / / A lit t le over a year lat er on anot her sum m er day, t he sam e scene is virt ually repeat ed. The light of t he set t ing sun is st ream ing int o t he t rading room , and John Gut freund and I are nearly t he only t wo people left . Again, I hear a voice behind m e, " Bill, Bill." I am st ruck by t he dej a vu qualit y of t he m om ent . I walk over and say, " Yes. Sir." " Where did t he franc close?" he asks. " Which one?" I ask. " The Swiss or t he French?" Wit hout m issing a beat , and wit hout showing any t race of a sm ile, he looks st raight at m e and says, " Belgian." Here's a guy who is chairm an of Salom on Brot hers, which in t hose years was probably t he m ost powerful firm on t he st reet , while I am a nobody t rainee. I t has been a year since t hat first encount er, and he has t he presence of m ind and t he int erest t o set m e up like t hat . As t he years went by, and I got t o know him bet t er t hrough m or e cont act , I r ealized t hat he was fully aware of t he im pact t hat conversat ion would have on m e. Here w e are t alking about it nearly t en years lat er, and I rem em ber every word of t hat conversat ion. He had t hat effect on people. He would very oft en have conversat ions wit h t rainees and support people. = = = = Was Gut freund a t rader him self? = = = = John cam e up t hrough t he ranks as a t rader. When he was chairm an, he spent his day on t he t rading floor t o see what was going on. We always said t hat John could sm ell deat h at a hundred paces. He didn't need t o know what your posit ion was t o know what your posit ion was, or how it was going. He could t ell t he st at e of your equit y by t he am ount of anxiet y he saw in your face. Salom on Brot hers was a cult ure like no ot her. People oft en spok e of Salom on's appet it e for risk. I t wasn't t hat t he com pany was a r isk- seeking firm , but it was cert ainly a firm t hat was com fort able wit h risk or wit h losing m oney, as long as t he t rade idea m ade sense. = = = = How was it t hat you ended up in currencies aft er t he t raining session was over as opposed t o going back t o equit ies? = = = = Act ually, I want ed t o go back t o equit ies, but one of t he senior people in t he depart m ent t ook m e aside and said, " You're m uch t oo quant it at ive. You don't need t o be down here in equit ies." He t alked m e int o going int o t his new depar t m ent t hat was being form ed: foreign exchange. I was one of t he m ore highly t hought - of t rainees, and at t he end of t he session, I was recruit ed by several depart m ent s, including t he currency depart m ent , which was j ust being form ed. = = = = How did you choose t he currency depart m ent ? = = = = I want ed a t rading posit ion, and I got along well wit h t he people. However, I had a lot less choice t han I m ight have been led t o believe at t he t im e.

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17 = = = = What do you m ean? = = = = You get r ecr uit ed, do your lobbying, and pick your choices, but by t he end of t he day, t he powers t hat be get t o m ove t he chess pieces and decide where t hey want you placed. = = = = Did you know anyt hing about currencies at t he t im e? = = = = I didn't even know what a Deut sche m ark was. But , t hen again, no one in t he depart m ent really knew m uch about currencies. = = = = No one? = = = = I Not really. There was one j unior person on t he desk who had previously worked for a bank. = = = = Wasn't t here anybody else in t he firm wit h expert ise in currencies? = = = = No. = = = = Why wasn't t here any t hought given t o get t ing som eone from t he out side wit h experience t o develop t he depart m ent ? = = = = That 's not how Salom on did t hings. At Salom on everyt hing was hom e- grown. You're asking quest ions like you t hink t here was som e sort of writ t en business plan. The realit y was t hat a few senior people got t oget her one day, and one said, "Hey, shouldn't we really st art a foreign exchange depart m ent ?" " Okay. Who can we get t o m n it ?" " How about Gil?" " Okay. Hey, Gil. Do you want t o run t he depar t m ent ?" " Sure, F 11 do it ." Gil cam e from bond ar bit rage. He had no experience in currencies. His idea was t o get a bunch of bright people t oget her, figure out how t his foreign exchange st uff worked, let t hem t rade t he product around, and see if t hey could m ake som e m oney. Wit h no one in t he depart m ent having any real background in currencies, how did you get t he experience t o know what t o do? One of t he fellows in t he depart m ent was very ext rovert ed. He had us going out t o dinner wit h int ernat ional bankers t hree or four t im es a week. I n t hose days, I was part icularly shy. I n fact , I rem em ber one day one of t he t rader s on t he desk asked m e t o call Morgan Guarant y t o place a D- m ark t ransact ion. I prot est ed, saying, " But I don't know anyone t here." He said, " What do you m ean you don't know anybody? Just pick up t he Ham bros [ a book t hat list s all t he int ernat ional foreign exchange dealers] , flip t hrough, find Morgan's D- m ark dealer, and call him ." I m ust have sat t here agonizing for over t en m inut es, t rying t o figure out how I could call som ebody I didn't know. = = = = Tell m e about your early t rading experiences m currencies. = = = = At around t he sam e t im e t hat t he Salom on Brot hers foreign exchange depart m ent was form ed, t he Philadelphia St ock Exchange int roduced a curr ency opt ion cont ract . I was t he only one at t he desk who even knew what a put or call was. Also, t he product was being t r aded on a st ock exchange wit h a specialist syst em , and I was t he only one on t he desk wit h any background in equit ies. Everyone else in t he depart m ent cam e from fixed- incom eland, which is t he fort y- second floor. Equit yland is on t he fort y- first , where I cam e from . I don't t hink anybody else in t he depart m ent had ever ev en been on t he fort y- first . I also knew specialist s and m ark et m akers on t he Philadelphia St ock Exchange floor. No one else in t he depart m ent even knew what a specialist was. [ I n a specialist syst em , a single individual m at ches buy and sell orders for a securit y, as opposed t o an open out cr y syst em , in which orders are execut ed by brokers shout ing t heir bids and offers in a t rading ring.] The sit uat ion was t ailor- m ade for m e. Gil said, " You're t he only one in t he depart m ent who knows anyt hing about t his, so j ust do it ." The key point I am t rying t o m ake is t hat Salom on's foreign exchange depart m ent , Bill Lipschut z as foreign exchange t rader, and currency opt ions all st art ed at t he sam e t im e, and we grew t oget her. I t was a unique, synergist ic t ype of experience. = = = = How did you becom e successful as a currency t rader wit hout any previous experience? = = = = Foreign exchange is all about relat ionships. Your abilit y t o find good liquidit y, your abilit y t o be plugged int o t he inform at ion flow- it all depends on relat ionships. I f you call up a bank and say, " I need a price on t en dollar [ $10 m illion] m ark," t hey don't have t o do anyt hing. They can t ell you, " The m ark dealer is in t he bat hroom ; call back lat er." I f I call up at 5 P. M. and say, " Hey, Joe, it 's Bill, and I need a price on t he m ark," t he response is going t o be ent irely different : " I was j ust on m y way out t he door, but for you I 'll see what I can do." = = = = As som eone brand new in t he business, how did you develop t hese cont act s? = = = = One t hing t hat helped m e a great deal was t hat I had a back ground in opt ions when it was new t o t he m arket place. " He knows opt ions," t hey would say. Hell, I didn't know t hat m uch about it , but t he point was t hat no one in foreign exchange knew very m uch about it eit her. Their percept ion was: " He can derive t he

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18 Black- Scholes m odel; he m ust be a genius." A lot of senior guys in t he currency m arket want ed t o m eet m e sim ply because t heir cust om ers want ed t o do opt ions, and t hey needed t o get up t o speed on t he subj ect quickly. Also, I worked for Salom on Brot hers, which at t hat t im e provided an elem ent of m yst ique: " We don't know what t hey do, but t hey m ake a lot of m oney." Anot her fact or in m y favor was t hat , alt hough I worked for an invest m ent bank, I t ried not t o act like a pom pous invest m ent banker. The t ypical guys in invest m ent banks who were doing for eign exchange back t hen were fixed- incom e t ypes. They were pr issy in t he eyes of t he FX [ foreign exchange] guys. They wore suspenders and Her m es t ies; t hey were w hit e- wine- and- arugula- salad t ype of guys. They were not t he go- out - for- past a- and- dribblem arinara- sauce- all- over- yourself t ype of guys, which is what t he foreign exchange t rader s basically were. I was really different ; m y background was different . I was t he first person at Salom on Brot hers t o have a Telerat e at hom e. They couldn't believe it . " You want a screen at hom e? Are you out of your m ind? Don't you ever t urn off?" I would look at t hem and say, " Foreign exchange is a t went y- four- hour m arket . I t doesn't go t o sleep when you leave at 5 P. M. The m arket is really t here all night , and it m oves! " = = = = I s having cont act s im port ant in order t o be plugged int o t he news? = = = = Absolut ely. Those of us w ho did w ell were generally t he ones who were accept ed by t he int erbank circle. The t rader s who st ayed aloof t ended t o be t he ones who couldn't m ake any m oney t rading foreign exchange. These t rader s would end up calling a clerk on t he Mere floor [ t he Chicago Mercant ile Exchange, w hich t rades fut ures on currencies- an act ive but st ill far sm aller m arket t han t he int erbank m arket ] and would say, " So, how does t he Swissy look?" What is a clerk going t o know about what is act ually driving t he int ernat ional currency m ar ket ? I would be t alking t o bankers t hroughout t he day and night - in Tokyo, London, Frankfurt , and New Yor k. = = = = Were you t rading off of t his inform at ion flow? = = = = That 's what foreign exchange t rading is all about . = = = = Can you give m e a recent exam ple of how inform at ion flow helps in t rading? = = = = At t he t im e t he Berlin Wall cam e down, t he gener al m arket sent im ent was t hat everyone would want t o get m oney int o East Ger m any on t he ground floor. The basic assum pt ion was t hat large capit al flows int o East ern Europe would m ost direct ly benefit t he Deut sche m ark. Aft er a while, t he realizat ion set in t hat it was going t o t ake a lot longer t o absorb East Germ any int o a unified Germ any. How does t hat shift in at t it ude com e about ? Kohl m akes a st at em ent ; Baker m akes a com m ent ; st at ist ics reveal very high East Germ an unem ploym ent . The East Ger m ans, who have lived all t heir life under a socialist syst em , begin saying, " We don't want t o work as hard as t hose West Germ ans, and by Hie way, how com e t he st at e is not paying for our m edical bills anym ore?" The invest m ent com m unit y begins t o realize t hat t he rebuilding of East ern Europe is going t o be a long haul. As t his t hinking becom es m ore prevalent , people st art m oving capit al out of t he Deut sche m ark. = = = = You could have m ade all t hose sam e argum ent s when t he wail first cam e down. = = = = I don't t hink m any people saw it t hat way at t he t im e, and even if t hey did, t hat 's not im port ant . What is im port ant is t o assess what t he m arket is focusing on at t he given m om ent . = = = = And t he way you get t hat inform at ion is by t alking t o lot s of part icipant s in t he foreign exchange m arket ? = = = = Yes. Not everyone is going t o int erpr et t hings in t he sam e way, at t he sam e t im e, as you do, and it 's im port ant t o underst and t hat . You need t o be plugged int o t he news and t o know what t he m arket is looking at . For exam ple, one day t he foreign exchange m ar ket m ay be focusing on int erest rat e different ials; t he next day t he m ar ket m ay be looking at t he pot ent ial for capit al appreciat ion, which is exact ly t he opposit e. [ A focus on int erest rat e different ials im plies t hat invest ors will shift t heir m oney t o t he indust rialized count ries wit h t he highest int erest rat e yields, whereas a focus on capit al appreciat ion im plies t hat invest ors will place t heir m oney in t he count ries wit h t he st rongest econom ic and polit ical out looks, which usually happen t o be t he count ries wit h lower int erest rat es.] = = = = Are t here any t rades t hat st and out from your early days as a currency t rader? = = = = I n 1983, in t he very early days of currency opt ions t rading on t he Philadelphia St ock Exchange, one of t he specialist s was quot ing a part icular opt ion at a price t hat was obviously off by 100 point s. I bought fift y. Since t his was a deep- in- t he- m oney opt ion, I im m ediat ely sold t he underlying m arket and locked in a risk- free profit . [ A deep- in- t he- m oney opt ion is j ust like an out right cont ract , wit h t he added advant age t hat if t he m arket has an ext rem e m ove t he m axim um risk is t heoret ically lim it ed.] I asked m y broker whet her t he specialist was st ill offering t o sell m ore opt ions at t he sam e price. " Yes," he replied, " t he offer is st ill t here." " Buy anot her fift y," I said.

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19 At t he t im e, I was t he only currency opt ions t rader on t he Philadelphia Exchange t hat regularly t raded in fift ies. The ent ire daily volum e in t he m arket was only about t wo or t hree hundred cont ract s. I did anot her fift y, anot her fift y, and anot her fift y. Then Goldm an Sachs cam e in and did fift y. All of a sudden, t he specialist had sold t hree t o four hundred of t hese opt ions. He obviously t hought he had a locked- in arbit rage profit , but he had done his arit hm et ic wrong. I knew exact ly what was happening. Finally, I said t o m y broker, " Ask him if he want s t o do one t housand." " Just a second," he answered. The broker cam e back a half- m inut e lat er and said, " He'll do one t housand at t his price." The specialist had backed off his offer, but he was obviously st ill off by alm ost 100 point s in his quot e. Finally I said t o m y broker, " Tell him t o call m e on m y out side line." The specialist calls m e up and says, " What are you doing?" I respond, " What are you doing?" He asks, " Do you really want t o do one t housand?" I answer, " List en, you're off by a big figure on your price." " What are you t alking about ?" he exclaim s. I st art walking him t hrough t he num bers. Before I finish he says, " I 've got t o go," and t he phone goes dead. I got off t he phone and t hought about it for a few m inut es. I realized t hat holding him t o t he t rade would put him out of business- a developm ent t hat would be bad for t he exchange and t errible for t he product [ currency opt ions] , which we were j ust beginning t o t rade in a significant way. I called m y broker and said, " Break all t he t rades aft er t he first fift y." At about t he sam e t im e, m y out side phone line rang. The specialist was on t he ot her end of t he line. " I can't believe it ! " he exclaim ed, agonizing over t he im m ensit y of his error. " This is going t o put m e out of business." I said, " Don't worry about it , I 'm breaking all t he t rades, except t he first fift y." ( By t he way, Goldm an refused t o br eak any of t he 150 t hey had done. Years lat er, aft er t he specialist com pany had gone out of business, and t he individual specialist had becom e t he head t r ader for t he largest m arket m aker on t he floor, he always m ade it very difficult for Goldm an on t he floor.) My act ion of breaking t he t rades represent ed a long- t erm business decision, which I didn't t hink about a lot at t he t im e, but which I agonized over for years aft erward. = = = = Why is t hat ? = = = = I have a reput at ion as being one of t he m ost - if not t he m ost - hard- assed players in t he m arket . I never, ever, ever, ever, cut anybody a br eak, because I figured t hat at Salom on everybody was t rying t o knock us off. I was sure t hat if t he t ables were r eversed, no one would ev er give us a break. My view was always t hat t hese are t he rules of t he gam e. I don't give any quart er, and I don't expect any quart er. Traders would som et im es call up when t hey had j ust m issed t he expirat ion of an over- t he- count er opt ion t hat went out m t he m oney. There were a m illion excuses: " I t ried t o get t hrough earlier." " I forgot ." " I 'm only a few m inut es lat e, couldn't you j ust m ake an except ion?" I always knew t hat if we called lat e, no one would let us exercise. The fact is, in all t he t im e I was t here, we never m issed an expirat ion. The argum ent I m ade was, " Look, we've put a lot of m oney and t hought int o our back- office operat ions. We've inst it ut ed num erous fail- safe m easures t o m ake sure t hat we don't m ake m ist akes." When I was working out t he m anagem ent com pany det ails wit h Merrill, t hey asked m e how m uch t hey should budget for back- office errors. I said, " Zero." They asked in disbelief, " What do you m ean by zero?" I said, " Zero. We don't have back- office errors." They said, "What do you m ean- of course you have back- office errors." I answered, " No, we don't m ake errors. I f you put in enough fail- safes, you don't m ake errors." That was m y at t it ude, and t hat was why I wouldn't break t he rules. People who knew m e really well would say, " Lipschut z, why do you have t o be such a hard- ass about everyt hing?" I would sim ply say, " Hey, t hese are t he rules; t hat 's t he way t he gam e is played." So for m e, let t ing t he specialist off t he hook was very m uch out of charact er. = = = = Did you decide t o give t he specialist a break because it was such an obvious m ist ake? Or because you t hought it m ight t hreat en t he longevit y of what was t hen a fledgling exchange and product ? = = = = I t was a long- t erm business decision based on t he opinion t hat it would have been bad for m y business t o hold him t o t he t rade. = = = = Bad for your business in what way? = = = = My business in t rading currency opt ions was exploding, and t he Philadelphia St ock Exchange was where t hey were t raded. ( The ov er- t he- count er currency opt ions m arket was only j ust st art ing at t he t im e.) = = = = So you did it m ore t o prot ect t he exchange. = = = = No, I did it t o prot ect m e. = = = = To prot ect your m arket place? = = = = That 's exact ly right .

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20 = = = = Then, hypot het ically, if t he exchange had been t here for t en years, t rading volum e was huge, and t his t rade would not have m ade any difference t o t he survival of t he exchange, you would have m ade a different decision. = = = = That 's correct . I t wasn't charit y. = = = = So t he fact t hat it was such an obvious error... = = = = No, t hat wasn't t he m ot ive, because I said t o t he broker, " Ask him t o check his price." " Ask him if he is sure." " Ask him if he want s t o do anot her fift y." = = = = I n t he int erbank m arket , don't t he dealers som et im es inadvert ent ly quot e a currency off by one big figure- for exam ple, t he real price is 1.9140 and t hey quot e 1.9240. Do you hold a dealer t o t he quot e ev en if it 's an obvious m ist ake? = = = = The convent ion is t hat t here has t o be an honest at t em pt . Let 's say t hat som e news com es out and t he m arket is m oving like crazy. You m ay not even know what t he big figure is. Assum e a dealer quot es 1.9140, and you t hink t he price should be 1.9240. The convent ion is t o say, " 1.9140. Are you sure? Please check your price." And if t he dealer r esponds, " Yeah, yeah, yeah, I 'm sure. Do you want t o deal or don^ t you?" t hen t he price should st and. = = = = Has t his happened t o you? = = = = Yes, and I can t ell you t hat every t im e t hat it has happened, t he ot her inst it ut ion has com e back and eit her want ed t o cancel t he t rade or split t he difference. = = = = And what did you say? = = = = I refused, because I had asked t hem t o verify t he price. There is a br eak in t he form al int erview t o devour som e Chinese food m at we have or dered in. During t he m eal, we cont inue t o discuss m arket s. One of t he subj ect s discussed is clearly st at ed t o be off t he record, because it cont ains a num ber of r eferences r egar ding one of t he exchanges. Since I believed t hat t he com m ent s and viewpoint s expressed in t his discussion would be of int erest t o m any readers, I event ually prevailed on Lipschut z t o perm it t he use of t his conversat ion. I n accordance wit h t his agreem ent , I have edit ed out all specific references t o t he exchange, m arket , and t raders. = = = = I n exchange- t raded m arket s, do you believe t hat st ops have a t endency t o get picked off? = = = = As you know, I do very lit t le t rading on exchanges wit h t rading pit s. The vast m aj orit y of m y t rades are done eit her in t he int erbank m arket or on t he Philadelphia Exchange, which uses a specialist syst em . However, in answer t o your quest ion, I can t eU you a st ory about a fellow who was at Salom on in t he lat e 1980s. He had been t rading a m arket t hat had gone int o a narrow range, and t rading act ivit y had dried up. During t his period, a lot of st ops had built up right above t his t rading range. One day, t his t rader's clerk on t he floor calls and says, " List en, t he t alk is t hat t om orrow [ a day on which t he liquidit y was expect ed t o be subst ant ially below norm al because of a holiday affect ing t he cash m arket ] t hey're going t o gun for t he st ops above t he m arket ." At t hat point , t he st ops were r elat ively close- about 40 or 50 t icks higher. The next day, t his t rader's plan is t o sell t he m arket heavily once t he st ops are hit , because he believes such a rally would be art ificial and t hat t he m arket would be vulnerable t o a subsequent sell- off. During t he m orning, t he m arket t rades sideways and not hing happens. Then around 1 P. M., prices st art t o m ove- down. = = = = You did say t hat t he st ops were above t he m arket ? = = = = That 's right . Anyway, t he m arket m oves down 50 point s, 100 point s, and wit hin a few m inut es t he m arket is down over 200 point s. What happened was t hat t he floor t raders went for t he st ops below t he m arket , which were 200 point s away, inst ead of t he st ops above t he m arket , which were only 50 point s aw ay. The reason was t hat everybody was ready for t he rally t o t ake out t he st ops on t he upside. Therefore, everyone was long, and t he direct ion of great est price vulnerabilit y was on t he downside. During t he sharp br eak, m y friend realizes t hat t he m arket is way overex t ended on t he downside. He scream s at his clerks, " Buy 'em ! Buy any am ount t hey'll sell you. Just buy 'em 1 " He was bidding for hundreds of cont ract s bet ween 100 and 200 point s lower, and he was only filled on fift y, even t hough t he m arket t raded down over 200 point s, wit h a couple t housand lot s t rading at t hose levels. = = = = What happened t o his bid? = = = = You've obviously never t raded on t he floor of an exchange. I n a t rading pit , it 's possible for t he m arket t o t rade at several different prices at t he sam e m om ent during per iods of rapid m ovem ent . They were looking right past m y friend's floor brokers, who were bidding higher. I t was a fast m arket . [ When an ex change designat es " fast m arket " condit ions, floor brokers can't be held for failing t o fill orders t hat were wit hin t he day's t raded price range.] A fast m arket gives t he floor brokers a special license t o st eal, above and beyond t heir norm al license t o st eal. I 'm not m aking any allegat ions, because I can't pr ove t hat any of t his happens. I t 's j ust m y opinion t hat sit uat ions like t his som et im es occur in som e open out cry m arket s. Dinner is over, and we ret urn t o t he living room for a cont inuat ion of t he int erview " on t he record."

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21 = = = = Do you rem em ber your first m aj or t rade and t he t hinking behind it ? = = = = The t rade involved a bond issue t hat allowed for redem pt ion in eit her st erling [ anot her nam e for Brit ish pounds] or U.S. dollars. The issue was grossly underpriced- t he problem was t hat it was m ispriced by Salom on Brot hers, one of t he lead underwrit ers. When I first heard t he det ails, I couldn't believe how m ispriced it was. I act ually want ed t o buy t he whole issue. = = = = What was t he essence of t he m ispricing? = = = = At t he t im e, U.K. int erest rat es were a lot lower t han U.S. rat es. Consequent ly, forward st erling was t rading at a huge prem ium t o t he spot rat e. [ I f t wo count ries have different int erest rat es, forward m ont hs of t he currency wit h lower rat es will invariably t rade at a prem ium t o t he spot currency rat e. I f such a prem ium did not exist , it would be possible t o borrow funds in t he count ry wit h lower rat es, convert and invest t he proceeds in t he count ry wit h higher rat es, and buy forward currency posit ions in t he currency wit h lower int erest rat es t o hedge against t he currency risk. The part icipat ion of int erest rat e arbit rageurs assures t hat t he forward prem ium s for t he currency wit h lower int erest rat es will be exact ly large enough t o offset t he int erest rat e different ial bet ween t he t wo count ries.] The way t he bond issue was priced, t he st erling redem pt ion opt ion essent ially assum ed no prem ium over t he spot rat e, despit e t he huge prem ium for t he currency in t he forward m arket . Therefore, you could buy t he bond and sell t he st erling forward at a huge prem ium , which over t he life of t he bond would converge t o t he spot rat e. = = = = What was t he t erm of t he bond? = = = = The bond m at ured in four t ranches: five, seven, nine, and t welve years. = = = = I don't underst and. I s it possible t o hedge a currency t hat far forward? = = = = Of course it is. Even if you can't do t he hedge in t he forward m arket , you can creat e t he posit ion t hrough an int erest r at e swap. However, in t he case of st erling/ dollar, which has a very liquid t er m forward m arket , t here was cert ainly a m arket for at least t en years out . = = = = How big was t he issue? = = = = There were t wo t ranches: t he first for $100 m illion and t he second for S50 m illion. = = = = What happened when you point ed out t hat t he issue was grossly m ispriced? = = = = The init ial response was t hat I m ust be wrong som ehow. They spent nine hours t hat day running it past every quant j ock in t he house unt il t hey were convinced I was right . = = = = Did t hey let you buy t he issue? = = = = Yes, but by t he t im e I got t he approval, $50 m illion of t he first t ranche had already been sold. For t he next year or t wo, I t ried t o acquire t he rest of t he issue in t he secondary m arket . I always had a bid in for t hose bonds. Lar gely wit h t he help of one salesperson who knew where t he original issue was placed, over t he next t wo years, I was able t o acquire $135 m illion of t he t ot al out st anding issue of $150 m illion. Once I bought t he issue, I im m ediat ely sold an equivalent of 50 percent of t he t ot al am ount in t he forward st erling m arket . Rem em ber t hat t he forward pound was at a large prem ium . For exam ple, t he spot rat e ( and t he rat e at w hich t he bonds were redeem able in st erling) was $1.3470, while seven- year forward st erling was t rading at approxim at ely $1.47 and t w elve- year forward st erling at approxim at ely $1.60. [ The sale of half t he t ot al am ount in t he forward m arket effect ively convert ed half t he posit ion int o a proxy put on t he Brit ish pound, while t he original issue was, in effect , a call posit ion. Thus, half t he posit ion was a call and half a put , t he key point being t hat t he put was est ablished at a m uch higher price t han t he call. This gap essent ially represent ed a locked- in profit , wit h t he pot ent ial for an even great er profit if t he forward pound m oved below $1.3470 or above, say, $1.47 in t he case of t he seven- year t ranche.] Anyway, what ult im at ely happened is t hat U.K. int erest rat es event ually reversed from below t o above U.S. rat es, t hereby causing t he Brit ish pound forward rat es t o invert from a prem ium t o a discount t o t he spot rat e. I covered t he w hole posit ion at a huge profit . = = = = Are t here any ot her t rades in your career t hat st and out as part icularly m em orable? = = = = One t hat com es t o m ind occurred at t he t im e of t he G- 7 m eet ing in Sept em ber 1985, which involved m aj or st ruct ural changes t hat set t he t one in t he currency m arket s for t he next five years. [ This was t he m eet ing at which t he m aj or indust rialized nat ions agreed t o a coordinat ed policy aim ed at lowering t he value of t he dollar.] = = = = You were obviously very closely t ied int o t he currency m arket s. Did you have any idea t hat such a m aj or policy change was at hand? = = = = No. There were som e people who had an inkling t hat t here was going t o be a m eet ing at which t he West ern governm ent s were going t o drive t he dollar down, but nobody underst ood t he m agnit ude of what t hat m eant . Even aft er t he result s of t he m eet ing were r eport ed, t he dollar t raded down, but not hing com pared t o t he decline t hat occurred in t he ensuing m ont hs. I n fact , aft er an init ial sell- off in New Zealand

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22 and Aust ralia, t he dollar act ually rebounded m odest ly in Tokyo. = = = = How do you explain t hat ? = = = = People didn't really underst and what was happening. The general at t it ude w as: " Oh, anot her cent ral bank int ervent ion." Rem em ber t hat t his m eet ing t ook place aft er years of ineffect ive cent ral bank int ervent ion. = = = = What was different t his t im e? = = = = This was t he first t im e t hat we saw a coordinat ed policy st at em ent from t he seven indust rialized nat ions. Anyway, I was out of t he count ry at t he t im e of t he G- 7 m eet ing. I don't t ak e vacat ions very oft en, but I had had a very good year, and I w as in Sardinia at t he t im e. Sardinia is fairly isolat ed, and it t akes som et hing like t wo hours t o m ake an overseas call. = = = = Were you aware of t he sit uat ion? = = = = I didn't ev en know what t he G- 7 was. The m eet ing didn't have any significant im plicat ion at t he t im e; it was Just a bunch of bureaucrat s get t ing t oget her t o t alk down t he value of t he dollar. = = = = There was never any G- 7 m eet ing before t hat t im e t hat had any significant im pact on t he dollar? ==== Absolut ely not . Anyway, I 'm lying on t he beach, t ot ally oblivious t o t he ongoing bedlam in t he world currency m arket s. For what ever reason- probably because it was close t o t he end of m y vacat ion and I was st art ing t o t hink about get t ing back int o t he m arket s- I decided t o call m y office early Monday m orning. New York t im e, and check whet her everyt hing was running sm oot hly in m y absence. Wit h great difficult y, I finally got a line t hrough t o New York, but t here was no answer in m y office. The failure t o get an answer was very unusual because m y assist ant , Andy [ Andrew Krieger] , always cam e in very early. I was a lit t le concerned. I t hen called our London office t o check on t he currency m arket s. " Dennis, what 's going on in t he currency m arket ?" I asked. " You know about t he G- 7 m eet ing, of course, don't you?" he asked. " No," I answered. " What are you t alking about ?" " Well, t hey've com e up wit h t his m anifest o t o bring down t he value of t he dollar, and t he dollar is going t o hell." " Do you know where Andy is?" I asked. " Oh, Andy is out sick t oday," he answered. This was odd, because neit her one of us was ever out sick. Aft er a great deal of effort , I finally got t hrough t o Andy at hom e. He was in bed wit h t he flu and running a high fever. = = = = Did you have any posit ion going int o t he G- 7 m eet ing? = = = = Yes, we had a sm all short dollar posit ion, but not hing significant . = = = = Did Andy have t he aut horit y t o t rade? = = = = Yes, of course. He was not only m onit oring m y posit ions but was responsible for t rading rat her significant ones him self. The int erest ing t hing was t hat as soon as Andy read t he news, he went int o t he New Zealand m arket , which is t he first of t he world's currency m arket s t o t rade aft er t he weekend. Not m any people t raded in t hat t im e zone, and it was a very t hin m arket . I t hink he was only able t o get price quot es at all because w e ( Salom on Brot hers) frequent ly t raded $20 m illion t o $50 m illion on Monday m ornings in New Zealand. Therefore, it was not abnorm al for Andy or m yself t o call. We had est ablished relat ionships in t hat t rading cent er when very few ot hers- New Yorkers or Europeans- had. On very wide price quot es- lit erally t wo big figures wide because everyone was confused- he sold $60 m illion in New Zealand, which was a t rem endous am ount back t hen. [ At t his point , Bill re- creat ed Andy's conversat ion wit h t he New Zealand Bank: ] " What 's your price for t went y [ m illion] dollars?" " Two eight y bid, t wo eight y- t wo offered." " Sold. How do you rem ain?" " Two sevent y- nine, t wo eight y- one." " Yours t went y. How do you rem ain?" " Two sevent y- eight , t wo eight y." " Yours t went y." Andy was hit t ing bids six big figures below Friday's close. I was really im pressed t hat he had t hat t ype of insight . I wouldn't have done t hat . To m ake a long st ory short , for six hours I had an open line from m y hot el room in Sardinia t o Andy, who was out sick, flat on his back, in Englewood, New Jersey. I t was so difficult get t ing an overseas phone connect ion t hat we j ust left t he line open all day. Andy had t he line t o m e and an open line t o t he floor on t he Philadelphia St ock Exchange, where we were t rading currency opt ions. I n addit ion, he had his wife run out t o Radio Shack as soon as t hey opened t o purchase one of t hose ext ra- long t elephone cord ext ensions. He m en brought in a t hird line from t he neighbor's house t o allow him t o est ablish an open phone t o our spot dollar/ m ark broker so t hat we could t rade t he cash m arket . We t raded t hat way for six hours. We m ade $6 m illion t hat day, which at t hat t im e was probably m ore t han 25 percent of our t ot al annual profit s. We were st aying at t his luxurious resort t hat was largely frequent ed by wealt hy Europeans. One hum orous sidelight was t hat , while all t hat was going on, t hese t wo indust rial m agnat e t ypes- older Germ an m en, im peccably groom ed, wit h perfect t ans and accom panied by wom en who were obviously t heir daught ers- kept com ing by m y room every t en m inut es t o ask in Germ an what was happening. My wife did t he t ranslat ing. They knew t hat som et hing im port ant was going on in t he foreign exchange m arket , but no one knew anyt hing specific. Sardinia is so isolat ed t hat all t he available new spapers ar e at least t wo days old. But I w as

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23 right t here. = = = = Were t here any ot her t rades t hat were part icularly unusual for one reason or anot her? = = = = One t rade t hat was int erest ing because it t urned int o a virt ual poker gam e occurred in 1987. I had put on a huge opt ion spread posit ion: long t went y- t hree t housand Japanese yen 54 calls and short t went y- t hree t housand 55 calls. I f t he calls expired in t he m oney, each side of t he spread would represent nearly $800 m illion- an enorm ous posit ion at t he t im e. When I put on t he posit ion, t he calls were well out of t he m oney. [ The posit ion Lipschut z is describing is a bull call spread. I n or der for t he t rade t o be profit able, t he price of t he yen m ust rise above 54 by an am ount sufficient t o at least offset t he cost of t he spr ead. Unlike a st raight call posit ion, however, t he profit pot ent ial is lim it ed t o one full point per cont ract , since t he long 54 call posit ion is offset by t he sale of an equal size 55 posit ion. Alt hough t he sale of t he 55 call lim it s t he profit pot ent ial, it also subst ant ially reduces t he cost of t he t rade, as t he incom e generat ed by selling t he 55 call part ially offset s t he cost of buying t he 54 call. The m axim um profit would be realized at any price above 55, in which case each spread posit ion would generat e one full point profit ( $625) m inus t he price difference bet ween t he 54 and 55 calls at t he t im e of t he posit ion im plem ent at ion. Given t he num bers described by Lipschut z, t he m axim um profit pot ent ial on t he ent ire spread, which again would occur at a price above 55, would approxim at e $13 m illion.] The risk of doing t his t ype of t rade is t hat if t he front st rike is in t he m oney but t he back st rike is not [ i.e., a price bet ween 54 and 55] , you could end up ex ercising t he long 54 call and not get t ing called away on your short 55 call. While t his would im ply a profit at expirat ion, it would also m ean m at you would be left net long a near $800 m illion posit ion, which would have t o be carried over t he weekend unt il t he Tokyo m arket opened on Sunday night . I n ot her words, you would be left wit h a t rem endous risk exposure t o an adverse price m ove over t he weekend. = = = = Couldn't you hedge t he posit ion near expirat ion? = = = = You could if you were sure about whet her t he m arket was going t o set - t ie significant ly above or below t he 55 st rike level. But what if t he m arket is t rading near t he st rike price as expirat ion approaches? I n t hat case, you're not sure whet her y ou're going t o be assigned on t he cont ract s or not . You cert ainly don't want t o t ry t o liquidat e t he ent ire t went y- t hree t housand cont ract spread posit ion in t he final hours of t rad- ing, since you would, have t o pay away a t rem endous am ount in t he bid/ offer spread t o get out of a t rade t hat size at t hat point . I f you don't hedge t he long 54 call posit ion because of t he assum pt ion t hat t he m arket will expire above 55 [ an event t hat would cause t he short 55 call t o get exercised] , but inst ead t he m arket closes below 55, you can end up carrying a net huge long posit ion over m e weekend. I f, on t he ot her hand, you hedge your long 54 call posit ion on t he assum pt ion t hat t he m arket is going t o close below 55, but inst ead it closes above 55 and t he short 55 call is exercised, t hen you can end up net short t he ent ire face am ount over t he weekend. I t 's t he uncert aint y about whet her t he m arket will close above or below 55 ( or, equivalent ly, whet her or not your short 55 call posit ion will be exercised) t hat m akes it im possible t o effect ively hedge m e posit ion. One part icularly int erest ing elem ent of t he t rade w as t hat one m arket m aker was on t he opposit e side of about t went y t housand lot s of t he spr ead posit ion. When you deal wit h posit ions of That size on an exchange, you generally know who is on t he ot her side. The expirat ion day arrives, and as t he m arket is in it s final hours of t rading, guess w hat ? The price is right near 55. The m arket - m aking firm doesn't know whet her I have hedged m y long 54 call or not , and I don't know whet her t hey have hedged t heir short 54 call or plan t o exercise t heir long 55 call t o offset t he posit ion. Neit her one of us will know t he ot her's posit ion unt il Sunday m orning, which is when you get not ified of any opt ion exercises. On Sunday evening we get t o play t he sam e poker gam e alt over again in t he Tokyo m arket . I f t hey have exercised t heir long 55 call ( m aking m e short t hat posit ion) , t hey won't know if I 'm short yen or not , depending on whet her or not I 've hedged. I f t hey haven't exercised t heir call, t hey won't know if I 'm net long yen or neut ral, again depending on whet her or not I 'm hedged. For m y part , I also won't know whet her t hey are net long, short , or neut ral, since I don't know w het her or not t hey have hedged. Consequent ly, going int o t he early New Zealand and Aust ralian m arket openings, eit her I 'm going t o be long nearly $800 m illion wort h of yen and t hey are going t o be short t he sam e posit ion, or t hey are going t o be long t hat am ount and I 'm going t o be short , or one of us is going t o have a net long or short posit ion while t he ot her is hedged, or we could bot h. be hedged. Neit her one of us will be able t o figure out t he ot her's posit ion wit h any cert aint y, and given our size at t hat t im e of t he day in t hose t rading cent ers, we're t he only gam e in t own. On Friday aft ernoon ( t he expirat ion day) , I heard t hat t he firm on t he ot her side of t he t r ade was buying yen in t he cash m arket . They had t ipped t heir hand. I knew t hen t hat t hey had not already hedged t heir short 54 call posit ion and had no int ent ion of exercising t heir long 55 calls. At 5 P. M., t he yen closed wit hin one t ick of t he 55 st rike level. Because of t he ot her firm 's act ions in t he cash m arket , I t hought t hey probably wouldn't exercise t heir long 55 calls, but I couldn't be cert ain. On Sat urday, t he phone rang and it was t he ot her firm 's t rader. " How are you doing?" I asked. " Very good. How are you doing?" he asked in ret ur n. " I don't know, you t ell m e," I answered. Rem em ber, you don't get your not ices unt il Sunday, and t his conversat ion was t aking place on Sat urday. " What did you do?" I asked. He said, " What do you t hink I did? You'll never guess." " Well, I t hink you kind of t ipped your hand on Friday aft ernoon," I answered.

23

24 " Yeah, t hat was t he st upidest t hing," he said. The purchase of yen in t he int erbank m arket hadn't been his decision; it was a com m it t ee decision at his com pany. He finally t old m e, " We're not going t o exercise." = = = = Did he j ust call t o let you know t hat t hey weren't going t o exercise and let you off t he hook? = = = = I would have had t hat inform at ion prior t o t he New Zealand opening anyway. He was probably t rying t o sniff out m y posit ion- t hat is, whet her I had hedged or not . I f he could figure out what I had done, t here would be a pot ent ial play for him in t he m arket place. As it t urns out , I had not hedged, and I was net long t he yen posit ion. I f he knew t hat , he could have gone int o New Zealand, which is t he first int erbank m arket t o open, and pushed t he m arket against m e. By t elling him t hat t hey had t ipped t heir hand by selling t he yen on Friday aft ernoon, I let him believe t hat I had figured out t heir posit ion- which I had- and hedged- which I had not . I n any event , t here was som e news over t he weekend, and t he dollar opened up sharply lower against t he yen. I act ually ended up subst ant ially increasing m y profit on t he t rade. = = = = How m uch did you end up m aking on t hat t rade? = = = = A t ot ally ridiculous am ount - som et hing like $20 m illion. However, t he t hing t hat was so great about t he t rade was not t he m oney but t he m ent al chess gam e t hat Friday aft ernoon- all t he back- and- fort h bluffing. People were calling m y desk all Friday aft ernoon t o ask us what was going on bet ween us and t he ot her firm . There was not hing else going on in t he m arket . These were t he biggest posit ions in t he m arket by a hundredfold t hat day. Are t here any ot her t rades you can t hink of t hat were part icularly m em orable? I can t ell you about t he one t im e since I first st art ed t rading t hat I was really scared. I n fall 1988, t here wasn't m uch going on in t he currency m arket s. The D- m ark had been in a very t ight t rading range. As was very t ypical in t hose t ypes of low- volat ilit y periods, our posit ion size t ended t o grow as we t ried t o capt ure sm aller and sm aller price m oves and st ill produce t he sam e r esult s. As a result , our posit ion size at t he t im e was larger t han norm al. We knew t hat Gorbachev was going t o m ake a speech at t he UN, but we didn't know what he was going t o say. At t he t im e, I was short about $3 billion against t he D- m ark. = = = = Three billion! Was t hat t he largest posit ion size you ever t raded? = = = = I 've been bigger, but t hat was a very large posit ion. The m arket had been t rading in a narrow 1- 2 percent range, and I had expect ed t hat sideways price act ion t o cont inue. Then Gorbachev m ade a speech about t roop reduct ions, which was int erpret ed by t he m ar ket as m eaning t hat t he Unit ed St at es could also cut it s arm ed force com m it m ent - a developm ent t hat would be beneficial for t he budget deficit . All of t his was considered very bullish for t he dollar. The dollar st art ed m oving up in New York, and t her e w as no liquidit y. Very quickly, it was up 1 percent , and I knew t hat I was in t rouble. = = = = One percent of a $3 billion posit ion is $30 m illion! Did t his loss t ranspire in j ust one aft ernoon? = = = = I t t ranspired in j ust eight m inut es. All I want ed t o do was t o m ake it t hrough t o t he Tok yo opening at 7 P. M. for t he liquidit y. I f you really have t o buy $3 billion, you can do it in Tokyo; you can't do it in t he aft ernoon m arket in New York- you can't even do it on a norm al day, let alone on a day when m aj or news is out . My st rat egy was t o t ry t o cap t he dollar in New York. Norm ally, if you sell several hundred m illion dollars in t he aft ernoon New Yor k m arket , you can pret t y m uch t ake t he st arch out of t he m arket . I sold $300 m illion, and t he m arket went right t hrough it . The people on m y desk didn't r eally know t he size of our posit ion, wit h t he except ion of Robert , who was m y num ber t wo m an. I looked at Robert and said, " That didn't slow t he m arket down t oo m uch, did it ?" He grim aced and shook his head slowly from side t o side. I realized t hat I couldn't cover t hese posit ions. I was really scared. I rem em ber t hinking: This is t he bullet t hat finally cat ches m e in t he back of t he head. Tom St rauss, t he president of t he com pany, sat about fift een feet away from m e. ( Gut freund was not t here t hat day.) I got up and walked over t o St rauss and said, " Tom m y, we have a problem ." He looked at m e and calm ly said, " What is it ?" I answered, " I 'm short t he dollar and I 've m isj udged m y liquidit y in t he m arket , I 've t ried t o hold t he m arket down, but it 's not going t o work. And I can't buy t hem back." He very calm ly asked, " Where do we st and?" " We're down som ewhere bet ween sevent y and ninet y m illion." " What do we want t o do about t his?" he asked. I dist inct ly rem em ber being st r uck by t he fact t hat he used m e word we, not you. I said, " I f I t ry t o buy som e back, I m ay get a lit t le here and a lit t le t here, but it won't am ount t o very m uch, and we'll j ust end up pushing t he m arket furt her against us. The first liquidit y is Tokyo." " What 's t he plan?" he asked. I answered, " When Tokyo opens, I have t o see where it 's t rading. My int ent ion now is t o cover half t he posit ion at t hat t im e, and go from t here. He said, " We've had a good m n on t his. Do what you need t o do." That was t he ent ire conversat ion. I t was over in t wo m inut es. I n discussing t his episode several day s lat er, Robert said, " I never saw you look like t hat ." I asked him what he m eant . He answered, " You were as whit e as a. sheet ." My percept ion of what was going on ar ound m e at t he t im e was, of course, quit e dist ort ed because I was so focused on t hat sit uat ion. I was lat er t old t hat , for t he ent ire aft ernoon, t here w as virt ually not a word spoken on t he desk and t hat Robert didn't let anybody com e near m e. I was oblivious t o all t his at t he t im e. Cont inuing our conversat ion, Robert said, " I don't know how you went over t o St rau- ss."

24

25 " Why?" I asked. " What would you have done? I t was m e only t hing I could do; I had t o inform St rauss about what was going on." Robert r esponded, " Ninet y m illion. You were down $90 m illion! Do you underst and what t hat m eans?" I asked, " What would you have done?" He answered, " I would have put m y coat on and walked out of here. I would have figured t hat was it , it 's over, I 'm fired." Now, I don't I know if t hat 's what he r eally would have done, but it never occurred t o m e t o walk out . The idea t hat I had possibly j ust lost m y j ob never ent ered m y m ind. This was a firm t hat bore m e and nurt ured m e; it was j ust inconceivable t hat t hat could happen. The first t hing I t hought about was t he posit ion. The second t hing I t hought about was m aking sure t hat m anagem ent knew about it . I n absolut e consist ency w it h t he firm 's approach, as exem plified by Tom St rauss's response, t here wasn't going t o be any negat ivit y in our conversat ion. I t was a m easured discussion, but if t here was going t o be any analysis of what went wrong, it would be aft er t he sit uat ion was resolved. = = = = What event ually happened t o t he posit ion? = = = = By t he t im e Tokyo opened, t he dollar was m oving down, so I held off covering half t he posit ion as I had previously planned t o do. The dollar kept on collapsing, and I cov ered t he posit ion in Europe. I ended up wit h an $18 m illion loss for t he day, which at t he t im e seem ed like a m aj or vict ory. = = = = Most people in your sit uat ion would have been so relieved t o get out t hat t hey would have dum ped t he posit ion on t he Tokyo opening. Apparent ly, you deferred t o your m arket j udgm ent and avoided t hat em ot ional t em pt at ion. = = = = The reason t hat I didn't get out on t he Tokyo opening was t hat it was t he wrong t rading decision. Act ually, I 'm a m uch bet t er t rader from a bad posit ion t han from a good posit ion. = = = = What did you learn from t he ent ire experience? = = = = Most ly I learned a lot about t he firm and m yself. I have a lot of respect for Salom on's willingness t o underst and what happens in t he m arket s. I f you want t o play t he gam e, som et im es som ebody is going t o get assassinat ed, som et im es som eone is going t o m ake a speech at t he UN, and you're going t o be on t he wrong side of t he t rade- it 's j ust t he way it is. Exogenous event s are exogenous event s. They really underst ood t hat . = = = = You said t hat you also learned about yourself. What did you learn? = = = = That was t he first t im e it hit hom e t hat , in regards t o t rading, I was really very different from m ost people around m e. Alt hough I was fright ened at t he t im e, it wasn't a fear of losing m y j ob or concern about what ot her people would t hink of m e. I t was a fear t hat I had pushed t he envelope t oo far- t o a risk level t hat was unaccept able. There was never any quest ion in m y m ind about what st eps needed t o be t aken or how I should go about it . The decision process was not som et hing t hat was cloudy or m urky in m y vision. My fear was relat ed t o m y j udgm ent being so incorrect - not in t erm s of m arket direct ion ( you can get t hat wrong all t he t im e) , but in t erm s of drast ically m isj udging t he liquidit y. I had let m yself get int o a sit uat ion in which I had no cont rol. That had never happened t o m e before. = = = = Any ot her t raum at ic t rading experiences? = = = = You never asked m e about what happened t o m y own account . = = = = All right , what happened? As I rem em ber, you st art ed out wit h about $12,000. = = = = That 's right , and t he peak was about $250,000. Really? You had built it up t hat m uch! Well, t his was over a period of about four t o five years. St ill ... Yes, I had a lot of success. Anyway, I ended up blowing out virt ually t he ent ire account in a few days. = = = = What happened? = = = = On Sept em ber 23, 1982, t he Dow went from down 30 point s t o closing up 20. This was t he fam ous Granville reversal, which was t he bot t om of t he bear m arket . = = = = Does " Granville reversal" refer t o t he rally occurring j ust aft er Joe Granville [ an ext raordinarily popular m arket advisor at t he t im e] had put out a sell recom m endat ion? = = = = Exact ly. I was very bear ish and heavily long put s. I kept py ram iding all t he way down. I was r eally pressing. I lost m ost of t he m oney t hat Monday, and by Wednesday t he account was virt ually all gone. = = = = You t ook over four years t o t urn $12,000 int o $250,000 and lost it all in a m at t er of days. Did you have a m om ent of self- quest ioning? = = = = No, I j ust saw it as one m aj or m ist ake. I 've always had a lot of confidence as a t rader. My feeling was t hat I had developed and pract iced t he basic t rading skills t hat had landed m e at Salom on Brot hers and t hat I had a t rem endous am ount of fun in t he process. I was devast at ed by t he way I had t raded, but t he m oney never had a m aj or effect on m e. = = = = Did you change anyt hing because of t his experience? = = = = I decided t hat since I was going t o work for Salom on Brot hers, all m y at t ent ion should go int o doing t hat very well, not t rading m y own account . Aft er t hat point , I never again t raded m y own account - not because I had lost m oney but because I didn't w ant t o split m y focus, as I saw som e ot her people do over t he years. I basically t ook m y pay- check every t w o weeks and put it in a m oney m arket account - a gov ernm ent - securit iesonly m oney m arket account because I want ed t he ext ra prot ect ion. = = = = How did t he sudden dem ise of your personal account change you as a t rader? = = = =

25

26 I probably becam e m ore risk- cont rol orient ed. I was never part icularly risk averse. = = = = What do you m ean by " risk cont rol" ? = = = = There are a lot of elem ent s t o risk cont rol: Always know exact ly where you st and. Don't concent rat e t oo m uch of your m oney on one big t rade or group of highly correlat ed t rades. Always underst and t he risk/ reward of t he t rade as it now st ands, not as it exist ed when you put t he posit ion on. Som e people say, " I was only playing wit h t he m arket 's m oney." That 's t he m ost ridiculous t hing I ever heard. I 'm not saying t hat all t hese concept s cryst allized in one day, but I t hink t hat experience wit h m y own account set m e off on t he t rack of considering t hese aspect s m uch m ore seriously. = = = = On t he subj ect of risk cont rol, how do you handle a losing st reak? = = = = When you're in a losing st reak, your abilit y t o properly assim ilat e and analyze inform at ion st art s t o becom e dist ort ed because of t he im pairm ent of t he confidence fact or, w hich is a by- product of a losing st reak. You have t o work very hard t o rest ore t hat confidence, and cut t ing back t rading size helps achieve t hat goal. = = = = Wit h all t he loyalt y you had t o Salom on, why did you event ually leave? = = = = Gil, who st art ed t he depart m ent , left in 1988, and I ended up running t he depart m ent for a year and a half. I w ould find m yself t alking on t he phone a lot - not about t rading, but rat her about a lot of personnel problem s. I was also not crazy about t raveling all over. I didn't like m anaging people in Tokyo, London, and New York. I want ed t o bring som eone in as a com anager for t he depart m ent . I want ed t o run t rading and let som eone else run t he adm inist rat ive side. That 's not t he st yle of Salom on Brot hers, however. I nst ead t hey brought in som eone from above m e. I nit ially, I t hought t hat it m ight work out , but t he person t hey picked had no foreign exchange background at all. He cam e from t he fixed- incom e depart m ent and saw everyt hing in t he eyes of t he bond world. He would frequent ly ask, " Gee, isn't t hat j ust like t he governm ent bond m arket ?" The answer in m y m ind was, " No, it 's not hing like t he governm ent bond m arket . Forget t he governm ent bond m arket ." = = = = How does your current t rading for your own m anagem ent firm differ from your t rading at Salom on? ==== At t he m om ent , I 'm t rading a lot sm aller t han at Salom on, which is a disadvant age. = = = = How is large size an advant age? You're kidding. = = = = No, I 'm serious. I f a big buyer com es in and pushes t he m arket 4 percent , t hat 's an advant age. He st ill has t o get out of t hat posit ion. Unless he's right about t he m arket , it doesn't seem like large size would be an advant age. He doesn't have t o get out of t he posit ion all at once. Foreign exchange is a very psychological m arket . You're assum ing t hat t he m arket is going t o m ove back t o equilibrium very quickly- m ore quickly t han he can cover his posit ion. That 's not necessarily t he case. I f you m ove t he m arket 4 per cent , for exam ple, you're probably going t o change t he m arket psychology for t he next few days. = = = = So youre saying size is an advant age? = = = = I t 's a huge advant age in foreign exchange. = = = = How large an account were you t rading at Salom on? = = = = That quest ion really has no direct m eaning. For a com pany like Salom on, t here are no asset s direct ly underlying t he t rading act ivit y. Rat her, over t im e, t he t rader s and t r easurer built up great er and great er am ount s of credit facilit ies at t he banks. The banks were eager t o ext end t hese credit lines because we were Salom on Brot hers. This is an exam ple of anot her way in which size was an advant age. By 1990, our depart m ent probably had $80 billion in credit lines. However, no specific asset s were segregat ed or pledged t o t he foreign exchange act ivit ies. = = = = I would like t o get som e feeling for how you reach your price direct ional decisions. St rict ly for purposes of illust rat ion, let 's use t he current out look for t he Deut sche m ark. I know t hat you expect t he dollar t o gain on t he Deut sche m ark. What is your reasoning behind t he t rade? = = = = First of all, I 'm very concerned about t he effect s of unificat ion on t he Germ an econom y. There are t rem endous infrast ruct ure problem s in East Germ any t hat m ay t ake a decade or longer t o solve. Also, t he plans t o rest ruct ure t he Bundesbank [ m e Germ an cent ral bank] t o include represent at ives of t he form er East Germ an cent ral bank creat e a lot of uncert aint y. Finally, Kohl's governm ent current ly appear s t o be on a m uch weaker foot ing. All of t hese fact ors should operat e t o provide disincent ives for capit al flowing int o Germ any. At t he sam e t im e, a com binat ion of low U.S. int erest rat es, an apparent desire by t he Federal Reserv e t o cont inue t o st im ulat e t he econom y, and prelim inary signs of favorable econom ic dat a suggest t hat t he Unit ed St at es m ay be com ing out of it s recession. Therefor e, people ar e st art ing t o t hink t hat t he Unit ed St at es m ay not be a bad place in which t o invest t heir m oney. = = = = Having est ablished a long- t erm philosophy about which way t he currency is going- in t his case, t he dollar going higher against t he D- m ark- how would you t hen recognize if t hat analysis were wrong? = = = = Event s t hat would change m y m ind would include evidence t hat t he Ger m an governm ent was dealing effect ively wit h som e of t he problem s I list ed befor e and econom ic st at ist ics suggest ing t hat m y assum pt ion of an end t o t he U.S. recession was prem at ure- essent ially, t he converse of t he sit uat ion I described for m aking m e bullish on t he dollar.

26

27 = = = = For argum ent 's sake, let 's say t hat t he fundam ent als ost ensibly don't change but t he dollar st art s going down. How would you decide t hat you're wrong? What would prevent you from t aking an openended loss? = = = = I believe in t his scenario very st rongly- but if t he price act ion fails t o confirm m y expect at ions, will I be hugely long? No, I 'm going t o be flat and buying a lit t le bit on t he dips. You have t o t rade at a size such t hat if you're not exact ly right in your t im ing, you won't be blown out of your posit ion. My appr oach is t o build t o a larger size as t he m arket is going m y way. I don't put on a t rade by saying, " My God, t his is t he level; t he m arket is t aking off right from here." I am definit ely a scale- in t ype of t rader. I do t he sam e t hing get t ing out of posit ions. I don't say, " Fine, I 've m ade enough m oney. This is it . I 'm out ." I nst ead, I st art t o light en up as I see t he fundam ent als or price act ion changing." = = = = Do you believe your scaling t ype of approach in ent ering and exit ing posit ions is an essent ial elem ent in your overall t rading success? = = = = I t hink it has enabled m e t o st ay wit h long- t erm winners m uch longer t han I 've seen m ost t raders st ay wit h t heir posit ions. I don't have a problem let t ing m y profit s run, which m any t raders do. You have t o be able t o let your profit s run. I don't t hink you can consist ent ly be a winning t rader if you're banking on being right m ore t han 50 per cent of t he t im e. You have t o figure out how t o m ake m oney being right only 20 t o 30 percent of t he t im e. = = = = Let m e ask you t he converse of t he quest ion I asked you before: Let 's say t hat t he dollar st art ed t o go up- t hat is, in favor of t he direct ion of your t rade- but t he fundam ent als t hat provided your original prem ise for t he t rade had changed. Do you st ill hold t he posit ion because t he m arket is m oving in your favor, or do you get out because your fundam ent al analysis has changed? = = = = I would definit ely get out . I f m y percept ion t hat t he fundam ent als have changed is not t he m arket 's percept ion, t hen t here's som et hing going on t hat I don't under st and. You don't want t o hold a posit ion when you don't underst and what 's going on. That doesn't m ake any sense. = = = = I 've always been puzzled by t he m ult it ude of banks in t he Unit ed St at es and worldwide t hat have large room s filled wit h t raders. How can all t hese t rading operat ions m ake m oney? Trading is j ust not t hat easy. I 've been involved in t he m arket s for nearly t went y years and know t hat t he vast m aj orit y of t raders lose m oney. How are t he banks able t o find all t hese young t rainees who m ake m oney as t raders? = = = = Act ually, som e of t he large banks have as m any as sevent y t r ading room s worldwide. First of all, not all banks are pr ofit able in t heir t rading every year. = = = = St ill, I assum e t hat t he m aj orit y are profit able for m ost years. I s t his profit abilit y due t o t he advant age of earning t he bid/ ask spread on cust om er t ransact ions, or is it prim arily due t o successful direct ional t rading? = = = = There have been a lot of st udies done on t hat quest ion. A couple of years ago, I read a st udy on t he t rading oper at ions of Cit ibank, w hich is t he largest and probably t he m ost profit able cuirency t rading bank in t he world. They usually m ake about $300 m illion t o $400 m illion a year in t heir t rading operat ions. There is always som e debat e as t o how t hey m ake t hat kind of m oney. Som e people argue t hat Cit ibank has such a franchise in currency t rading t hat m any of t he m arginal t raders and hedgers in t he currency m arket im m ediat ely t hink of Cit ibank when t hey need t o do a t ransact ion- and Cit ibank can earn a wide spread on t hose unsophist icat ed t r ades. Also, Cit ibank has operat ions in m any count ries t hat don't have t heir own cent ral bank. I n t hese count ries, m uch or even all of t he foreign currency t ransact ions go t hrough Cit ibank. The st udy concluded t hat if Cit ibank t raded only for t he bid/ ask spread and never t ook any posit ion t rades, t hey probably would m ake $600 m illion a year. = = = = That would im ply t hat t hey probably lose a couple of hundred m illion dollars a year on t heir act ual direct ional t rading. Of course, t hat would help explain t he apparent paradox posed by m y quest ion- t hat is, how can all t hose t raders m ake m oney? Am I int erpret ing you correct ly? = = = = Personally, t hat 's what I believe. However, t he argum ent wit hin Cit ibank would probably be; " We doubt t hat 's t rue, but even if it were, if we weren't in t he m arket doing all t hat propriet ary t rading and developing inform at ion, we wouldn't be able t o service our cust om ers in t he sam e way." = = = = That sounds like rat ionalizat ion. = = = = Assum e you're a t rader for a bank and you're expect ed t o m ak e $2.5 m illion a year in revenues. I f you break t hat down int o approxim at ely 250 t rading days, t hat m eans you have t o m ake an average of $10,000 a day. Let 's say an unsophist icat ed cust om er who t rades once a year and doesn't have a screen com es in t o do a hedge. You do t he t rade at a wide spread, and right off t he bat you're up $110,000. You know what you do? You spec your buns off for t he rest of t he day . That 's what alm ost ever y currency t r ader in New York does, and it 's virt ually im possible t o change t hat m ent alit y. Because if you are lucky, you'll m ake $300,000 t hat day, and you'll be a fucking hero at t he bar t hat night . And if you give it all back- " Ah, t he m arket screwed m e t oday." = = = = Bot t om line: I f it weren't for t he bid/ ask spread, would t he banks m ake m oney on t heir t rading operat ions? = = = = Probably not in convent ional posit ion t rading in t he way you t hink of it . However, t here is anot her aspect of direct ional t rading t hat 's very profit able. Take Joe Trader. Day in. day out , he quot es bid/ ask spreads and m akes a sm all average profit per t ransact ion. One day a cust om er com es in and has t o sell $2 billion. The t rader sells $2.1 billion, and t he m arket breaks 1 percent . He's j ust m ade $1 m illion on t hat one t rade. = = = = I n a lot of m arket s t hat 's illegal. I t 's called front running. = = = =

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28 I t 's not illegal in t he int erbank m arket . He's not put t ing his order in front of t he cust om er's; he's basically riding his coat t ails. = = = = So he does t he w hole order at t he sam e price? = = = = Generally, t he first $100 m illion would be t he bank's. That 's j ust t he way t he m arket is. = = = = I s t here any difference bet w een t hat t ransact ion and what is norm ally referred t o as front running? ==== Yes, it 's legal m one m arket and illegal in t he ot her. = = = = That 's t he answer from a regulat ory viewpoint . I 'm asking t he quest ion from a m echanical perspect ive: I s t here an act ual difference in t he t ransact ion? = = = = The real answer is no, but I 'll give you t he answer from a bank's perspect ive. When I allow you t o com e in and sell $2 billion in t he foreign exchange m arket , I 'm accept ing t he credit risk and providing t he liquidit y and facilit y t o m ake t hat t rade. I n exchange, you're providing m e wit h t he inform at ion t hat you're about t o sell $2 billion. That is not a t ot ally unreasonable rat ionalizat ion. = = = = How do you m ove a large order like $2 billion? How do you even get a bid/ ask quot e for t hat am ount ? ==== I 'll t ell you what happens. Let 's say an order com es in for $500 m illion or m ore. The dealer st ands up and shout s, " I need calls! " I m m ediat ely, am ong t he dealers, j unior dealers, clerks, and even t he t elex oper at ors, you have fort y people m aking calls. Everyone has t heir own call list s so t hey don't call t he sam e banks. They probably m ake an average of about t hree rounds of calls; so t here ar e 120 calls in all. All of t his is done in t he space of a few m inut es. The dealer act s as a coordinat or- t he bank st aff shout s out bids t o him and he calls back, " Yours! Yours! Yours! " all t he t im e, keeping t rack of t he t ot al am ount sold. A large bank can m ove an am azing am ount of m oney in a few m inut es. = = = = When you get right down t o it , virt ually all t he t rading profit s seem t o com e from profit m argins on t he hid/ ask spread and coat t ailing of large order s. That m akes a lot m ore sense t o m e, because I couldn't figure out how t he banks could hire all t hose kids right out of school who could m ake m oney as t raders. I don't t hink t rading is t hat easily learned. = = = = You know m y pet peeve? I s t hat t rading? Even at Salom on Brot hers, where t here's a percept ion t hat everyone is a t rader, it cam e down t o only about a half- dozen people who t ook real risk. The rest wer e essent ially j ust m aking m arket s. That nuance is lost on m ost people. = = = = Get t ing hack t o t he credit risk associat ed wit h t he int erbank m arket t hat you m ent ioned earlier, when you do a t rade, are you com plet ely dependent on t he credit wort hiness of t he ot her part y? I f t hey go down, are you out t he m oney? = = = = You got it . = = = = Has t hat ever happened t o you? = = = = No. = = = = How oft en does it happen? = = = = I f a t rade involves anyone who is even in quest ion, you can ask t hem t o put up m argin. = = = = I sn't it possible for a bank wit h a good credit rat ing t o suddenly go under? = = = = Suddenly? No. What is t he worst case you can t hink of? Drexel? Salom on st opped doing currency t ransact ions wit h Drexel a year and a half before t hey went under. = = = = Are you saying t hat t here's not m uch of a credit risk involved? = = = = There is som e risk, but does a Cont i fail overnight ? We st opped t rading wit h Cont i five m ont hs before t he Fed bailed t hem out . = = = = But som eone was t rading wit h Cont i in t hose last few m ont hs. Were t hey j ust less well inform ed? ==== Not necessar ily. They were j ust willing t o t ake t he risk. You can be sur e t hat in t hose final m ont hs, Cont i was not dealing at t he m arket . At a cert ain int erest rat e level, you would lend any bank m oney. The reason why surprises don't happen is because it 's in everyone's int erest t o know when t here is a problem . Therefore, credit officers are very quick t o share inform at ion whenever t hey t hink a problem exist s. = = = = Do you ever have dream s about t rades? = = = = On one part icular occasion, I had a very specific dream t he night before a balance- of- t rade num ber was t o be released. I dr eam t t hat t he t rade figure would be a specific num ber; t he revision would be a specific num ber; t he dollar would m ove up t o a cert ain level, and I would buy dollars; t he dollar would m ove up t o a second level, and I would buy m ore dollars; t he dollar would m ove up t o a t hird level, and I would buy yet again; t he dollar would m ove up t o a fourt h level, and I would want t o sell but would buy again. The next day, t he t rade num ber cam e out , and it was exact ly t he sam e num ber as in m y dream . The revision was also exact ly t he sam e num ber. Even t he price sequence was exact ly t he sam e as in m y dream . The only difference was t hat [ he pauses] I didn't t rade at all. = = = = I Why not ? = = = = Because I don't t rade on dream s or rum ors. I 'm a fundam ent al t rader. I t ry t o assem ble fact s and decide what kind of scenario I t hink will unfold. To walk in and t rade on a dream is absurd. I t old m y assist ant about m y dream , and we laughed about it . He said, 'The day you st art t rading on dream s is t he day we m ight as well pack it up." As I wat ched t he price act ion unfold, t he m arket looked good at each of t he price levels. I ronically, if I had

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29 never had ( he dream , I m ight very well have bought dollars. = = = = I n your conscious st at e, you agreed wit h t he basic t rade. Right ? = = = = Absolut ely. = = = = Was it a m at t er of not t aking t he t rade because you didn't want t o appear t o be t rading on a dream ? ==== Very m uch so. Wit hin m yself, I was very confused as t o what was happening. I t was a very odd experience. = = = = Was it sort of shades of t he Twilight Zone? = = = = Just like it . I couldn't believe it . My assist ant and I j ust kept looking at each ot her. When t he t r ade num bers cam e out exact ly as I had dream t , he said, " Billy, com e on, where did you get t hose num ber s?" = = = = Has t his t ype of experience happened t o you at any ot her t im e? = = = = That was t he rim e t hat I rem em ber t he best . I had sim ilar experiences on ot her occasions, but I don't rem em ber t he specifics as clearly. = = = = D o you w a n t m y t h e or y on a logica l e x pla n a t ion ? I 'd love t o hear it . How do you explain picking t he exact num ber? = = = = You work, relax, eat , and lit erally sleep wit h t he m arket s* You have a st orehouse of fundam ent al and t echnical inform at ion em bedded in your m ind. Let 's say t hat because of som e unconscious clues you picked up- m aybe som et hing som ebody said, or som e posit ions you saw cert ain people t ake, or what ever- you t hought t hat t he t rade num bers would be out of line wit h expect at ions. But for som e reason, you didn't want t o t rade on t his expect at ion. Maybe, in t his case, t he expect at ion seem ed irrat ional and you would have felt st upid t rading on it . Maybe you don't like t rading in front of t he release of governm ent num bers because of som e past negat ive experiences. The reason is not im port ant . I 'm j ust m aking up exam ples* The point is t hat it 's easy t o envision how you m ight correct ly ant icipat e an unreleased st at ist ic and why such a proj ect ion m ight occur on a subconscious level* . Your proj ect ion of t he m arket m oving in a cert ain direct ion is even easier t o explain. Given your vast experience, once you were right about t he t rade num bers, it would hardly be surprising t hat you would get t he direct ion of t he m arket right . Even dream ing about t he ex act price levels is not so absurd, because you have an except ional feel for m arket swings. I n fact , j ust t he ot her day, I saw you pause in m idconversat ion t o place a buy order in a plum m eling Aust ralian dollar m arket at what proved t o be t he exact t urning point . All I 'm saying is t hat all t his inform at ion is in your m ind, and it m ay com e out in a dream because, for what ever reason, you haven't t ranslat ed it int o act ion. There is not hing part icularly m yst erious about it . You don't have t o believe in p recognit ion t o explain it . You can even argue furt her t hat playing out scenarios is som et hing t hat I do all t he t im e. That is a process a fundam ent al t rader goes t hrough const ant ly. What if t his happens? What if t his doesn't happen? How will t he m arket respond? What levels will t he m arket m ove t o? = = = = So you t hink t hat not backing up an expect ed scenario by t aking a posit ion will t end t o force it out in t he subconscious m ind as a dream ? = = = = Som et im es- sure. I 'm not speaking as an expert . I 'm not a psychologist , but it seem s logical t o m e. I 'll give you a personal exam ple. Several years ago, I had a st rong feeling t hat t he Canadian dollar w as in t he early st ages of a m ult iyear bull m arket . The m arket had a good upm ove and t hen went int o a narrow consolidat ion. I felt it was going t o go higher, but I was already long four cont ract s, which was a relat ively large posit ion for a single m arket , given m y account size. That night I had a dream t hat t he Canadian dollar j ust went st raight up. The next m orning I cam e in and, right off t he hat , I doubled m y posit ion from four t o eight cont ract s. The m arket went st raight up. I believe t he reason t his proj ect ion cam e out in a dr eam w as t hat m y logical m ind couldn't accept t aking t he t rading act ion dict at ed by m y m arket experience. My logical side said, " How can I double m y posit ion when t he m arket has gone st raight up wit hout even a slight react ion?" Of course, as we bot h know, t rades t hat are t he m ost difficult t o t ake are oft en t he successful ones. = = = = On a som ewhat relat ed t opic, do you believe t hat except ional t raders are aided by accurat e gut feelings about t he m arket s? = = = = Generally speaking, I don't t hink good t raders m ake gut or snap decisions- cert ainly not t raders who last very long. For m yself, any t rade idea m ust be well t hought out and grounded in reason before I t ake t he posit ion. There are a host of reasons t hat preclude a t rader fr om m aking a t rade on a gut decision. For exam ple, before I put on a t rade, I always ask m yself, " I f t his t rade goes w rong, how do I get out ?" That t ype of quest ion becom es m uch m ore germ ane when you're t rading large posit ion sizes. Anot her im port ant considerat ion is t he evaluat ion of t he best way t o express a t rade idea. Since I usually t end not t o put on a st raight long or short posit ion, I have t o give a lot of t hought as t o what part icular opt ion com binat ion will provide t he m ost at t ract ive ret urn/ risk profile, given m y m arket expect at ions. All of t hese considerat ions, by definit ion, preclude gut decisions. Having said t his, t here ar e inst ances when, despit e all m y planning, t rading decisions are m ade t hat m ight best be described as inst inct ive. For exam ple, consider t he sit uat ion when I at t em pt ed t o buy t he Aust ralian dollar t he last t im e you were here. I n t hat part icular inst ance, t he Aust ralian finance m inist er had m ade a st at em ent t o t he effect t hat he didn't care if t he currency lost 10 percent of it s value overnight . How do you react ? Those t ypes of panic sit uat ions are t he inst ances when gut feeling com es int o play. During t he m arket t urm oil t hat followed his

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30 st at em ent , I felt t hat t here was no way t he currency could adj ust even rem ot ely close t o 10 percent before large buyers would com e in and push it t he ot her way. = = = = How far was it down at t he t une you ent ered your buy order? = = = = About 5 percent . Even t hough I was already long a long- t erm posit ion t hat was adversely affect ed by t he news, I j ust felt t hat , over t he short t erm , t he m arket was bound t o rebound. = = = = How do you gauge when a panic has run it s course? = = = = I t hink it 's a com binat ion of m arket ex perience and innat e feel. Many currency t raders operat e under rules t hat if t hey lose a cert ain am ount of m oney, t hey m ust liquidat e t he posit ion. Those are not t he t ype of decisions t hat are m ade rat ionally given t he specific sit uat ion at a given m om ent ; rat her, t hey are gener al rules t hat have been est ablished pr eviously. How do you decide when t hat t ype of last - dit ch selling is nearly exhaust ed? I t 's pr obably largely a m at t er of past experience t hat has suffused your subconscious. I n t his sense, what people describe as gut feel is probably bet t er described as subconscious m arket experience. = = = = What do you believe are t he charact erist ics of t he t ruly superior t raders? = = = = Let m e st art wit h an analogy. When I was in college, m y im pression was t hat people who were really sm art could do very well, even if t hey didn't work t hat hard, and people who really worked hard could also do very well, even if t hey weren't out st andingly bright . I n cont rast , in t rading, I t hink you need bot h elem ent s. The best t raders I know are really quit e brilliant , and t hey all work very hard- m uch harder t han anyone else. By t he way, when I t alk about working hard, I m ean com m it m ent and focus; it has not hing t o do wit h how m any hours you spend in t he office. These t rader s have t r em endous com m it m ent t o t he m arket s- t o t heir craft , so t o speak. They develop scenarios, reevaluat e scenarios, collect inform at ion, and reevaluat e t hat inform at ion. They const ant ly ask t hem selves: What am I doing r ight ? What am I doing wr ong? How can I do what I am doing bet t er? How can I get m ore inform at ion? I t 's obsessive. = = = = I s t his t ype of analysis som et hing t hat 's ongoing during all your waking hours? = = = = Absolut ely. Som e professional t raders m ay claim t hat t hey separ at e t heir personal life from t heir business life and are able t o com plet ely t urn off on t he week ends. I don't believe t hat for a second. I t hink t hat when t hey're relaxing in t heir sailboat s, at som e level t hey're st ill focused on t he m arket . = = = = I know you like t o play golf. When you're out on t he course, are you st ill t hinking about t he m arket s? ==== Probably so. The r eally best t raders ar ound don't t hink t wice about how m any hours t hey're working or whet her t hey com e in on a weekend. There's no subst it ut e for t hat level of com m it m ent . = = = = When you're int erviewing som eone for a j ob as a t rader, how do you det erm ine whet her t hey have t hat t ype of com m it m ent ? = = = = Som et im es it 's obvious. For exam ple, in an int erview som eone m ight ask you, " What t im e do I have t o com e t o work in t he m orning?" I n m y opinion t hat 's a very bizarre quest ion. Com e in what ever t im e you believe is appropriat e. " How lat e do I have t o st ay in t he aft ernoon?" Leave whenever you want . I 'm not going t o t ell som eone when t o com e in and when t o leave. = = = = Besides int elligence and ext rem e com m it m ent , are t here any ot her qualit ies t hat you believe are im port ant t o excel as a t rader? = = = = Courage. I t 's not enough t o sim ply have t he insight t o see som et hing apart from t he rest of t he crowd, you also need t o have t he courage t o act on it and t o st ay wit h it . I t 's very difficult t o be different from t he rest of t he crowd t he m aj orit y of t he t im e, which by definit ion is what you're doing if you're a successful t rader. Many people t hink t hat t rading can be reduced t o a few rules. Always do t his or always do t hat . To m e, t rading isn't about always at all; it is about each sit uat ion. So m any people want t he posit ive rewards of being a successful t rader wit hout being willing t o go t hrough t he com m it m ent and pain. And t here's a lot of pain. = = = = The pain being what ? = = = = You give up a lot of t hings. I t 's all t radeoffs. I t 's t he m iddle of t he night , everyone else is asleep, and you're sit t ing in front of a m achine wit h glowing green num bers, wit h a pain in your psyche because t he m arket is going against you and you don't know whet her t he fundam ent als have changed or whet her it 's j ust a m eaningless short - t erm m ove. Those are very t rying t im es. = = = = Trading is such a pervasive elem ent in your life, including being up half t he night on a regular basis. Does t his obsession, as you yourself t erm ed it a lit t le earlier, creat e a source of frict ion in your m arried life? ==== Not at all. My wife was a bond salesm an at Goldm an Sachs for m any years. Personally, I t hink she would m ake a very good t rader- she has m any of t he right qualit ies- but she doesn't want t o t rade. I wouldn't lessen it by saying sim ply t hat she is underst anding, because t hat sounds so docile. She's m ore t han underst anding; she's fully cognizant , support ive, and I t hink she get s a big t hrill out of what I do. = = = = Why do you t rade? = = = = I like t he gam e. I t hink it 's a great challenge- I t 's also an easy gam e t o keep score of. = = = = Wit h t rading consum ing m ost of your day, not t o m ent ion night , is it st ill fun? = = = = I t 's t rem endous fun! I t 's fascinat ing as hell because it 's different every day. = = = = Would you st ill t rade if t here were no m onet ary rem unerat ion? = = = = Absolut ely. Wit hout quest ion, I would do t his for free. I 'm t hirt y- six years old, and I alm ost feel like I have

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31 never worked. I som et im es can't believe I 'm m aking all t his m oney t o essent ially play an elaborat e gam e. On t he ot her hand, when you look at all t he m oney I 've produced over t he years, I 've been vast ly underpaid. The m ore supert raders I int erview, t he m ore convinced I becom e t hat , at least t o som e degr ee, t heir success can be at t ribut ed t o an innat e t alent . Bill Lipschut z provides an excellent exam ple. His first encount er w it h t rading act ually involved paper t r ading in a college invest m ent course. Lipschut z ended up running a hypot het ical $100,000 int o an incredible $29 m illion by t he end of t he course. Alt hough t his accom plishm ent has t o be t ak en wit h a grain of salt because it didn't involve real m oney and t he rules of t he experim ent were flawed by t he lack of realist ic lim it at ions on leverage, t he result s were st riking nonet heless. Lipschut z's first experience in act ual t rading was pr om pt ed by a $12,000 inherit ance t hat he st eadily built up t o $250,000 over a four- year period. Alt hough he ended up blowing t he ent ire account because of one drast ic m ist ake of wildly overleveraging his posit ion, t hat does not t ake away from t he skill t hat was needed t o produce t he st eady equit y growt h in t he first place. Finally, and m ost im port ant , despit e having had no previous experience what soever in t he currency m arket s, Lipschut z was significant ly profit able in his very first year of t rading t hese m arket s and ext raordinarily profit able over t he next seven years. Alt hough he declines t o quot e any specific figures, it has been est im at ed t hat his t rading alone account ed for an excess of one- half billion dollars in profit s for Salom on Brot hers over his eight - year st ay wit h t he firm . Lipschut z him self cit es hard work and an all- consum ing com m it m ent t o t he m arket s as t he principal ingredient s for his success, Alt hough hard work by it self is not sufficient t o m ake one a great t r ader, it does appear t o be an im port ant ingredient in t he success of m any of t he world's best t r aders. Lipschut z also believes t hat superior int elligence is an im port ant ingredient t o t r ading success. How ever, it should be not ed t hat ot hers whom I have int erviewed ( e.g., Vict or Sperandeo) do not share t his view. One t hem e t hat seem s t o recur in m any of m y conversat ions wit h t he world's t op t raders is t heir view of t he m arket s as a wonderful gam e rat her t han as work. Lipschut z em phat ically claim s t hat , for him , t rading is such an engaging gam e t hat he would do it for free if he had t o. One lesson t hat could be drawn from Lipschut z's t r ading st yle is t hat you don't have t o get in or out of a posit ion all at once. Lipschut z scales in and out of virt ually all his t rades. One sensible piece of advice for m ost t raders is t his: Avoid t he t em pt at ion of want ing t o be com plet ely right . For exam ple, let 's say you becom e convinced t hat a m arket should be bought , but prices have already had a sizable run- up. I n m any inst ances, if t he t rade is really good, by w ait ing for a significant react ion before put t ing on t he ent ire posit ion you are apt t o m iss t he m ove com plet ely. However, by adopt ing a scale- in plan- put t ing on part of t he int ended t ot al posit ion at t he m arket and t he rem ainder on a scale- down basis- you assure t hat you will at least have a part ial posit ion if t he m arket keeps on going, w it hout t he excessive risk t hat w ould be im plied by put t ing on t he ent ire posit ion aft er a large, unint errupt ed advance. As anot her exam ple, assum e t hat you are long wit h a large profit and are concerned about a m arket t op. I f you get out of t he ent ir e posit ion and t he m arket advance cont inues, you can m iss a large part of t he t ot al m ove. On t he ot her hand, if you keep t he ent ire posit ion and t he m arket does indeed t op, you can end up giving back a very large por t ion of t he gain. By using a scale- out approach, you m ay never get t he best out com e, but at t he sam e t im e you will never get t he worst out com e eit her. Also, by using a scale- in and scale- out approach, you can rest rict full posit ions t o t hose inst ances in which your confidence in a t rade is great est . Anot her lesson t o be learned from t his int erview is t hat if you have a st rong convict ion about a t rade and t he m arket has a large m ove because of a news event , t he best decision m ay well be t o bit e t he bullet and buy on ext rem e st rengt h ( or sell on ext rem e weakness) . A perfect exam ple of t his concept was provided by t he way t he t rader in Lipschut z's group handled t rading t he m arket following t he G- 7 m eet ing. I n Market Wizards, Mart y Schwart z m ade t he obser vat ion t hat if a t rade t hat you are very worried about does not t urn out as badly as feared, don't get out . The rat ionale is t hat if t here is no follow- t hrough in a direct ion adverse t o your posit ion, t hen t here m ust be som e very st rong underlying forces in favor of t he direct ion of t he original posit ion ( since t he reasoos- fundam ent al or t echnical- for your own fears are probably shared by m any ot hers in t he m arket place) . A prim e exam ple of t his rule in act ion was provided by t he one t rade t hat Bill Lipschut z adm it t ed scared him . I n t hat inst ance, he was short a very lage dollar posit ion against t he D- m ark in t he m idst of a shan, dot e rally and had t o wait for t he Tokyo opening t o find sufficient liquid, y t o ex, t he posit ion. However, by t he t im e Tokyo opened, t he dollar wa weaker, let t ing him off t he hook easily and t herefor e im plying t hat he shouldn't get out . Lipschut z, being a highly skilled t rader, responded ex act ly right and delayed liquidat ing his posit ion, t hereby recoupingm ost of his loss. One it em I found part icularly curious was t hat . at t er m ore t han four years of st eady t rading gains in his st ock opt ion account . Lipschut z lost virt ually t he ent ire am ount in a few days- nm e. I ronically, t his loss coincided w it h his st art of fall em ploym ent at Salom on Brot hers. I nt erest ingly. as expressed in t he int erview, he had st rong feelings agiuns sim ult aneously t rading personal and com pany account s. The dem ise of his own account , t herefore, played neat ly int o avoiding .m y pot ent sour ce of conflict . I n our conversat ion, Lipschut z insist ed t hat t he loss was probably coincident al since he was only in t he t raining class and not yet aware of any pot ent ial conflict . Despit e Lipschut z- s denial. I couldn't help but be rem inded of t he provocat ive aphorism : " Everybody get s what t hey want out of t he m arket • ." I wondered whet her Lipschut z- s subconscious was perhaps a bit m ore foresight ful t han he realized. I n any case, t he t im ing of t his large loss and it s r elat ive uniqueness in Lipschut z- s t rading career does seem som ew hat ironic. Whet her t his int erpret at ion is st rained com ec ure or

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32 fact . one t hing is cert ain: Lipschut z did indeed get what he want ed- a Perfect j ob, huge t rading profit s, and an absence of conflict bet ween m s personal and com pany t rading. • Ai proposed by Ed Seykola ill Market Wizards.

* * Not e: * * For a few sect ions of t his int erview, a basic underst anding of opt ion t e r m in ology w ou ld be very h e lpfu l. Readers t ot ally unfam iliar wit h opt ions m ay wish first t o r e a d t he prim er provided in t he Appe n dix .

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33 PART III Futures-The Variety-Pack Market

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34 Futures-Understanding the Basics Today s fut ures m arket s encom pass all t he worlds m aj or m arket groups: int erest rat es ( e.g., T- bonds) , st ock indexes ( e.g., t he S&P 500) , currencies ( e.g., Japanese yen) , precious m et als ( e.g., gold) , energy ( e.g., cm de oil) , and agricult ural com m odit ies ( e.g., corn) . Alt hough t he fut ures m arket s had t heir origins in agricult ural com m odit ies, t his sect or now account s for only about one- fift h of t ot al fut ures t rading. During t he past t wo decades, t he int roduct ion and spect acular growt h of m any new cont ract s have result ed in t he financial m arket s ( currencies, int erest rat e inst rum ent s, and st ock indexes) account ing for approxim at ely 60 percent of all fut ures t rading. ( Energy and m et al m arket s account for nearly half of Today's fut ur es m arket s encom pass all t he world's m aj or m arket groups: int erest rat es ( e.g., T- bonds) , st ock indexes ( e.g., t he S&P t he rem aining 40 percent .) Thus, while t he t erm com m odit ies is oft en used t o refer t o t he fut ures m arket s, it has increasingly becom e a m isnom er. Many of t he m ost act ively t raded fut ures m arket s, such as t hose in t he financial inst rum ent s, are not t rue com m odit ies, and m any com m odit y m arket s have no corresponding fut ures m arket s.. Trading volum e in fut ures has expanded t rem endously during t he past gener at ion. I n 1991 t ot al volum e of all fut ures t raded in t he Unit ed St at es alone exceeded 263,000,000. Conservat ively assum ing an average cont act value of at least $40,000, t he t ot al dollar value of t hese cont ract s exceeded $10 t rillion! ( Yes, t rillion, not billion.) The essence of a fut ures m arket is in it s nam e. Trading involves a st andardized cont ract for a com m odit y, such as gold, or a financial inst rum ent , such as T- bonds, for a fut ure delivery dat e, as opposed t o t he present t im e. For exam ple, if an aut om obile m anufact urer needs copper for current operat ions, it will buy it s m at erials direct ly from a producer. I f, however, t he sam e m anufact urer were concerned t hat copper prices would be m uch higher in six m ont hs, it could appr oxim at ely lock in it s cost s at t hat t im e by buying copper fut ures now. ( This offset of fut ure price risk is called a hedge.) I f copper prices clim bed during t he int erim , t he profit on t he fut ures hedge would approxim at ely offset t he higher cost of copper at t he t im e of act ual purchase. Of course, if copper prices declined inst ead, t he fut ures hedge w ould result in a loss, but t he m anufact urer would end up buying it s copper at lower levels t han it was willing t o lock in. While hedgers, such as t he above aut om obile m anufact urer, part icipat e in fut ures m arket s t o reduce t he risk of an adverse price m ove, t rader s part icipat e in an effort t o profit from ant icipat ed price changes. I n fact , m any t raders will prefer t he fut ures m arket s over t heir cash count erpart s as t rading vehicles for a variet y of reasons: 1. St andardized cont ract s- Fut ures cont r act s are st andardized ( in t erm s of quant it y and qualit y) ; t hus, t he t rader does not have t o find a specific buyer or seller in order t o init iat e or liquidat e a posit ion. 2. Liquidit y- All of t he m aj or m arket s provide excellent liquidit y. 3. Ease of going short - The fut ures m arket s allow equal ease of going short as w ell as long. For exam ple, t he short seller in t he st ock m arket ( who is act ually borrowing st ock t o sell) m ust wait for an upt ick before init iat ing a posit ion; no such rest rict ion exit s in t he fut ures m arket s. 4. Leverage- The fut ures m arket s offer t rem endous leverage. Roughly speaking, init ial m argin requirem ent s are usually equal t o 5 t o 10 percent of t he cont ract value. ( The use of t he t erm m argin in t he fut ures m arket is unfort unat e because it leads t o t rem endous confusion wit h t he concept of m argins in st ocks. I n t he fut ures m arket s, m argins do not im ply part ial paym ent s, since no act ual physical t ransact ion occurs unt il t he expirat ion dat e; rat her , m argins are basically good- fait h deposit s.) Alt hough high leverage is one of t he at t ribut es of fut ures m arket s for t raders, it should be em phasized t hat leverage is a t wo- edged sword. The undisciplined use of leverage is t he single m ost im port ant reason why m ost t raders lose m oney in t he fut ures m arket s. I n general, fut ures prices ar e no m ore volat ile t han t he underlying cash prices or, for t hat m at t er, m any st ocks. The high- risk reput at ion of fut ures is largely a consequence of t he leverage fact or. 5. Low t ransact ion cost s- Fut ures m arket s provide very low t ransact ion cost s. For exam ple, it is far less expensive for a st ocJc port folio m anager t o reduce m arket exposure by selling t he equivalent dollar am ount of st ock index fut ures cont ract s t han by selling individual st ocks. 6. Ease of offset - A fut ures posit ion can be offset at any t im e dur ing m arket hours, providing prices are not locked at lim it - up or lim it - down. ( Som e fut ures m arket s specify daily m axim um price changes. I n cases in which free m arket forces would norm ally seek an equilibrium price out side t he range of boundaries im plied by price lim it s, t he m arket will sim ply m ove t o t he lim it and virt ually cease t o t rade.) 7. Guarant eed by exchange- The fut ures t rader does not have t o be concerned about t he financial st abilit y of t he person on t he ot her side of t he t rade. All fut ures t ransact ions are guar ant eed by t he clearinghouse of t he exchange. Since, by t heir very st ruct ure, fut ures are closely t ied t o t heir underlying m arket s ( t he act ivit y of arbit rageurs assures t hat deviat ions are relat ively m inor and short - lived) , price m oves in fut ures will very closely parallel t hose in t he corresponding cash m ar ket s. Keeping in m ind t hat t he m aj orit y of fut ures t rading act ivit y is concent rat ed in financial inst rum ent s, m any fut ures t r aders are, in realit y, t raders in st ocks, bonds, and currencies. I n t his cont ext , t he com m ent s o- f fut ures t raders int erview ed in t he following chapt ers have direct relevance even t o invest ors who have never vent ured bey ond st ocks and bonds. Not e: This chapt er was adapt ed from Jack Schwager, Market Wizards ( New York: New York I ? I nst it ut e of Finance, 1989) .

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35 Randy McKay: Veteran Trader There ar e few fut ures t r aders who have gone from a st art ing account of several t housand dollars t o double- digit m illion- dollar gains. Those who have kept t heir winnings are even fewer. I f we now add die st ipulat ion of holding a t went y- year record of highly consist ent profit abilit y, w e are dow n t o about t he sam e num ber as t here are Republican support ers of Teddy Kennedy. Randy McKay is one of t hose individuals ( a consist ent t rader, t hat is- I don't know what his polit ical leanings are) . The st art of McKay's t rading career coincided wit h t he birt h of currency fut ures t rading. Alt hough currencies have becom e am ong t he m ost act ively t raded fut ures m arket s, at t heir incept ion t hey were m oribund. I n t hose days, t he currency t rading ring was so quiet t hat in t he list of daily act ivit ies conduct ed in t he pit , t rading was probably a dist ant t hird t o newspaper reading and board gam es. Yet , alt hough t he currency fut ures m arket 's survival was init ially in quest ion, McKay's success as a t rader was never in doubt . Despit e t he lack of act ivit y, McKay was able t o parlay an init ial $2,000 st ake int o $70,000 in his first calendar y ear in t he business ( act ually, a seven- m ont h t im e span) . McKay cont inued his success, m aking m ore m oney each year t han in t he previous year. This pat t ern of st eadily increasing annual gains was br oken when McKay decided t o swit ch from t rading on t he floor t o t rading at hom e. He quickly m ade t he necessary adj ust m ent s, however, and by his second year of t rading from hom e, he regist ered his first m illion- dollar gain. McKay cont inued t o increase his winnings each successive year unt il 1986, when he suffered his first t rading loss. Prior t o t hat point , he had st rung t oget her seven consecut ive m illion- dollar- plus years in his own account . Over his ent ire t rading career, McKay has been profit able for his own account in eight een out of t went y years. A conservat ive est im at e would place his cum ulat ive earnings in t he t ens of m illions. McKay has also m anaged a handful of account s for fam ily and friends. The t wo oldest account s, which were init iat ed in 1982 wit h a st art ing equit y of $10,000, have each generat ed cum ulat ive earnings in excess of $1 m illion. Despit e his great success in t he m arket s, McKay has m aint ained a very low profile. Unt il recent ly, even wit hin t he indust ry, few people had heard of him , m yself included. McKay, however, has decided t o ent er t he world of m oney m anagem ent , a t ransit ion t hat requires at least a m odest ly higher public profile. The int erview was conduct ed in McKay's office during t rading hours. Alt hough McKay t raded int erm it t ent ly t hroughout t he int erview, he seem ed t ot ally focused on our conversat ion, wit h t he except ion of when he m ade act ual t rading decisions. I found McKay r efreshingly open about his personal ex periences and his t hinking process in regards t o t he m arket s. = = = = How did you first get involved in t his business? = = = = I n 1970, I ret urned from a t our of dut y in Viet nam ... = = = = Before you cont inue, I 'm curious, were you draft ed or did you volunt eer? = = = = I was draft ed. I n m y second year of college, I learned t o play bridge and becam e addict ed t o t he gam e. I played day and night and skipped all m y classes. My lack of at t endance led t o six Ps. I flunked out and was im m ediat ely draft ed by t he m arines. = = = = I didn't know t hat t he m arines draft ed recruit s. = = = = They norm ally don't . However, t here were t wo m ont hs in 1968- April and May- in which t hey were allowed t o t ake eight t housand draft ees. = = = = Did you t ry t o avoid get t ing draft ed? = = = = I didn't have t o be draft ed. My fat her was a colonel in t he reser ves and he could easily have got t en m e a cushy j ob in t he reserves. = = = = How com e you didn't t ake t hat opt ion? = = = = At t he t im e, I felt it was m y obligat ion t o serve. I guess I was a conservat ive kid. I felt t hat if I accept ed t he privileges of being a U.S. cit izen, I also had t o accept t he responsibilit ies. = = = = Did you have any personal opinions about t he war at t he t im e? = = = = I t hought it was a st upid war, but I felt t hat we elect ed leaders and t hey m ade t he decisions. = = = = You m ake it sound like it was a m at t er of civic responsibilit y. = = = = That 's exact ly t he way I felt about it before Viet nam . During and aft er t he war, m y feelings changed drast ically. = = = = I n what way? = = = = One of t he experiences t hat will always be wit h m e is st anding guard dut y, which is som et hing every one did regardless of his j ob. I would hear a noise in t he bushes and t hink, " What is t hat ?" Of course, t he worst possibilit y was t hat it was one of t he enem y sneaking up t o t ry t o shoot m e. I would t hink; t o m yself, " This is t he enem y; I really want t o kill him ." Then I t hought about who was really out t here. I t was probably a young kid j ust like m e. He didn't hat e m e; he was j ust doing what his superiors t old him t o do- j ust like m e. I rem em ber t hinking, " What 's going on here? Here's a kid who's as scared as I am , t rying t o kill m e, and I 'm t rying t o kill him ." I st art ed t o r ealize t hat war is insanit y. I t doesn't m ake t he slight est bit of sense for count ries t o t ry t o set t le t heir polit ical differences by sending t heir children out t o kill each ot her and whoever kills t he m ost people get s t he piece of land. The longer I was in Viet nam , and t he m or e personal m y experiences becam e, t he m ore int ent ly I felt t hat war was insanit y. = = = = I t alm ost sounds as if t he war m ade you a pacifist . = = = = Very m uch so.

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36 = = = = What about t he rest of t he unit ? Was t here any prevailing sent im ent about t he war? = = = = There was a pret t y wide range of feelings, but m ost of t he unit leaned t o t he hawkish side. Most of t hem t hought t hat we were doing t he right t hing; t hat we were t her e t o help free t hese people from com m unism . I don't know if t hey were, as we say in t he m arket s, " t alking t heir posit ion," or whet her t hey really believed it . = = = = Did you get int o argum ent s because your beliefs were different ? = = = = I t ried t o avoid it . You have t o rem em ber t hat t he m arines were alm ost all volunt eer. Therefore, t he people who were t here believed in what t hey were doing. Their backgrounds were very different from m ine. Few of t hem were college educat ed. A num ber of t hem cam e from st reet gangs. Som e were even t here because t he j udge had given t hem a choice bet ween j ail and probat ion on condit ion of j oining t he service. = = = = Did you feel out of place? = = = = I felt very m uch out of place. I was in an art illery unit . Each hour we received weat her r eport s, which we were supposed t o use t o derive a com posit e adj ust m ent fact or. We filled out a form specifying t he wind . direct ion and velocit y, air densit y, t em perat ure, r ot at ion of t he eart h, ; and ot her fact ors and perfor m ed a m at hem at ical process t o derive a net t fact or. Every t im e t he weat her report cam e in, it becam e a gam e t o see I s who could derive t his fact or m ost quickly. Before I was t here, t he speed & record was ninet een seconds. On m y second day t here, I broke t he record, and I event ually got t he t im e down t o nine seconds. I t hought t his was great fun. Lit t le did I realize t hat I was m aking enem ies by t he t ruckload. The people who were t here pr eferred t he new guy s being ignorant so t hat t hey could have t he feeling of helping t o bring t hem along. Here I was, a new guy, a college kid, doing t hings bet t er and fast er t han t hey were. I also got t hree pr om ot ions in m y first four m ont hs, which was unheard of in t he m arines. All of t his didn't go over t oo well. I t t ook m e a while, but I finally realized t hat being a college hot shot was doing m e a lot m ore harm t han good. I m ade an effort t o blend in bet t er, wit h m odest success. = = = = Were you in sit uat ions in which your unit was in direct line of fire? = = = = Oh sure. We were bom barded by m ort ars and rocket s nearly every ot her day, and t here were about a dozen t im es when we were in face- t o- face com bat wit h t roops t rying t o overrun our posit ion. However, for t he m ost par t , t he great est danger was t hat art illery pieces were prim ary t arget s for t he Nort h Viet nam ese t roops and Viet cong. = = = = What was t he em ot ional response t o going from civilizat ion int o a sit uat ion where your life was being t hreat ened alm ost daily? = = = = There are t wo responses one has. The first is fear. I rem em ber get t ing off t he plane in Da Nang, wit h gunfire all around, and being rushed int o t he back of a j eep. Ther e were repeat ed burst s of gunfire t hroughout our ride t o t he base cam p. We had our weapons wit h us, but we had no exper ience in shoot ing at people. I was absolut ely t errified. Aft er a few m ont hs, t he prim ary feeling changed from fear t o boredom . Once you get used t o t he idea t hat you m ight die, you're faced w it h a sixt een- hour w orkday in absolut ely horrible condit ions. Eit her it was 110 degr ees wit h dust blowing in your face, or during t he m onsoon season you were knee- deep in m ud and freezing, even t hough t he t em perat ure was about 50 or 60 degr ees. = = = = Did t he fear dissipat e aft er a while? = = = = There is always fear, but you get used t o it . There were even t im es when an at t ack was alm ost welcom e because it helped break up t he boredom . I don't m ean t hat t o sound flip- som e of m y friends were killed or lost t heir arm s and legs in t hese at t acks- but aft er a few m ont hs, t he boredom becam e a bigger problem t han t he fear. = = = = Did you have any experiences in hand- t o- hand com bat in which you know t hat you killed som ebody? ==== Yes and no. I know t hat I personally killed people, but t here w ere no specific inst ances in w hich I fired and saw som eone drop. Firefight s are different in realit y t han t hey are on TV. You don't fire single shot s at specific t arget s. I nst ead, you put your rifle on aut om at ic and put out as m uch lead as you can. I know t hat I killed people wit h m y rifle and cert ainly wit h t he art illery shells t hat I was direct ing, but fort unat ely I never had t he experience of seeing a person bleed t o deat h by m y bullet . I 'm very t hankful for t hat . I have night m ares t o t his day, but I 'm sure m y night m ares would be m uch worse if I had t hat experience. = = = = Night m ares because you were t he inst rum ent of deat h? Or because y ou were exposed t o deat h? ==== Night m ares from being exposed t o deat h. The one night m are I st ill have t o t his day is being chased by people wit h rifles. My feet get bogged down; I can't m n fast enough; and t hey're gaining on m e. = = = = While you were in Viet nam , did you feel t hat you were going t o com e out of it alive? = = = = I guess you'r e always an opt im ist in t hat t ype of sit uat ion. I t hought I would, but I cert ainly had plent y of friends who didn't . I knew t hat was a possibilit y. But you can't have an anxiet y at t ack every t hirt y seconds for a year. Event ually, your m ind forces you t o get used t o t he idea t hat you m ight die or lose a leg, and you go on. = = = = How did t he Viet nam experience change you? = = = = The m aj or change was t hat I went from being a rule follower t o t hinking for m yself. When I realized t hat t he leaders in t he count ry didn't necessarily know what t hey were doing, I becam e m uch m ore independent . = = = = Given t hat you cam e out of Viet nam in one piece, in ret rospect do you consider it a beneficial experience? = = = =

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37 The discipline of boot cam p and learning t hat war is insanit y were beneficial experiences. Out side of t hat , it was largely a wast e of t wo years. I used t o have philosophical argum ent s wit h one of t he ot her m em bers of t he fire direct ion cont rol unit . I would argue t hat I would prefer t o be put t o sleep for t wo years and t hen be awakened rat her t han t o go t hrough t he act ual experience. He argued t hat any experience was wort hwhile. = = = = How do you feel now? = = = = The sam e w ay. I feel t hat it was t wo years st olen out of m y life. When I was in Viet nam , t he t er m for everywhere else was " t he world." " What 's happening in t he world?" " I want t o get back int o t he world." We felt as if we had not only been rem oved from our hom e and friends but from t he ent ire world as well. I t was as if we were in anot her dim ension. = = = = I guess t he day you left m ust have been one of t he best days of your life. = = = = Absolut ely! I 'll never forget t he feeling. I had a window seat . When I saw t hat runway in Da Nang get t ing fart her and fart her away, I felt as if I were on m y way up t o heaven. = = = = I 'm afraid we got off on a bit of a t angent Before I int errupt ed you, I had asked how you becam e a t rader. = = = = Since I didn't finish college before I left for Viet nam , I needed a j ob t hat would allow m e t o go t o school at t he sam e t im e. My brot her , Terry, was a floor broker on t he Chicago Mercant ile Exchange [ CME] . He got m e a j ob as a runner on t he floor, which allowed m e t o work in t he m orning, at t end school in t he aft ernoon, and st udy in t he evening. I worked as a r unner for a couple of year s wit h absolut ely no int ent ion of get t ing int o t his business, or for t hat m at t er any ot her business. I was st udying t o be a clinical psychologist . = = = = Obviously you changed your m ind at som e point . What happened? = = = = Just at t he t im e I w as finishing college, in 1972, t he CME launched a subdivision, t he I nt ernat ional Monet ary Market [ I MM] , t o t rade curr encies. At t he t im e, CME seat s were selling for $100,000, which is equivalent t o nearly $500,000 t oday. The seat price was such an ast ronom ical am ount t o m e t hat becom ing a floor t rader didn't even appear t o be a rem ot e possibilit y. When t he exchange st art ed t he I MM division, t hey sold seat s for only $10,000 in an effort t o t ry t o get bodies int o t hese new t rading pit s. They also gave away free I MM seat s t o all exist ing m em bers. As a m em ber, m y brot her received one of t hese seat s. He had no part icular need for t his seat at t he t im e, and he asked m e if I 'd like t o use it in t he int erim . While working on t he floor, I had becom e int erest ed in t he m echanics of t he m arket . I had always liked j uggling num bers and playing st rat egy gam es, such as bridge and chess. I enj oyed wat ching prices fluct uat e and t rying t o out guess t he m arket . I t hought t hat t rading m ight be an int erest ing t hing t o do. = = = = You said t hat your st udies were direct ed t oward a career goal of being a clinical psychologist Did you see a connect ion bet ween psychology and t he m arket s? = = = = As a m at t er of fact , I did. While I was on t he floor during t hose t wo years, I realized t hat prices m oved based on m e psychology of t he people who were t rading. You could act ually see anxiet y, greed, and fear in t he m arket s. I found it v ery int erest ing t o follow t he cust om ers' m oods and t o see how t hese em ot ions t ranslat ed int o orders and ult im at ely int o m arket price m ovem ent s. I was fascinat ed by t he process. I decided t o accept m y br ot her's offer. He gave m e t he use of t he seat and lent m e $5,000. I put $3,000 in t he bank t o pay m y living expenses, and I used t he $2,000 for m y t rading account . = = = = As I recall, currency fut ures didn't t rade very m uch in t he first couple of years. = = = = That 's right . There was a bit of act ivit y m t he first few weeks t he cont ract s t raded, but once t he novelt y wore off, t he m arket liquidit y com plet ely dried up. I n an effort t o keep t he m arket alive, each day t he president of t he exchange, Leo Melam ed, who had conceived and spear- headed currency fut ures, would collar t raders m t he livest ock pit s once t hose m arket s had closed and caj ole t hem int o t rading in t he curr ency pit . Thus, t he currency fut ures m arket s were dead all day long, but t hen t here was a sm all flurry of act ivit y aft er t he livest ock m arket s closed. For m ost of t he day, t hough, we j ust sat around playing chess and backgam m on. = = = = How did you m anage t o t rade t he m arket s during t hose years of m inim al liquidit y? = = = = A few lim it orders [ buy or sell orders indicat ing a specific execut ion price] would com e in from t he brokerage houses. I n t hose days, t he prices were st ill post ed on a chalkboard. I f I saw som eone buying up all t he offers in t he Swiss franc, I would buy t he offers in t he Deut sche m ark. I had no idea, however, as t o t he probable direct ion of t he overall price m ove. On average, I m ade about t wo t rades per day. = = = = That doesn't sound like very m uch. Given t he m arket very lim it ed liquidit y, how m uch were you m aking off your t rading? = = = = Currency t rading began in May 1972. By t he end of t hat calendar year, I had m ade $70,000, which was a sum beyond m y wildest dr eam s. = = = = I t 's am azing t hat you could have m ade so m uch in such an inact ive m arket * = = = = I t is. Part of t he explanat ion is t hat t he price inefficiencies were very great m t hose days because of t he t rem endous am ount of ignorance about t he currency m arket s. For exam ple, we didn't even realize t hat t he banks were t rading forward currency m arket s, which were exact ly equivalent t o fut ures. = = = = Did you cont inue t o m eet success aft er your init ial year? Were t here any pivot al t rades in t hose first years? = = = = I read your ot her book [ Market Wizards] . There are t raders you int erviewed whom I respect t rem endously. Many of t hem t alked about t heir early experiences of going broke t wo or t hree t im es befor e t hey m ade it . I didn't have t hat experience. I don't want t o sound arrogant , but I was successful at t rading

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38 right from t he st art . The t rade t hat w as a t urning point for m e was t he one t hat t ook m e from being a t went y- t o- fort y- lot t rader t o t rading hundreds of cont ract s. I n 1976, t he Brit ish governm ent announced t hat t hey weren't going t o allow t he pound t o t rade above $1.72. They were concer ned t hat t he pound's st r engt h would lead t o incr eased im port s. At t he t im e, t he pound was t rading in m e m id- 160s. To m y surprise, t he m arket responded t o t he announcem ent by im m ediat ely going t o $1.72. The pound t hen fell back t o $1.68 and rebounded again up t o $1.72. Ever y t im e it reached $1.72, it fell back, but by sm aller and sm aller am ount s each t im e. The price range st eadily converged unt il t he pound was t rading narrowly j ust below t he $1.72 level. Most of t he people I knew said, " They're not going t o let it go above $1.72. We m ight as w ell sell it . I t 's a no- risk t rade." I saw it different ly. To m e, t he m arket looked like it was locked lim it - up. [ I n m any fut ures m arket s, m e m axim um daily price change is rest rict ed by a specified lim it . " Lim it - up" refers t o a price rise of t his m agnit ude. When t he m arket 's nat ural equilibrium price lies above t his lim it price, t he m arket will lock at t he lim it - t hat is, t rading will virt ually cease. The reason for t his is t hat t here will be an abundance of buyers but alm ost no sellers at t he rest rict ed lim it - up price.] I felt t hat if t he governm ent announced t hat t hey weren't going t o let t he price go above a cert ain level and t he m arket didn't break, it indicat ed t hat t her e m ust be t rem endous underlying dem and. I t hought t o m yself, " This could be t he opport unit y of a lifet im e." Up t o t hat point in t im e, t he largest posit ion I had ever t aken was t hirt y or fort y cont ract s. I went long t wo hundred Brit ish pound cont ract s. Alt hough int ellect ually I was convinced t hat I was right , I was scared t o deat h because t he posit ion was so m uch larger t han what I had been t rading. I n t hose days, t here was no Reut ers or sim ilar service providing cash m arket quot es in t he currencies. I was so nervous about m y posit ion t hat I woke up at five o'clock each m orning and called t he Bank of England t o get a quot e. I would m ut t er som et hing about being a t rader from Cit iBank or Harris Trust and needing a quot e quickly. I would norm ally t alk t o som e clerk who t hought I was a big shot , and he would give m e t he quot es. One m orning, I m ade t he call from m y kit chen, and when I asked t he clerk for t he quot e, he answered, 'The pound is at $1.7250." I said, " What ! ? You m ean $1.7150, don't you?" " No; ' he replied. " I t 's $1.7250." I realized t hat was it . By t hat t im e, I had got t en m y brot her and a num ber of m y friends int o t he t rade, and I was so excit ed t hat I called all of t hem wit h t he news. I was so confident t hat I even bought som e m ore cont ract s for m yself. I t hen j ust sat back and wat ched t he m arket ride all t he way up t o t he $1.90 level. = = = = How long did it t ake for t he m arket t o get up t hat high? = = = = About t hree or four m ont hs. = = = = Weren't you t em pt ed t o t ake profit s in t he int erim ? = = = = Once t he m arket pushed past t he $1.72 level, it was like wat er breaking t hrough a dam . I knew t here was going t o be a big m ove. = = = = How did you decide on $1.90 as t he level for get t ing out ? = = = = I t hought t hat , as a round num ber, it would be a psychologically crit ical area. Also, I t hink $1.90 had been an im port ant chart point on t he way down. The day t hat I got out was one of t he m ost excit ing days of m y life. I had a t ot al of fourt een hundred cont ract s t o sell, because I had t alked everyone t hat I knew int o t he posit ion. That m orning, it seem ed like everyone in t he world was buying, arbit rageurs included. I w ent int o t he pit and st art ed hit t ing all t he bids. I t last ed for about fort y- five m inut es. I was so excit ed t hat I act ually ended up selling four hundred cont ract s m ore t han I was supposed t o. When t he im pact of m y selling finally hit t he bank m arket , t he pound fell about a hundred point s, and I act ually ended up m aking m oney on t hose four hundred cont ract s as well. = = = = What part of t he fourt een hundred cont ract s represent ed your own posit ion? = = = = About four hundred cont r act s. = = = = How m uch did you end up clearing on t he t rade? = = = = About $1.3 m illion. = = = = I assum e t hat up t o t hat point your m axim um profit had been under $100,000. = = = = Correct . But t he m ost im port ant t hing about t hat t rade was t hat it propelled m e int o being a hundred- lot t rader. One of m y goals at t he t im e was t o becom e a larger t rader as quickly as possible, because I felt t he business was j ust t oo dam n easy and t hat it couldn't possibly last forever. Fort unat ely I had t hat insight , because t rading is m uch m ore difficult now t han it was t hen. = = = = The insight being t hat t hose were really good days t o be involved in t he m arket ? = = = = Right . Many of t he people I knew were spending m oney as fast as t hey were m aking it , assum ing t hat t hey would be able t o cont inue m aking t he sam e rat e of ret urn ad infinit um . I n cont rast , I t hought t hat som e day t he opport unit y wouldn't be t here. = = = = When did t hings change? = = = = The m arket s st art ed get t ing m ore difficult during t he 1980s. The high inflat ion of t he 1970s led t o m any large price m oves and heavy public part icipat ion in t he m arket s. The declining inflat ion t rend in t he eight ies m eant t here were fewer large m oves, and t hose price m oves t hat did occur t ended t o be choppier. Also, m ore oft en t han not , t he price m oves were on t he downside, which led t o reduced public act ivit y, because t he public always likes t o be long. Therefore, you ended up wit h m ore professionals t rading against each ot her. = = = = What about t oday [ 1991] , when t he professionals account for an even larger port ion of t ot al t rading

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39 act ivit y, while inflat ion rat es have rem ained low? Has t rading becom e even m ore difficult ? = = = = Trading has not only becom e m uch harder, but it has also changed. I n t he 1970s, t he price m oves were so large t hat all you had t o do was j um p on t he bandwagon. Tim ing was not t hat crit ical. Now it 's no longer sufficient t o assum e t hat because you t rade wit h t he t rend, you'll m ake m oney. Of course, you st ill need t o be wit h t he t rend, because it put s t he percent ages in your favor, but you also have t o pay a lot m ore at t ent ion t o where you're get t ing in and out . I would say t hat in t he 1970s prognost icat ion was 90 percent and execut ion 10 percent , whereas t oday prognost icat ion is 25 percent and execut ion 75 percent . = = = = You provided a good exam ple of prognost icat ion in t he Brit ish pound t rade you t alked about earlier. However, can you generalize your approach in forecast ing prices? = = = = I wat ch t he m arket act ion, using fundam ent als as a backdrop. I don't use fundam ent als in t he convent ional sense. That is, I don't t hink, " Supply is t oo large and t he m arket is going down." Rat her, I wat ch how t he m arket responds t o fundam ent al inform at ion. = = = = Give m e a specific exam ple. = = = = Over t he past year or t wo, we've had a severe recession- probably worse t han t he governm ent is adm it t ing- t he worst real est at e bust since t he depr ession, and a war. Moreover, t he m arket should have been part icularly vulnerable aft er a nine- year advance. I n t he m idst of all t his negat ive news, t he st ock m arket has hardly budged, and we're st ill t rading j ust below all- t im e highs. The fact t hat t he st ock m ar ket has been a lot st ronger t han it should have been t ells m e t hat it 's likely t o go higher. = = = = Can you give m e anot her exam ple? = = = = On t he eve of t he U.S. air war against I raq, gold was t rading near t he crucial $400 level. The night our planes st art ed t he at t ack, gold went from $397 t o $410 in t he Far East m ar ket s and closed t he evening at about $390. Thus, gold had broken t hrough t he crit ical $400 level, st art ing t he rally t hat everyone ex pect ed, but it finished t he evening significant ly low er, despit e t he fact t hat t he Unit ed St at es had j ust ent er ed t he war. The next m orning, t he m arket opened very sharply lower and it cont inued t o m ove down in t he following m ont hs. = = = = I 'll keep pum ping you for exam ples, as long as you can t hink of t hem . Any ot hers? = = = = During t he past sum m er, soybean prices were t rading at relat ively low levels j ust under $6.00. I n close proxim it y, we w it nessed a dry spell as t he crit ical phase of t he growing season approached, and we saw dram at ically im proved relat ions wit h t he Soviet Union, which enhanced t he chances of increased grain sales t o t hat count ry. Export sales and m e t hreat of drought have always been t he t wo prim ary price- boost ing fact ors. Here we had bot h t hese fact ors occurr ing at t he sam e t im e, wit h prices at relat ively low levels. Not only did soybeans fail t o m anage m ore t han a short - lived, m oderat e rally, but on balance prices act ually m oved lower. I n t his cont ext , t he m ore recent price break down t o t he $5.30 level w as alm ost inevit able. I f prices couldn't sust ain an advance wit h large export s expect ed t o t he Soviet Union and t he t hreat of a drought , what could possibly rally t he m arket ? = = = = Besides t he Brit ish pound t rade we discussed earlier, what ot her t rades st and out as part icularly prom inent in your t went y- year career? = = = = One of m y favorit e t rades was being short t he Canadian dollar from about 85 cent s down t o under 70 cent s during t he early 1980s. Up unt il about five years ago, t he Canadian governm ent had a policy of not int ervening aggressively t o support it s currency. I t would int ervene halfheart edly at obvious point s ( for exam ple, 120 t o t he U.S. dollar, 130, 140) for a few days and t hen let t he Canadian dollar go. I t was a very easy m ove. I was able t o hold bet ween one t housand and fift een hundred cont ract s for virt ually t he ent ire decline, which spanned five years. = = = = Was t he fact t hat t he governm ent was int ervening t o support t he Canadian dollar, albeit inefficient ly, a reinforcem ent for being in t he t rade? I n fact , is t hat one of t he t hings you look for in a currency t rade- being on t he opposit e side of t he int ervent ion t rend? = = = = Exact ly. Of course, you have t o be careful in sit uat ions where int ervent ion m ight be for ceful. But as I m ent ioned, at t he t im e, int ervent ion in t he Canadian dollar was never forceful. That governm ent policy, however, changed in t he course of t he price m ove I 'm t alking about . The Canadian dollar event ually declined t o 67 cent s. Then, one day, it opened 120 point s higher. The next day it opened 120 point s higher again. My profit s declined by over $1 m illion on each of t hese t wo successive days, which helped wake m e up a lit t le bit . On t he t hird day, t here was a st ory on Reut ers quot ing Prim e Minist er Mulroney, and I 'm paraphrasing here, " We will not allow Chicago speculat ors t o det erm ine t he value of our currency. Our currency is solid and we will not perm it it t o fall apart because of a bunch of gam blers." Touche. = = = = I t ake it t hat you got out at t hat point . = = = = Right , t hat was t he end of it . When t he t rade was easy, I want ed t o be in, and when it wasn't , I want ed t o be out . I n fact , t hat is part of m y general philosophy on t rading: I want t o cat ch t he easy part . = = = = How do you define t he " easy part " ? = = = = I t 's t he m eat of t he m ove. The beginning of a price m ove is usually hard t o t rade because you're not sure whet her you're right about t he direct ion of t he t r end. The end is hard because people st ar t t aking profit s and t he m arket get s very choppy. The m iddle of t he m ove is what I call t he easy part . = = = = I n ot her words, t he m arket s you^ re least int erest ed in are t he t ops and bot t om s. = = = = Right . I never t ry t o buy a bot t om or sell a t op. Even if you m anage t o [ pick t he bot t om , t he m arket can end up sit t ing t here for years and t ying up your capit al. You don't want t o have a posit ion before a m ove has

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40 st art ed. You want t o wait unt il t he m ove is already under way before you get int o t he m arket . = = = = Do you see t hat as a m ist ake t hat m any t raders m ake, spending t oo m uch effort t rying t o pick t ops and bot t om s? = = = = Absolut ely. They t ry t o put t heir own opinion of what will happen before t he m arket act ion. = = = = You t alked earlier about t he general desirabilit y of being on t he opposit e side of cent ral bank int ervent ion. Let 's t alk about sit uat ions in which such int ervent ion is very forceful. To t ake a specific case, in Novem ber 1978 t he Cart er dollar rescue plan, which was announced over a weekend, caused a huge overnight price break in foreign currencies. I assum e t hat , being a t rend t rader, you m ust have been long going int o t hat announcem ent . = = = = I was ext rem ely long, but I had liquidat ed over half m y posit ion a week earlier. = = = = I don't underst and. What was your m ot ivat ion for liquidat ing part of t he posit ion? As I recall, t here was no evidence of any weakness before t he act ual announcem ent . = = = = The upm ove was decelerat ing inst ead of accelerat ing. I t 's possible t o see m arket weakness even when prices are st ill going up and set t ing new all- t im e highs. I had been long bot h t he Deut sche m ark and Brit ish pound. I sold m y Deut sche m ark posit ion and kept t he Brit ish pound. = = = = Can you describe what your response was on Monday m orning when t he m arket opened drast ically lower? = = = = I knew t he m arket was going t o open sharply lower well before t he opening. I w as very lucky in being able t o get a couple hundred cont ract s sold in t he fut ures m arket s, which was locked lim it - down. [ Since t he cash currency m arket was t rading far below t he perm issible daily lim it decline in fut ures, t here was a plet hora of sellers at t he lim it - down price, but virt ually no buyers; hence, t he m arket was locked lim it - down. Presum ably, t here were som e naive buy orders on t he opening from t raders who didn't realize t hat t he cash m arket was discount ing an addit ional t w o lim it - down days in fut ures, and t hese were t he orders t hat part ially offset McKay's sell order. I liquidat ed t he rest of t he posit ion in t he bank m arket , which was down about 1,800 point s [ equivalent t o approxim at ely t hree lim it - down m oves in fut ures] . = = = = You j ust t ook t he 1,800 point loss on t he first day? = = = = Of course. = = = = Would t he loss have been great er if you wait ed unt il t he fut ures m arket t raded freely? = = = = I t would ha ve been a lit t le worse. = = = = I n cat ast rophic sit uat ions, when a surprise news event causes fut ures t o lock at t he daily lim it and t he cash m arket t o im m ediat ely m ove t he equivalent of several lim it days in fut ures, do you find t hat you're generally bet t er off get t ing out right away, as opposed t o t aking your chances by wait ing unt il t he fut ures m arket t rades freely? = = = = There's a principle I follow t hat never allows m e t o even m ake t hat decision. When I get hurt in t he m arket , I get t he hell out . I t doesn't m at t er at all where t he m arket is t rading. I j ust get out , because I believe t hat once you're hurt in t he m arket , your decisions are going t o be far less obj ect ive t han t hey are when you're doing well. And if t he m arket had rallied 1,800 point s t hat day t o close higher, I couldn't have cared less. I f you st ick around when t he m arket is severely against you, sooner or lat er t hey're going t o carry you out . = = = = How m uch did you end up losing in t hat overnight break? = = = = About $1.5 m illion. = = = = I assum e t hat was your worst loss up t o t hat point . = = = = I t was. = = = = Can you describe what your em ot ions were at t he t im e? = = = = As long as you're in t he posit ion, t here's t rem endous anxiet y. Once you get out , you begin t o forget about it . I f you can't put it out of your m ind, you can't t rade. = = = = What ot her t rades in your career st and out for one reason or anot her? = = = = Are we t alking bot h winners and losers? * * Sure* * . [ He laughs.] I m issed t he giant gold rally in 1979, which culm inat ed in early 1980. I had t rem endous anxiet y at t acks about m issing t hat m ove. = = = = Can you t ell m e why you m issed it ? = = = = The m arket sim ply ran away from m e. Every day I t hought , "I f only I had bought it yest erday, I would have been OK." But I had a t wofold problem . First , here was one of t he great est price m oves in t he hist ory of com m odit ies, and I was m issing it . Second, t he cash I had in t he bank was st eadily losing value because of t he inflat ionary environm ent . I felt really horrible about t he sit uat ion. I finally ended up buying gold on t he exact day it m ade it s high. I bought fift y cont ract s- The next day, t he m arket opened $150 lower. I was out $750,000, but I was so relieved t hat t he t ort ur e was finally over t hat I couldn't have cared less about t he m oney I lost . I n fact , I was act ually praying for t he m arket t o open lower. = = = = I n essence, t hen, you j ust went long t o st op t he pain. = = = = That 's right . = = = = I t sounds like you found t hat t he pain of m issing a m ove was act ually far worse t han being on t he wrong side of t he m arket . = = = = I t was- at least in m y first t en or t welve years in t he m arket s. I hope t hat I 've becom e som ewhat m ore m at ure now and no longer feel t hat way.

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41 = = = = What did you learn from t hat experience? ==== I learned t hat you have t o be m ore concerned about t he m oves you're in t han t he m oves you're not in. I didn't always realize t hat . I n t hose days, if I had a sm all posit ion inst ead of a big one, I would act ually hope t hat t he m arket would open against m e. = = = = Are t here any ot her t rades t hat st and out on t he losing side? For exam ple, what was your worst loss ever? = = = = My worst loss ever. [ He laughs as he slowly repeat s t he phrase, m ulling it over in his m ind.} hi 1988, I becam e very bullish on t he Canadian dollar once it broke t hrough t he 80- cent level. I st art ed st eadily building a large posit ion unt il I was long a t ot al of t wo t housand cont ract s. = = = = What m ade you so bullish? = = = = I had always been very good wit h t he Canadian dollar. The m arket was in an ext rem e bull m ove and it had j ust broken t hrough t he psychologically crit ical 80- cent level. I j ust felt very st rongly t hat The m arket was going t o m ove m uch higherAnyway, t his was going t o be m y second- t o- last play. Ever since m y early years in t his business, m y goal has been t o t ake $50 m illion out of t he m arket . I want ed $25 m illion in a bank account so t hat I could live as high as I want ed off t he int erest , and anot her $25 m illion t o play wit h- t o buy a newspaper or a baseball t eam . ( I n t hose days, you could buy a baseball t eam for t hat am ount of m oney.) I had planned from very early on t hat m y last t rade was going t o be five t housand cont ract s and m y second- t o- last t rade approxim at ely t went y- five hundred cont ract s. This was t hat t rade. My plan was t o hold t he posit ion unt il t he Canadian dollar reached t he 87- 88- cent area, a price m ove t hat w ould net m e about $15 m illion on t he t rade. My next play would be t o m ake $30 m illion, and t hen I would be done. That was t he plan, but it didn't work out t hat way. At t he t im e, I was having a house built in Jam aica, and I had t o go back every few weeks t o supervise t he const ruct ion. One Sunday evening, as I was leaving t o cat ch a connect ing flight t o Miam i, I st opped t o check m y screen for t he currency quot es in t he Far East . The Canadian dollar rarely m oves m uch in t he Far East m arket . I was st art led t o see t hat t he price was 100 point s lower. I lit erally had t he bag in m y hand, and t he lim o was wait ing. I said t o m yself, "The Canadian dollar never m oves 100 point s in t he Far East . I t doesn't even m ove 20 point s- That quot e m ust be a m ist ake. I t 's probably j ust off by 100 point s." Wit h t hat t hought in m ind, I walked out t he door. I t wasn't a m ist ake. The m arket opened m ore t han 150 point s lower on t he I MM t he next m orning. To m ake m at t ers worse, I had no phone in t he house. The best I could do was t o go t o a nearby hot el and wait on line t o use t he public phones. By t he t im e I got m y call t hrough, I was down over $3 m illion on t he posit ion. = = = = What caused t hat sudden collapse in t he Canadian dollar? = = = = At t he t im e, t he Canadian elect ion was about a m ont h away. The prim e m inist er, Mulroney, had an enorm ous lead in t he polls over his opponent , Turner, who espoused ext rem ely liberal views, including his support for an independent Quebec. There was a debat e t hat Sunday evening and Turner dest royed Mulroney. The next m orning, t he polls showed t hat Mulroney's overwhelm ing 24 percent lead had shrunk t o a m ere 8 percent m argin overnight . All of a sudden, t he out com e of t he elect ion, which had been a foregone conclusion t he day before, appear ed t o be a t oss- up. To m ake m at t ers wor se, at t he t im e, Canada and t he Unit ed St at es were in t he m idst of delicat e negot iat ions on a t rade agreem ent , and a Turner vict ory would also have placed t hat agreem ent in j eopardy. This sudden uncert aint y on t he polit ical front t hrew t he m arket int o com plet e t urm oil. = = = = Did you get out of your posit ion? = = = = I got out of about four hundred cont r act s, but t he m arket was down so m uch t hat I couldn't see it going down m uch furt her. The next t wo or t hree days, however, it broke even m ore. By t hat t im e, I was out $7 m illion. Once I realized I was down t hat m uch, I t old m y clerk, " Ge t m e out of everyt hing." = = = = Was t hat t he bot t om of t he m arket ? = = = = I t was t he exact bot t om . Wit hin a m ont h, t he price was back t o where it had been before t he debat e. = = = = Did you m iss t he rest of t he m ove? = = = = I m issed t he ent ire m ove, and t he m arket event ually surpassed m y original t arget . I had m ade $2 m illion on t he rally and lost $7 m illion on t he break, because I had been adding all t he way up. I nst ead of earning t he $15 m illion I had planned t o m ake on t he t rade, I ended up losing about $5 m illion. = = = = Was it during t hat period down in Jam aica t hat you suffered t he m ost anxiet y you ever had in t he m arket s? = = = = No. I t was t he m ost I ever lost , but it wasn't t he m ost anxiet y. = = = = Which t rade caused t he m ost anxiet y? = = = = The Brit ish pound t rade in Novem ber 1978 t hat we t alked about earlier, because it was m y first big loss. = = = = Any ot her m em orable t rades? = = = = I n 1982, I began t o not ice on t he evening news t hat t he Dow was up alm ost every day. I st art ed get t ing very st rong bullish feelings about t he st ock m arket . This was t he first t im e I had ev er had any m ark et feel based on som et hing ot her t han wat ching fut ures. I was reluct ant t o st art picking st ocks, because t hat was som eone else's gam e. I opened an account wit h a friend of m ine who was a st ockbroker, inst ruct ing him t o buy a cross sect ion of st ocks because I felt t he m arket in general was going higher. At t he t im e, I didn't know t hat his m et hod of picking st ocks was exact ly opposit e t o m y approach in t he fut ures m arket . His t heory was t o buy t he weakest

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42 st ocks on t he pr em ise t hat t hey could go up t he m ost . Well, t hat cert ainly wasn't m y t heory. He ended up buying m e only t hree st ocks, his favorit es, which he had been in love wit h for t he past t en years; Aft er wat ching t he Dow go up for about t hree m ont hs while m y account went down at t he sam e t im e, I asked him t o send m e chart s on t he st ocks I owned. I discovered t hat he was st eering m e int o st ocks t hat were near t heir lows, while m y nat ural inclinat ion was t o buy st ocks t hat were m oving higher. I decided t he arrangem ent wasn't working out , and I closed t he account . I pulled out t he phone book and found t hat t here was a Merrill Lynch office nearby at t he com er of Michigan and Wacker [ in Chicago] . One sum m er aft ernoon aft er t he m arket had closed, I walked over t o t he bank and wit hdrew a cashier's check for $1 m illion. I t hen went t o t he Merrill Lynch office, walked t hrough t he door and asked, " Who's in charge here?" The branch m anager cam e over , and I t old him , " I want t o t alk t o your least experienced broker." That 's t he honest t rut h. I want ed som ebody wit hout any opinions. He t urned m e over t o a broker who was about t went y- t hree years old. I put t he check down in front of him and said, " I want t o open an account , and here's what I want you t o do. I want you t o st art out by invest ing t hree- quart ers of t his m oney in a wide variet y of st ocks, all of which are at or near all- t im e highs. Aft er t hat , each week, I want you t o send m e a list of st ocks broken down by m arket sect or ranking t he st ocks in each sect or by how close t hey are t o t heir all- t im e highs. He followed m y inst ruct ions exact ly, and I did very well in t hat account . However, t hat sam e year, t he Chicago Mercant ile Exchange began t rading t he S&P 500 fut ures cont ract , which solved m y problem s on how t o t rade t he general st ock m arket . I t hanked m y broker for his effort s, closed t he account , and swit ched int o buying S&P fut ures. I felt bad about closing t he account because he had done exact ly what I had want ed him t o do. He broke t he m arket down int o different sect ors and bought t he st rongest st ock in each sect or. = = = = Don't feel bad; you probably t aught him a lot about t he m arket s. How did you fare once you swit ched t o st ock index fut ures? = = = = Very well. I was fort unat e t o cat ch m ost of t he m ove in t he S&P from 120 t o 300. = = = = Could you t ell m e m ore about what m ade you so bullish on t he st ock m arket ? = = = = Part of it was j ust seeing t he m arket up alm ost every day wit hout any part icular support ing news. I n fact , t he news was act ually quit e negat ive: inflat ion, int erest rat es, and unem ploym ent were all st ill very high. Anot her im port ant fact or was t hat t he st ock m arket was virt ually unchanged from it s level t went y years earlier, w hile inflat ion had skyrocket ed in t he int erim . Therefore, in real dollar t erm s, st ock prices w ere ext rem ely low. Also, I liked t he fact t hat m ost of t he expert s w eren't part icularly bullish. One popular analyst at t he t im e whose com m ent s I found part icularly am using was Joe Granville. Each t im e t he m arket m ade a new high, he got m ore bearish t han ever- and he was supposed t o be a t echnician! = = = = Are t here any specific t rading m ist akes you m ade t hat provided valuable lessons? = = = = hi m y first significant loss, I was short t he Deut sche m ark when t he m arket went lim it - up. I could st ill have got t en out lim it - up, but I didn't . The next day , t he m arket went lim it - up again. I ended up not only doubling m y loss, but it also t ook m e t wo m ont hs t o recover t o m y account size before t hat t rade. I basically learned t hat you m ust get out of your losses im m ediat ely. I t 's not m erely a m at t er of how m uch you can afford t o risk on a given t rade, but you also have t o consider how m any pot ent ial fut ure winners you m ight m iss because of t he effect of t he larger loss on your m ent al at t it ude and t rading size. = = = = How has t he t rem endous increase in professional t rading t hat we discussed earlier changed m arket behavior during t he past decade? = = = = The big pict ure is probably t he sam e, but t he nat ur e of t he shor t - t erm price act ion is alm ost diam et rically opposit e t o what it used t o be. I n order t o get a rally, you need people on m e sidelines who want t o buy. When m ost m arket part icipant s were unsophist icat ed, t raders t ended t o w ait unt il t he m arket was in t he headlines and m aking new highs before t hey st art ed t o buy. I n cont rast , pr ofessional t raders, who dom inat e t he m arket s t oday, will only be on t he sidelines when t here's a large m ove in t he opposit e direct ion. As a result , t he price m oves t hat precede m aj or t rends t oday are very different from what t hey used t o be because t he behavior of professional t raders is very different from t hat of naive t raders. = = = = How have t hese considerat ions changed t he way you t rade? = = = = I used t o like buying or selling on breakout s [ price m oves out side of a previous range- a developm ent frequent ly int erpret ed by t echnicians as signaling an im pending price ext ension in t he sam e direct ion] . How ever, nowadays t he br eakout s t hat work look sim ilar t o t he breakout s t hat are sucker plays. I n fact , t he false breakout s pr obably out num ber t he valid signals. Consequent ly, t rading on breakout s is a st rat egy t hat I no longer em ploy. I find t hat m aj or t rends are now frequent ly preceded by a sharp price change in t he opposit e direct ion. I st ill m ake m y j udgm ent s as t o probable price t rends based on ov erall m arket act ion, as I always did. However, wit h a few except ions, I now buy on breaks and sell on rallies. = = = = I f you're always wait ing for a react ion before ent ering t he m arket , don't you t ake a chance of m issing m aj or m oves? = = = = Cert ainly, but so what ? I 've got t hirt y- eight m arket s on m y scr een. I f I m iss m oves in t en of t hem , t here w ill be t en ot hers t hat have a price m ove. The wor st t hing t hat can happen t o you in t he m arket s is being right and st ill losing m oney. That 's t he danger in buying on rallies and selling on breaks t hese days. = = = = You m ake it sound like a chess gam e* When your opponent is a farm er or a dent ist , you play one way, and when your opponent is a professional, you play anot her* = = = = No doubt about it . That 's exact ly right . You have t o keep adapt ing t o changes.

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43 = = = = What was your m ot ivat ion for com ing off t he floor? = = = = I st opped t rading on t he floor when m y first child was born, because I want ed t o be hom e wit h her. I was det erm ined not t o be one of t hose fat hers t hat spends an hour wit h his kids before bedt im e and t hat 's it . I was going t o use t he advant age of being self- em ployed t o not only get wealt hy but also t o bet t er enj oy m y life. = = = = How did you find t he t ransit ion from t rading on t he floor t o t rading at hom e? = = = = At first I found it very t ough. During t he first t welve or t hirt een years I t raded, t he only t im e I m ade less m oney t han t he previous year was t he year I st art ed t rading at hom e. I n t he pit , you can m ake quick hit s by t aking advant age of prices being out of line. I n t rading off t he floor, however, you have t o be willing t o t rade longer t erm , because you have an execut ion disadvant age. I t hink part of m y problem t hat first year off t he floor was t hat I j ust assum ed I would keep on m aking m ore m oney year aft er year and didn't have t o worry about it . Once I had a m ediocre year, I realized I had t o put m uch m ore energy and focus int o m y t rading. The next year I cam e back wit h a lot m ore det erm inat ion, and I had m y first m illion- dollar year. = = = = You said earlier t hat you were a winning t rader right from t he st art . I s t here anyt hing specific you did t hat helps explain t hat early success? = = = = One of t he t hings I did t hat worked in t hose early years was analyzing every single t rade I m ade. Every day, I m ade copies of m y cards and r eviewed t hem at hom e. Every t rader is going t o have t ons of winners and losers. You need t o det erm ine why t he winners are winners and t he losers are losers. Once you can figure t hat out , you can becom e m or e select ive in your t rading and avoid t hose t rades t hat are m or e likely t o be losers. = = = = What ot her advice would you have for t raders? = = = = The m ost im port ant advice is t o never let a loser get out of hand. You want t o be sure t hat you can be wrong t went y or t hirt y t im es in a row and st ill have m oney in your account . When I t rade, I 'll risk perhaps 5 t o 10 percent of t he m oney in m y account . I f I lose on t hat t rade, no m at t er how st rongly I feel, on m y next t rade I 'll risk no m ore t han about 4 percent of m y account . I f I lose again, I 'll drop t he t r ading size down t o about 2 percent . I 'll keep on reducing m y t rading size as long as I 'm losing. I 've gone from t rading as m any as t hree t housand cont ract s per t rade t o as few as t en when I was cold, and t hen back again. = = = = I s t his drast ic variat ion in your t rading size a key elem ent t o your success? = = = = Absolut ely, because every t rader will go t hrough cold spells. I I n essence, t hen, you t reat McKay as a t rend as well. Definit ely, and t here's a logical reason for t hat . When you're t rading well, you have a bet t er m ent al at t it ude. When you're t rading poorly, you st art wishing and hoping. I nst ead of get t ing int o t rades you t hink will work, you end up get t ing int o t rades you hope will work. = = = = I n ot her words, you want t o wait unt il you get back int o t he proper fram e of m ind, but t he only way you can do t hat is by winning, and you don't want t o bet large in t he m eant im e. = = = = That 's right . = = = = You've seen lot s of t raders in your day bot h on and off t he floor. Do t he winners and losers separat e int o any dist inct profiles? = = = = One very int erest ing t hing I 've found is t hat virt ually every successful t rader I know ult im at ely ended up wit h a t rading st yle suit ed t o his personalit y. For exam ple, m y brot her is a very hardworking, m et iculous t ype of person. When April 15 com es around, he loves t o sit down, sharpen his pencils, and do his incom e t ax. I n fact , he probably get s all his pencils sharpened in March. = = = = He m ust be a populat ion of one. = = = = Right . Anyway, he becam e a spreader , which suit ed his per sonalit y per fect ly. [ A spreader seeks t o t ake advant age of discrepancies bet ween relat ed cont ract s by sim ult aneously im plem ent ing bot h long and shor t offset t ing posit ions, as opposed t o being net long or short t he m arket .J And he was great at it . You could go int o t he pit and ask him for a quot e on any spr ead com binat ion, and he would be able t o give you t he price in an inst ant . He would never st ep out and t ake a risk like I would, but he t raded t h e way he want ed t o t rade. On t he ot her hand, m y friends who are speculat ors are t he t ype of people who w ill fly off t o Las Vegas at a m om ent 's not ice or clim b a m ount ain in Africa. The bot t om line is t hat t he t rading st yles of successful t raders t end t o m at ch t heir personalit ies. = = = = How about your own personalit y- how does t hat m at ch your t rading st yle? = = = = I t m at ches it very well, I t hink. I grew up being very conservat ive. I was raised as a Cat holic, and I was act ually in a sem inary for four years because I want ed t o be a priest . As we discussed earlier, I deliberat ely allowed m yself t o get draft ed. I was a st raight - down- t he- line kid. I n adult hood, once I got t he freedom t hat cam e wit h m aking m oney, I becam e m uch m ore of a risk t aker. I went t o Africa fift een years ago, before it becam e a popular t hing t o do. I 've t aken lot s of personal chances as an adult , because I believe life is short and you should live and enj oy it while it 's here. My t rading st yle blends bot h of t hese opposing personalit y t rait s. I t ake t he risk- orient ed part of m y personalit y and put it where it belongs t rading. And, I t ake t he conservat ive part of m y personalit y and put it where it belongs: m oney m anagem ent . My m oney m anagem ent t echniques are ext rem ely conservat ive. I never risk anyt hing approaching t he t ot al am ount of m oney in m y account , let alone m y t ot al funds. = = = = You're im plying t hat it doesn't m ake any difference what one's personalit y is, as long as t here's no conflict bet ween personalit y and t rading st yle. = = = = That 's right , it doesn't m ake any difference because t here are so m any different t rading st yles t hat you

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44 can always find one t hat will suit your personalit y. = = = = Any specific advice for a losing t rader? = = = = Som et im es t he reason people lose is t hat t hey're not sufficient ly select ive. Upon analysis, a t rader m ay find t hat if he only concent rat es on t he t rades t hat do well and let s go of t he ot her t ypes of t rades, he m ight act ually be successful. However, if a t rader analyzes his t rades and st ill can't m ake m oney, t hen he probably should t ry anot her endeav or. What is t he first rule of t rading? I would argue t hat before anyt hing else, t he prospect ive t rader m ust find t he approach t hat he or she is com fort able wit h- t hat is, t he approach t hat suit s t he t r ader's per sonalit y. McKay cit es t his qualit y as t he single m ost im port ant elem ent separat ing winners from losers, Each t rader m ust select t he appropriat e m arket arena, choose bet ween syst em t r ading and discret ionary t rading, fundam ent al and t echnical m et hods, posit ion t rading and spr ead t rading, short - t erm and long- t erm horizons, aggressive and conservat ive approaches, and so on. For all of t hese opposing choices, one alt ernat ive will suit t he t rader's personalit y, while t he ot her will lead t o int ernal conflict . At t his point , you m ight be t hinking t hat t he concept of select ing a t rading m et hodology in sync wit h one's personalit y doesn't sound like m uch of an insight . "Aft er all," you m ight ask, " doesn't every t rader choose a m et hod com pat ible w it h his or her personalit y?" Absolut ely not ! My own ex perience in t his regard is det ailed in t he final sect ion of t his book. I n a m ore general sense, it is rem arkably com m on for t raders t o adopt m et hods ent irely unsuit ed t o t heir personalit ies. There are t r aders who ar e good at sy st em developm ent but end up consist ent ly overriding and int erfering wit h t heir own syst em s, wit h disast rous result s. There are t raders who ar e nat urally inclined t oward developing long- t erm st rat egies but end up inst ead t rading short t erm because of im pat ience or a com pulsion t o " do som et hing." There are nat urally bom floor t raders wit h gr eat int uit ive skills who abandon t heir environm ent of expert ise and becom e m ediocre port folio m anagers. And t here are t heoret ically orient ed individuals who develop int ricat e, low- risk arbit rage st rat egies but t hen decide t o becom e posit ion t raders- an approach t hat m ay require a degr ee of risk accept ance far beyond t heir com fort levels in order t o be applied successfully. I n all t he above cases, individuals wit h a nat ural bent for one st yle of t rading end up ut ilizing a diam et rically opposit e st yle, usually t o fulfill som e em ot ional need. I n ot her words, t he need t o m at ch personalit y and t rading st yle m ay be a m at t er of com m on sense, but it is cert ainly not com m on. The im port ance of t his concept , how ever, is highlight ed by McKay's assert ion t hat virt ually every successful t rader he knew ended up wit h a t rading st yle suit ed t o his personalit y. An essent ial elem ent in McKay's own t rading approach is t he dr ast ic variat ion in posit ion size. When he is doing well and t herefore assum es his chances for success are great est , McKay will t rade very large. On t he ot her hand, when he is doing poorly, he will shrink his t rading size t o m inuscule levels. I t is not uncom m on for McKay t o vary his t rade size by m ore t han a fact or of 100: 1. This approach serves not only t o reduce risk during t he losing periods but also t o enhance profit s during t he winning periods. A t rader who ut ilizes a const ant - posit ion- size approach gives up an im port ant edge in m uch t he sam e way as does a blackj ack player who always bet s t he sam e am ount regardless of t he cards t hat have been previously dealt . Risk cont rol is anot her essent ial elem ent in McKay's approach, as indeed it is for m ost of t he great t raders. I n addit ion t o sharply reducing posit ion size during losing st reaks, as j ust discussed above, McKay also believes in im m ediat ely get t ing out of a posit ion t hat has gone sour. I n one of t he few inst ances when he deviat ed from t his self- proclaim ed crit ical principle ( t he long Canadian dollar posit ion discussed in t he int erview) , an uncharact erist ic t wo- day procrast inat ion t urned a $3.5 m illion loss int o a $7 m illion loss. Alt hough McKay is predom inant ly a t echnical t rader, fundam ent al analysis plays a crit ical role in defining his m aj or t rade st rat egies. His use of fundam ent als, however, is som ewhat unconvent ional. McKay doesn't t ry t o gauge whet her t he fundam ent als ar e bullish or bearish, nor does he place any direct weight on whet her t he fundam ent al new s is bullish or bearish. Rat her, he focuses on t he m arket 's response t o fundam ent al news. For exam ple, if t he m arket is shrugging off a barrage of bearish news, McKay would view t hat as evidence of an im pending bull m ove.

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45 William Eckhardt: The Mathematician William Eckhardt is one of t he key figures in a fam ous financial t ale, yet he is virt ually unknown t o t he public. I f elit e t raders w ere as fam iliar as leading individuals in ot her fields, one could pict ure Eckhardt appearing in one of t hose old Am erican Express ads ( which feat ured fam ous yet obscure nam es such as Barry Goldwat er's vice president ial running m at e) : " Do you know m e? I was t he part ner of perhaps t he best - known fut ures speculat or of our t im e, Richard Dennis. I was t he one who bet Dennis t hat t rading skill could not be t aught . The t rading group known in t he indust ry as t he Turt les was an out growt h of an experim ent t o resolve t his wager." At t his point , t he nam e William Eckhardt m ight be print ed across t he screen. So who is William Eckhardt ? He is a m at hem at ician who j ust short of earning his Ph.D. t ook a det our int o t rading and never ret urned t o academ ics ( at least not officially) . Eckhardt spent his early t rading years on t he floor. Not surprisingly, he event ually abandoned t his reflexive t rading arena for t he m ore analyt ical approach of syst em s- based t rading. For a decade, Eckhardt did very well wit h his own account , prim arily based on t he signals generat ed by t he syst em s he developed but supplem ent ed by his own m arket j udgm ent . During t he past five years, Eckhardt has also pianaged a handful of ot her account s, his average r et ur n during t his period has been 62 percent , ranging from a 7 percent loss in 1989 t o a 234 percent gain in 1987. Since 1978, he has averaged bet t er t han 60 percent per year in his own t rading, wit h 1989 t he only losing year. At t he t im e of our int erview, aft er a career of anonym it y, Eckhardt was poised t o expand his involvem ent in m anaged m oney t o a broader audience. Why was Eckhardt now willing t o em erge int o t he lim elight by act ively seeking public funds for m anagem ent ? Why not sim ply cont inue t o t rade his own account and t hose of a few friends and associat es, as he had done all along? I n an obvious reference t o t he Turt les [ see next chapt er] , Eck hardt candidly adm it t ed, " I got t ired of seeing m y st udent s m anaging hundreds of m illions while I was m anaging com parat ively palt ry am ount s." Obviously, Eckhardt felt it was t im e t o collect t he dues he had earned. Trading syst em research is obviously som et hing Eckhardt enj oys, and, of course, it is t he way he earns his living, but his t rue passion m ay be scient ific inquiry. I ndeed, in a sense, t rading and t rading- relat ed research is t he m eans by which Eckhardt gener at es his own personal gr ant s for t he scient ific proj ect s t hat int rigue him . He is drawn t o exploring som e of t he great paradoxes t hat cont inue t o baffle scient ist s. Quant um m echanics has capt ured his int erest because of t he com m on- sense- defying Bell's t heorem , which dem onst rat es t hat m easurem ent s on dist ant ly separat ed par t icle syst em s can det erm ine one anot her m sit uat ions in which no possible influence can pass bet ween t he syst em s. Evolut ion is anot her area he st udies, t rying t o find an answer t o t he riddle of sexual reproduct ion: Why did nat ure evolve sexual reproduct ion, wherein an organism passes on only half of it s genes, whereas in asexual reproduct ion 100 percent of t he genes are passed on? Perhaps his m ost int ensive st udy is direct ed at underst anding t he concept of t im e. When I int erviewed Eckhardt , he was working on a book about t he nat ure of t im e ( his basic prem ise is t hat t he passage of t im e is an illusion) . Eckhardt brings m any st rengt hs t o t he art of t rading syst em design: years of experience as a t rader bot h on and off t he floor, an obviously keen analyt ical m ind, and rigorous m at hem at ical t raining. This com binat ion gives Eckhardt an edge over m ost ot her t rading syst em designers. = = = = How did you becom e part ners wit h Richard Dennis? = = = = Rich and I were friends in high school. We probably m et because of a m ut ual int erest in t he m arket s, but t he friendship was never about t rading- Rich began t rading when he was in college. I st ayed in school working t oward a doct oral dissert at ion in m at hem at ical logic. I n 1974 I got bogged down for polit ical reasons. = = = = What do you m ean by " bogged down" ? = = = = I was writ ing a doct oral dissert at ion on m at hem at ical logic at t he Universit y of Chicago under a worldfam ous m at hem at ician. Everyt hing was going along fine unt il a new facult y m em ber whose specializat ion happened t o be m at hem at ical logic j oined m e st aff. Theoret ically, I was his only st udent . Consequent ly, t he supervisory role on m y t hesis was shift ed from m y exist ing advisor t o t his new facult y m em ber, who t hen decided t hat he really want ed m e t o do a different t hesis. As a result , aft er I had done all m y course work, t aken m y exam s, and finished t hree- quart ers of m y dissert at ion, m y progress was st ym ied. At t he t im e, Rich suggest ed t hat I t ak e a sabbat ical t o t ry t rading on t he floor. I did, and I never ret ur ned t o school. = = = = The shift from being a graduat e st udent of m at hem at ics t o a floor t rader sounds like a radical t ransit ion. = = = = Yes, it was. Alt hough I had m aint ained an int erest in t he nat ure of speculat ive prices, I have t o adm it t hat m at hem at ical logic is a far cry from floor t rading. I f anyt hing, I went int o t he pit wit h t oo m any preconcept ions of how m arket s work. = = = = What kind of preconcept ions? = = = = I went in wit h t he idea t hat I could apply t he analyt ical t echniques t hat I had picked up as a m at hem at ician t o t he m arket s in a st raight forward m anner. I was wrong about t hat . = = = = Did you t ry doing t hat ? = = = = Off- t he- floor t raders live or die by t heir ideas about t he m arket or t heir syst em s. That 's not t rue of floor t raders. As a pit t rader, you only need t o be able t o gauge when a m arket is out of line by a t ick, or a few t icks. Once you m ast er t hat skill, you t end t o survive, whet her your underlying t heory is sound or not . I n fact , I know a lot of pit t raders who subscribe t o various bogus syst em s: m ov ing averages, lunar cycles, and

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46 god only knows what . When t hey get signals from t hese syst em s, t hey essent ially buy on t he bid or sell on t he offer. At t he end of t he m ont h, t hey have a profit , which t hey always at t ribut e t o t heir syst em . Yet som e of t hese syst em s ar e com plet ely vacuous. Perhaps I did a variat ion of t he sam e t hem e. I had ideas about speculat ing and t rading, and I did well in t he pit . But I 'm not sure t hat I m ade any m oney from m y ideas about t he m arket . = = = = What was t he basis of your buying and selling decisions on t he floor? = = = = Basically, I would buy when weak hands were selling and sell when t hey were buying. I n ret rospect , I 'm not sure t hat m y st rat egy had anyt hing t o do wit h m y success. I f you assum e t hat t he t rue t heoret ical price is som ewhere bet ween t he bid and t he offer, t hen if you buy on t he bid, you're buying t he m arket for a lit t le less t han it 's wort h. Sim ilarly, if you sell on t he offer, you're selling it for a lit t le m ore t han it 's wort h. Consequent ly, on balance, m y t rades had a posit ive expect ed ret urn, regardless of m y st rat egy. That fact alone could very well have represent ed 100 percent of m y success. = = = = I s t hat , in fact , what you t hink? = = = = I t hink t hat t he execut ion edge was probably t he prim ary reason for m y success as a floor t rader. The m aj or fact or t hat whit t les down sm all cust om er account s is not t hat t he sm all t raders ar e so inevit ably wrong, but sim ply t hat t hey can't beat t heir own t ransact ion cost s. By t ransact ion cost s I m ean not only com m issions but also t he skid in placing an order. As a pit t rader, I was on t he ot her side of t hat skid. = = = = As a form er Ph.D. candidat e in m at hem at ics, did you m iss t he int ellect ual challenge in what you were doing? = = = = I nit ially, yes. But I event ually got int o serious research on prices, and t hat was as t ough a problem as anyt hing I ever cam e across in academ ia. = = = = Were any of t he areas you st udied in m at hem at ics applicable t o developing t rading syst em s? = = = = Cert ainly- st at ist ics. The analysis of com m odit y m arket s is prone t o pit falls in classical st at ist ical inference, and if one uses t hese t ools wit hout having a good foundat ional underst anding, it 's easy t o get int o t rouble. Most classical applicat ions of st at ist ics are based on t he key assum pt ion t hat t he dat a dist ribut ion is norm al, or som e ot her known form . Classical st at ist ics work well and allow you t o draw precise conclusions if you're correct in your assum pt ion of t he dat a dist ribut ion. However, if your dist ribut ion assum pt ions are even a lit t le bit off, t he error is enough t o derail t he delicat e st at ist ical est im at ors, and cruder, robust est im at ors will yield m ore accurat e result s. I n general, t he delicat e t est s t hat st at ist icians use t o squeeze significance out of m arginal dat a have no place in t rading. We need blunt st at ist ical inst rum ent s, robust t echniques. = = = = Could you define what you m ean by " robust " ? = = = = A robust st at ist ical est im at or is one t hat is not pert urbed m uch by m ist aken assum pt ions about t he nat ure of t he dist ribut ion. = = = = Why do you feel such t echniques are m ore appropriat e for t rading syst em analysis = = = = Because I believe t hat price dist ribut ions are pat hological. = = = = I n what way? = = = = As one exam ple, price dist ribut ions have m ore v ariance [ a st at ist ical m easure of t he variabilit y in t he dat a] t han one would ex pect on t he basis of nor m al dist ribut ion t heory. Benoit Mandelbrot , t he originat or of t he concept of fract ional dim ension, has conj ect ur ed t hat price change dist ribut ions act ually have infinit e variance. The sam ple variance [ i.e., t he im plied variabilit y in prices] j ust get s larger and larger as you add m ore dat a. I f t his is t rue, t hen m ost st andard st at ist ical t echniques are invalid for price dat a applicat ions. = = = = I don't underst and. How can t he variance be infinit e? = = = = A sim ple exam ple can illust rat e how a dist ribut ion can have an infinit e m ean. ( By t he way, a variance is a m ean- it 's t he m ean of t he squares of t he deviat ions from anot her m ean.) Consider a sim ple, one- dim ensional random w alk generat ed, say, by t he t osses of a fair coin. We are int erest ed in t he av erage w ait ing t im e bet ween successive equalizat ions of heads and t ails- t hat is, t he average num ber of t osses bet ween successive t ies in t he t ot als for heads and t ails. Typically, if we sam ple t his process, we find t hat t he wait ing t im e bet ween t ies t ends t o be short . This is hardly surprising. Since we always st art from a t ie sit uat ion in m easuring t he wait ing t im e, anot her t ie is usually not far away. However, som et im es, eit her heads or t ails get s far ahead, albeit rarely, and t hen we m ay have t o wait an enorm ous am ount of t im e for anot her t ie, especially since addit ional t osses are j ust as likely t o increase t his discrepancy as t o lessen it . Thus, our sam ple will t end t o consist of a lot of relat ively short wait ing t im es and a few disquiet ingly large out liers. What 's t he average? Rem arkably, t his dist ribut ion has no average, or you can say t he average is infinit e. At any given st age, your sam ple average will be finit e, of course, but as you gat her m or e sam ple dat a, t he average will creep up inexorably. I f you draw enough sam ple dat a, you can m ake t he average in your sam ple as large as you want . = = = = I n t he coin t oss exam ple you j ust provided, com put er sim ulat ions m ake it possible t o generat e huge dat a sam ples t hat allow you t o conclude t hat t he m ean has no lim it . But how can you definit ively st at e t hat t he variances of com m odit y price dist ribut ions are not finit e? I sn't t he available dat a far t oo lim it ed t o draw such a conclusion? = = = = There are st at ist ical problem s in det erm ining w het her t he variance of price change is infinit e. I n som e ways, t hese difficult ies are sim ilar t o t he problem s in ascert aining whet her w e're ex periencing global warm ing. There are suggest ive indicat ions t hat w e are, but it is difficult t o dist inguish t he recent rise in t em perat ur e from random variat ion. Get t ing enough dat a t o assure t hat price change v ariance is infinit e could t ake a cent ury.

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47 = = = = What are t he pract ical im plicat ions of t he variance not being finit e? = = = = I f t he variance is not finit e, it m eans t hat lurking som ewhere out t here are m ore ext rem e scenarios t han you m ight im agine, cert ainly m ore ext rem e t han would be im plied by t he assum pt ion t hat prices confor m t o a norm al dist ribut ion- an assum pt ion t hat underlies m ost st at ist ical applicat ions. We wit nessed one exam ple in t he one- day, 8,000- point drop in t he S&P on Oct ober 19, 1987. Norm al est im at ion t heory would t ell you t hat a one- day price m ove t his large m ight happen a few t im es in a m illennium . Here we saw it happen wit hin a decade of t he inaugurat ion of t he S&P cont ract . This exam ple pr ovides a perfect illust rat ion of t he fact t hat if m arket prices don't have a finit e variance, any classically derived est im at e of risk will be significant ly underst at ed. = = = = Besides im plying t hat t raders need t o be m ore conservat ive in risk cont rol t han m ight be im plied from st raight forward st at ist ical int erpret at ions, are t here ot her pract ical im plicat ions of using what you t erm a robust approach as opposed t o m et hods t hat assum e a norm al probabilit y dist ribut ion? = = = = One im port ant applicat ion concerns a sit uat ion in which you have several indicat ors for a cert ain m arket . The quest ion is: How do you m ost effect ively com bine m ult iple indicat ors? Based on cer t ain delicat e st at ist ical m easures, one could assign weight s t o t he various indicat ors. But t his approach t ends t o be assum pt ionladen regarding t he relat ionship am ong t he various indicat ors. I n t he lit erat ure on robust st at ist ics you find t hat , in m ost circum st ances, t he best st rat egy is not som e opt im ized weight ing schem e, but rat her weight ing each indicat or by 1 or 0. I n ot her words, accept or r ej ect . I f t he indicat or is good enough t o be used at all, it 's good enough t o be weight ed equally wit h t he ot her ones. I f it can't m eet t hat st andard, don't bot her wit h it . The sam e pr inciple applies t o t rade select ion. How should you apport ion your asset s am ong different t rades? Again, I would argue t hat t he division should be equal. Eit her a t rade is good enough t o t ake, in which case it should be im plem ent ed at full size, or it 's not wort h bot hering wit h at all. = = = = You t alked earlier about t he pit falls in m arket analysis. Can you provide som e ot her exam ples? = = = = chooses t o average. This is a degree of freedom , and it s allowed values ar e posit ive int egers. But t here can also be hidden degr ees of freedom . One can have st ruct ures wit hin t he syst em t hat can t ake on various alt ernat ive form s. I f various alt ernat ives are t est ed, it gives t he syst em anot her chance t o conform t o past idiosyncrasies in t he dat a. Not only is it perilous t o have t oo m any degrees of freedom in y our syst em , t here ar e also " bad" degr ees of freedom . Suppose a cert ain degr ee of freedom in your syst em im pinges only on a very few over sized t rends in m e dat a and ot herwise does not affect how t he syst em t rades. By affixing t o accident al feat ures of t he sm all sam ple of large t rends, such a degree of freedom can subst ant ially cont ribut e t o overfit t ing, even t hough t he overall num ber of degrees of freedom is m anageable. = = = = How do you det erm ine t o what ext ent t he perform ance of a syst em is affect ed by overfit t ing past dat a as opposed t o capt ur ing t rut hs about m arket behavior? = = = = The best way is t o look at hundreds of exam ples. Add degr ees of freedom t o a syst em and see how m uch you can get out of t hem . Add bogus ones and see what you can get . I know of no subst it ut e for ex per ience in t his m at t er. Try a lot of syst em s. Try syst em s t hat m ake sense t o you and ones t hat don't . Try syst em s t hat have very few param et er s and ones t hat are profligat e wit h t hem . Aft er a while, you develop an int uit ion about t he t r ade- off bet ween degr ees of freedom and t he r eliabilit y of past perform ance as an indicat or of fut ure perform ance. = = = = Do you have a lim it t o how m any degrees of freedom you would put int o a syst em ? = = = = Seven or eight is probably t oo m any. Three or four is fine. = = = = What is your opinion about opt im izat ion? [ Opt im izat ion refers t o t he process of t est ing m any variat ions of a syst em for t he past and t hen select ing t he best - perform ing version for act ual t rading.] = = = = I t 's a valid part of t he m echanical t rader's r eper t oire, but if you don't use m et hodological care in opt im izat ion, you'll get result s t hat are not reproducible. = = = = How do you avoid t hat pit fall? = = = = You really are caught bet ween conflict ing obj ect ives. I f you avoid opt im izat ion alt oget her, you're going t o end up wit h a syst em t hat is vast ly inferior t o what it could be. I f you opt im ize t oo m uch, however, you'll end up wit h a syst em t hat t ells you m ore about t he past t han t he fut ure. Som ehow, you have t o m ediat e bet ween t hese t wo ext rem es. = = = = Ot her t han t he t hings we have already t alked about , what advice do you have for people who are involved in syst em developm ent ? = = = = I f t he perfor m ance result s of t he syst em don't sock you in t he eye, t hen it 's probably not wort h pursuing. I t has t o be an out st anding result . Also, if you need delicat e, assum pt ion- laden st at ist ical t echniques t o get superior perform ance result s, t hen you should be very suspicious of t he syst em 's validit y. As a general rule, be very skept ical of your results. The bet t er a syst em looks, t he m ore adam ant y ou should be in t rying t o disprove it . This idea goes ver y m uch against hum an nat ure, which want s t o m ake t he hist orical perform ance of a syst em look as good as possible. Karl Popper has cham pioned t he idea t hat all progress in knowledge result s from effort s t o falsify not t o confirm , our t heories. Whet her or not t his hypot hesis is t rue in general, it 's cert ainly t he right at t it ude t o bring t o t rading resear ch. You have t o t ry your best t o disprove your result s. You have t o t r y t o kill your lit t le creat ion. Try t o t hink of everyt hing t hat could be wrong wit h your syst em , and every t hing t hat 's suspicious about it . I f you challenge your syst em by sincerely t rying t o disprove it , t hen m aybe, j ust m aybe, it 's valid.

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48 = = = = Do you use chart pat t erns in your syst em s? ==== Most t hings t hat look good on a chart - say, 98 percent - don't work. = = = = Why is t hat ? = = = = The hum an m ind was m ade t o creat e pat t erns. I t will see pat t erns in random dat a. A t um - of- t he- cent ury st at ist ics book put it t his way: " Too fine an eye for pat t ern will find it anywhere." I n ot her wor ds, you're going t o see m ore on t he chart t han is t ruly t here. Also, we don't look at dat a neut rally- t hat is, when t he hum an eye scans a chart , it doesn't give all dat a point s equal weight . I nst ead, it will t end t o focus on cert ain out st anding cases, and we t end t o form our opinions on t he basis of t hese special cases. I t 's hum an nat ure t o pick out t he st unning successes of a m et hod and t o overlook t he day- in, day- out losses t hat grind you down t o t he bone. Thus, even a fairly careful perusal of t he chart s is prone t o leave t he researcher wit h t he idea t hat t he syst em is a lot bet t er t han it really is. Even if you carry it a st ep furt her by doing careful hand resear ch, t here is st ill a st rong t endency t o bias t he r esult s. I n fact , t his bias exist s in all scient ific research, which is why t hey have persnicket y double- blind t est s. Even t he m ost honest researcher will t end t o bias dat a t oward his or her hypot hesis. I t can't be helped. When I did research by hand, I t ook t he at t it ude t hat I had t o discount m y result s by 20 t o 50 percent . I rem em ber one t im e when I was on a flight from San Francisco t o New York, I had a new syst em idea t hat I was excit ed about and want ed t o t est pr elim inarily off t he chart s. The syst em involved using a convent ional indicat or I st ochast ics. I believe) in an unconvent ional way. I t ried t he syst em on several different m arket s, and it seem ed t o do t errifically. When I event ually had t he syst em com put er t est ed, I discovered t hat it act ually lost m oney. What happened was t hat m y alignm ent bet ween t he indicat or on t he bot t om of t he chart and t he price on t op was off by a day or so. Since t he signals t ended t o com e during periods of rapid price m ovem ent , being off by one day could m ean t he difference bet w een being on t he wrong side of t he m arket for a 500- point m ove ( say, in a m arket such as t he S&P) inst ead of on t he right side- a 1,000- point ( $5,000 in t he S&P) difference alt oget her. So what had act ually looked like a great syst em proved t o be t ot ally wort hless. Ever since t hen, I 've been very caut ious about drawing any conclusions from hand t est ing. I now wait unt il t he com put er result s are in. The desire t o find pat t erns is t he sam e hum an quirk t hat convinces people t hat t here is validit y in superst it ions, or ast rology, or fort une t ellers. The successes are m uch m ore st art ling t han t he failures. You rem em ber t he t im es when t he oracle really hit t he naii on t he head, and you t end t o forget t he cases in which t he predict ion was am biguous or wrong. = = = = Your com m ent s basically seem t o im ply t hat chart reading is j ust laden wit h pit falls and unfounded assum pt ions. = = = = Yes, it is. There m ay be people out t here who can do it , but I cert ainly can't . Every pat t ern recognit ion chart t rader I know m akes t he t r ades he really likes larger t han t he t rades he doesn't like as m uch. I n general, t hat 's not a good idea. You shouldn't be invest ing yourself in t he individual t rades at all. And it 's cert ainly wrong t o invest yourself m ore in som e t r ades t han ot hers. Also, if you t hink you're creat ing t he profit able sit uat ion by having an eye for chart s, it 's very difficult not t o feel excessively responsible if t he t rade doesn't work. = = = = Which, I assum e, is bad. = = = = Yes, it 's very dest abilizing. = = = = Whereas if you have a m echanical syst em , t hat 's not a problem . = = = = That 's right . Your j ob is t o follow t he syst em . I f t he syst em does som et hing t hat result s in losses, t hat 's j ust an expect ed part of t he syst em . Your j udgm ent m ight be on t he line over t he ent ire perform ance of your syst em , but t here's no sense in which your j udgm ent is on t he line on any single t rade. = = = = I fully underst and t he psychological advant ages of a m echanical approach ( assum ing, of course, t hat it 's effect ive) , but are you also saying t hat you're skept ical of chart reading as a general approach t o t rading? ==== When I have an idea based on a char t pat t ern, I t ry t o reduce it t o an algorit hm t hat I can t est on a com put er. I f a m et hod is t ruly valid, you should be able t o explain it t o a com put er. Even if you can't define it precisely, you should st ill be able t o concoct an algorit hm t hat approxim at ely describes t he pat t ern. I f your algorit hm gives you an expect ed gain near zero- as is t ypically t he case- t hen don't delude yourself int o believing t hat t he pat t ern has validit y t hat depends on som e indescribable int erpret at ion you bring t o it . = = = = I n ot her words, t he com put er doesn't lie; believe it rat her t han your int uit ive not ions of a pat t ern's reliabilit y. = = = = Yes, because, as I m ent ioned before, t he hum an m ind will t end t o find pat t erns where none exist . = = = = Do you follow your syst em s absolut ely, or do you som et im es int ervene? = = = = At t his st age of t he gam e, com put er t r ading syst em s are rot e algorit hm s. They m ay be com plex, but t hey are st ill sim plem inded. Any syst em t hat I know of, if t raded at a level t hat is large enough, will occasionally st ray int o overly risky t errain. Of course, t his vulnerabilit y can be avoided by t rading t oo sm all- t hat is, scaling t o t he worst cases- but t hat is a cost ly solut ion in t erm s of overall perform ance. I t 's bet t er t o t rade at a reasonable level, and when you find yourself wit h t oo m uch exposure, override your sy st em and cut back. Also, a good syst em will occasionally direct you t o do som et hing st upid, hi such cases, your own j udgm ent is vit al.

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49 Generally speaking, however, if your syst em is any good, don't override it , except when it 's clearly violat ing t he int ent ions of it s design. Don't get int o t he habit of finagling t he syst em day in and day out . Save your ingenuit y and creat ivit y for research. = = = = Can you give m e an exam ple of a syst em violat ing t he int ent ions of it s design? = = = = On t he day of t he st ock m arket crash [ Oct ober 19, 1987] , I was short S&Ps, and I was also short Eurodollars. At t he close, t he S&Ps were down 8,000 point s, but t he Eurodollars were dow n only 5 point s. My t rader m ent alit y t old m e t hat t he Eurodollars should have been down at least 40 or 50 point s in sym pat hy wit h t he S&P collapse. Even t hough m y syst em was st ill short Eurodollars, I covered m y posit ion because I didn't like t he m arket act ion. = = = = Was t hat t he right t hing t o do? = = = = Yes. The m arket opened nearly 300 point s higher t he next day. = = = = When you discover t hat your syst em does som et hing t hat is not opt im al for reasons you can verbalize, as in t he Eurodollar exam ple you j ust cit ed, do you t hen m odify your syst em t o incorporat e a new rule t o address such sit uat ions? = = = = I f you find yourself repeat edly running int o a cert ain kind of problem , or if you find a st ruct ural flaw in t he syst em , t hen it 's t im e t o change t he syst em . But you shouldn't change it ev ery t im e it does som et hing you don't like. No syst em of reasonable algorit hm ic com plexit y is going t o behave according t o t he int ent ions of t he designer under all const ellat ions of circum st ances. A designer cannot ant icipat e all possible sit uat ions. Even if he could, it would be unwise t o add a degr ee of freedom t o t he syst em for som et hing t hat happens less t han once a year. = = = = Any ot her exam ples of overriding your syst em t hat st ick in your m ind? = = = = Yes, around t he t im e of t he Gulf War. This was a com plet ely unprecedent ed sit uat ion. We had never before had a war by deadline. My inst inct was t o not t rade, but I had ot her concerns. I t ake t he point of view t hat m issing an im port ant t rade is a m uch m ore serious error t han m aking a bad t rade. I n any wort hwhile syst em , you have all kinds of backups t o prot ect you ( t hat is, t o assure t hat you get out ) when you t ake a bad t rade. On t he ot her hand, t ypically, if you m iss a good t r ade, you hav e not hing t o prot ect you- t hat is, not hing in t he syst em will assure t hat you event ually get in. Also, m issing a good t rade can be dem or alizing and dest abilizing, especially if you've been in t he m idst of a losing period. And like so m any bad t rading decisions, it ends up cost ing you m ore t han j ust t he m oney lost or not m ade on t he t r ade. Missing a m aj or t rade t ends t o have a r everberat ing effect t hroughout your whole t rading st rat egy. Som et im es it can be weeks before you get back on t rack. For all t hese reasons, I felt t hat it was inappropriat e t o not t rade. = = = = But I t hought you said t his was an inst ance when you overrode t he sy st em ? = = = = I t ook t he t rades, but I cut m y norm al posit ion size in half. = = = = What happened? = = = = I got clobber ed, or , m ore accurat ely, half- clobbered. = = = = So, once again, your int ervent ion seem ed t o help your perform ance. Were t here sit uat ions when overriding t he syst em blew up in your face? = = = = Many. One t hat st ands out occurred several years ago aft er I had suffered a longer- t han- usual st ring of losses. At t he t im e, I happened t o be long currencies. Som e int ernat ional sit uat ion developed over t he weekend t hat caused t he curr encies t o m ove sharply higher. By Monday m orning I had what appeared t o be a windfall profit . On t he alleged basis t hat I was reducing m y exposure because of t he increased volat ilit y, I t ook profit s on half of m y posit ion. I n fact , m y exposure across all m arket s at t hat t im e was light , and I could easily have afforded t he ext ra risk in t he currency posit ion. I t was sim ply t hat com ing aft er a period of m uch losing, I couldn't st and t he idea of giving back all t hat profit . I n effect , I reasoned t hat t he currencies had gone up enough- t he call of t he count ert rend. Short ly t hereaft er, t he currencies underwent anot her upside explosion t hat exceeded t he first . Such willfully m issed opport unit ies hurt m ore t han losses. = = = = On balance, have you found t hat your int ervent ion has helped or hindered your perform ance? = = = = I had t he experience of sim ult aneously t rading for m yself, which is what I 've done for m ost of m y career, and also m anaging an account for an associat e, which I t raded exclusively on a m echanical syst em . Alt hough t he perform ance in m y account was good, t he account t rading ent irely on t he m echanical syst em definit ely did bet t er. I had known t hat a good syst em would out perform m e in a windfall year, but I t hought I could out perform t he syst em in a m ediocre year. ( Maybe I could have once, but m y syst em s have im proved over t he years.) This experience indicat ed ot herwise. = = = = Yet , I t ake it t hat unt il t his unint ent ional experim ent , you m ust have t hought t hat your overrides were helping perform ance. = = = = That 's because t he t im es when you do som et hing t hat appears t o out sm art t he syst em are t he ones t hat st ay wit h you. The day- in, day- out slippage is t he sort of t hing you forget . Clearly, m y overriding was cost ing m e m oney, even t hough I t hought ot herwise. = = = = Have you t hen changed your viewpoint s on overriding? = = = = Cert ainly, I now feel t hat it should be a far m ore select ive process t han I did years ago. You should t ry t o express your ent husiasm and ingenuit y by doing research at night , not by overriding your syst em during t he day. Overriding is som et hing t hat you should do only in unexpect ed circum st ances- and t hen only wit h great foret hought . I f you find yourself overriding rout inely, it 's a sure sign t hat t here's som et hing t hat you want in t he syst em t hat hasn't been included.

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50 = = = = I s t here anyt hing t hat you can say about how you pick your t rades ot her t han off t he syst em ? ==== I don't like t o buy ret racem ent s. I f t he m arket is going up and I t hink I should be long, I 'd rat her buy when t he m arket is st rong t han wait for a ret r acem ent . Buying on a ret racem ent is psychologically seduct ive because you feel you're get t ing a bargain versus t he price you saw a while ago. However, I feel t hat approach cont ains m ore t han a dr op of poison. I f t he m arket has ret raced enough t o m ake a significant difference t o your purchase price, t hen t he t rade is not nearly as good as it once was. Alt hough t he t rade m ay st ill work, t here's an enhanced chance t hat t he t rend is t urning. Perhaps even m ore cr it ical, a st rat egy of t rying t o buy on ret racem ent s will oft en result in your m issing t he t rade ent irely or being forced t o buy at an even higher price. Buying on ret racem ent s is one of t hose ploys t hat gives psychological sat isfact ion rat her t han providing any benefit s in t erm s of increased pr ofit s. As a general rule, avoid t hose t hings t hat give you com fort ; it 's usually false com fort . = = = = Do you have any rat ional explanat ion for why t rend- following syst em s work? = = = = People t end t o focus on t he few broad out com es t hat appear m ost probable and ignore t he low- probabilit y scenarios. As various possible out com es becom e less and m ore likely, cert ain neglect ed ones of sm all probabilit y pop int o view- a t hreshold phenom enon. The m arket has t o discount t hese " new" possibilit ies som ewhat discont inuously. Evident ly, t he success of t rend- following m eans t hat m oves of a charact erist ic size are m ore t han random ly likely t o be t he beginnings of such discont inuous adj ust m ent s. Of course, t he inference problem facing t he t rend follow er is t o dist inguish t he init ial part s of such adj ust m ent s from random swings. = = = = Do you have any fam iliarit y wit h t he syst em s t hat are sold t o t he public? = = = = I used t o t ry t o keep abreast of t hem , but , given t he preponderance of garbage out t here, I found it an exasperat ing experience. You have t o sift t hrough so m uch t hat 's bot h com plicat ed and wort hless t hat I t hink t im e is bet t er spent brainst orm ing. = = = = Why do you cat egorize t hese syst em s as Wort hless ? = = = = Because t hey t end t o overfit t he past dat a. = = = = Do you t hink t he overfit t ing is a consequence of naivet e? Or an unbridled desire t o sell m ore syst em s? = = = = At t his lat e dat e, it 's probably predom inant ly disingenuous. Have you looked at a lot of out side syst em s? I 've looked at about fift y. Out of t hose fift y, how m any had value? One. And I don't t hink it had a value as a syst em , but it had an elem ent t hat I was able t o use lat er. = = = = Do you t hen feel t hat purchasing syst em s is a wast e of m oney? = = = = For t he m ost part , J feel t hat * s t rue. I would hat e t o t hink how m uch m oney a per son would have t o spend t o chance on som et hing good. I f you have t he resources t o evaluat e syst em s, your t im e is bet t er spent developing your own ideas, I wouldn't recom m end buying syst em s. = = = = I s t he idea t hat if a syst em really worked- by t hat I m ean a com binat ion of good profit abilit y, low volat ilit y, and durabilit y- it wouldn't m ake any m onet ary sense for som eone t o sell it ? = = = = Occasionally, it m ight happen t hat som ebody com es up wit h som et hing really good and sells it because he needs t he m oney. But in m y experience, som et hing good isn't discovered on a Greyhound bus w hile leafing t hrough m e chart s; it 's som et hing developed over a period of years. Typically, if a. person has invest ed sufficient t im e and m oney int o developing a syst em , he or she will want t o use t he syst em , not sell it . = = = = What is your opinion about cont rary opinion? = = = = Cont rary opinion at t em pt s t o push t he idea of t rading against t he m aj orit y in individual t rades. Alt hough t heoret ically t his approach m ight work given t he right kind of inform at ion about m ark et com posit ion, in pract ice t he inform at ion available t o cont rary opinion t raders is of quest ionable significance. For inst ance, consider t he consensus num bers. These ar e based on recom m endat ions from m arket newslet t ers, advisory services, and so on. Therefore, t hese num bers m odel a very nonrepr esent at ive gr oup of t raders- t hose who t rade on m arket - let t er advice. I don't know even one. I n any case, t his is an em pirical quest ion: Do t he consensus figures work? Our research indicat es t hat it 's m arginally profit able t o buy- not t o sell- a m arket wit h an ext rem ely high bullish consensus. = = = = Do you have any opinion about popular t echnical overbought / over- sold- t ype indicat ors, such as RSI and st ochast ics? = = = = I t hink t hese indicat ors are nearly wort hless. I 'm not im plying t hat you shouldn't do research on t hese approaches- y ou can be very prom iscuous in your research, but not in your t rading. = = = = Having done t he research, would you t erm t hese approaches " bogus indicat ors" ? = = = = Yes, t hey're close t o zero in t erm s of t heir profit expect at ions. What t hese pat t erns m ak e during m arket consolidat ions, t hey lose during t rends. = = = = Why do you believe t hese approaches are so popular if t hey 're ineffect ive for t rading purposes? ==== For one t hing, when you look at t hese indicat ors superim posed on a price chart , t hey look m uch bet t er t han t hey really are. The hum an eye t ends t o pick up t he t im es t hese indicat ors accurat ely called m inor t ops and bot t om s, but it m isses all t he false signals and t he ext ent t o which t hey were wrong during t rends. Form ally, t he m ist ake is t he confusion bet ween prior and post erior probabilit ies. For exam ple, it 's t rue t hat a lot of ext rem es have r eversal days. [ A reversal day is one in w hich t he m arket reaches a new high ( low)

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51 and t hen reverses direct ion, closing below ( above) one or m ore im m ediat ely preceding daily closes.] All t hat 's t elling you is t he probabilit y of having a reversal day given a price ext rem e. What you really want t o know is what t he probabilit y is. of having an ext rem e- t hat is, a sust ained change in m arket t rend- given t hat you have a reversal day. That is a very different pr obabilit y. Just because one probabilit y is high, it in no way im plies t hat t he ot her one is high as w ell. I f 85 percent of all t ops and bot t om s have pr opert y X, but propert y X also occurs oft en enough in ot her places, using t hat indicat or as a signal will rip you t o shreds. Also, t hese approaches ar e appealing because t hey play int o powerful hum an t endencies t hat induce one t o t rade count ert rend or t o abbreviat e t rend- following t rades. I t 's always t em pt ing t o liquidat e a good t rade on flim sy evidence. = = = = What about cyclical analysis, which is anot her t echnique t raders use t o t ry t o pick t ops and bot t om s? ==== There are very pow erful scient ific m et hods of cyclical analysis, part icularly Fourier analysis, w hich was invent ed in t he ninet eent h cent ury, essent ially t o underst and heat t ransfer. Fourier analysis has been t ried again and again on m arket prices, st art ing in t he lat e ninet eent h cent ur y wit h t he work of t he French m at hem at ician Louis Bachelier. All t his scient ific research has failed t o uncover any syst em at ic cyclic com ponent s in price dat a. This failure argues st rongly against t he validit y of various t rading syst em s based on cycles. And, I want t o st r ess t hat t he t echniques for finding cycles are m uch st ronger t han t he t echniques for finding t rends. Finding cycles is a classic scient ific problem . = = = = What about all t he various st udies t hat purport t o find cycles in price dat a? = = = = The m arket s go up and down. So in som e loose sense of t he w ord t here are cycles. The problem is t hat you can fit sine waves pret t y closely even t o purely random pat t erns. I f you allow cycle periods t o shrink and expand, skip beat s, and even invert - as m any of t hese cycle t heorist s ( or, perhaps m ore accurat ely, cycle cranks) do- t hen you can fit cycles ont o any dat a series t hat fluct uat es. The bot t om line is t hat rigor ous st at ist ical t echniques, such as Fourier analysis, dem onst rat e t hat t hese alleged cycles are pract ically random . = = = = Do you believe t hat at t em pt s t o apply art ificial int elligence t o t rading can succeed? = = = = I t hink t hat event ually cybernet ic devices w ill be able t o out perform hum ans at every t ask, including t rading. I can't believe t hat j ust because we'r e m ade of carbon and phosphorus t here ar e t hings we can do t hat silicon and copper can't . And since cybernet ic devices lack m any of our hum an lim it at ions, som eday t hey'll be able t o do it bet t er I have no doubt t hat event ually t he world's best t rader will be an aut om at on. I 'm not saying t his will happen soon, but probably wit hin t he next few generat ions. = = = = A good part of t he academ ic com m unit y insist s t hat t he random nat ure of price behavior m eans t hat it 's im possible t o develop t rading syst em s t hat can beat t he m ar ket over t he long run. What 's your response? ==== The evidence against t he random walk t heory of m arket act ion is st aggering. Hundreds of t rader s and m anagers have profit ed from price- based m echanical syst em s. = = = = What about t he argum ent t hat if you have enough people t rading, som e of t hem are going t o do well, even if j ust because of chance? = = = = That m ay be t rue, but t he probabilit y of experiencing t he kind of success t hat we have had and cont inue t o have by chance alone has t o be near zero. The syst em s wor ked for us year aft er year. We t aught som e of t hese syst em s t o ot hers, and it worked for t hem . They t hen m anaged ot her people's m oney, and it worked again. There's always t he possibilit y t hat it all could have happened by luck, but t he probabilit y would be infinit esim ally sm all. There has act ually been a dram at ic shift in t he academ ic view on t his subj ect . When I first st art ed in t his business, m echanical t rading was considered crackpot st uff. Since t hen, t here has been a st eadily increasing num ber of papers providing evidence t hat t he random walk t heory is false. Syst em t rading has gone from a fringe idea t o being a new kind of ort hodoxy. I don't t hink t his could have happened if t here weren't som et hing t o it . However, I have t o adm it t hat I find it unset t ling t hat what began as a renegade idea has becom e an elem ent of t he convent ional wisdom . = = = = Of course, you can't act ually prove t hat price behavior is random . = = = = That 's right . You're up against t he problem of t rying t o prove a negat ive proposit ion. Alt hough t he cont ent ion t hat t he m ar ket s are random is an affirm at ive proposit ion, in fact you're t rying t o prove a negat ive. You're t rying t o prove t hat t here's no syst em at ic com ponent in t he price. Any negat ive proposit ion is very difficult t o confirm because you're t rying t o prove t hat som et hing doesn't exist . For exam ple, consider t he negat ive proposit ion t hat t here ar e no chocolat e cakes orbit ing Jupit er. That m ay be t rue, but it 's very hard t o prove. The random walk t heory has t he disadvant age of being a negat ive proposit ion. Nevert heless, in t he absence of any evidence t o t he cont rary, it m ight be a plausible t heory t o m aint ain. At t his point , however, I t hink t here is enough cont rary evidence so t hat any academ ic who st ill espouses t he idea t hat t he m arket s are random is not looking at t he realit ies. = = = = I n recent years, t here has been a t rem endous increase in t he am ount of m oney being m anaged by professional t raders using com put erized, t rend- following st rat egies. Will t his proliferat ion event ually kill t he proverbial goose t hat lays t he golden egg? = = = = The quest ion of whet her t he preponder ance of syst em t raders, especially t he group of large m anagers, is spoiling syst em s t rading is difficult t o answer because t here are t wo very different kinds of evidence t hat yield opposit e conclusions. First t here is t he quant it at ive st at ist ical evidence t hat syst em s cont inue t o work.

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52 Then t here is t he qualit at ive argum ent t hat a preponderance of syst em t raders has t o change t he m arket in such a way t hat profit can no longer be ext ract ed in t his m anner. I n ot her words, t he random walk t heorist s m ay st ill have t he last laugh. I t 's difficult t o t reat such het erogeneous evidence in a com m on fram ework so t hat one kind of evidence can be weighed against t he ot her. = = = = Well, bot h argum ent s can't be right . Which do you believe? = = = = Syst em t raders st ill have an im port ant old ally: hum an nat ure. Hum an nat ure has not changed. Fort unat ely, t here are st ill a lot of people Trading on t heir inst inct s. But t here's no quest ion t hat t he gam e has becom e m uch m ore difficult . I n evolut ionary biology, one of t he proposed solut ions t o t he quest ion of why sexual ( as opposed t o asexual) reproduct ion is so abundant is t he Red Queen Hypot hesis, based on t he charact er in Alice in Wonderland in whose count ry you had t o run as fast as you could j ust t o st ay in place. The idea is t hat com pet it ion is so severe t hat a species has t o evolve as fast as it can j ust t o st ay where it is; sexual reproduct ion provides a kind of evolut ionary overdrive. Sim ilarly, t here is such st rong com pet it ion in t he syst em s t rading niche t hat t he t rader has t o develop syst em s as fast as he or she can t o m erely st ay in place. = = = = I s t he im plicat ion t hat t he increasing proport ion of professionals in t he t ot al t rading universe will change t he nat ure of t he m arket s in such a way t hat previously valid syst em s m ay no longer work? = = = = I t hink t hat 's t rue. That 's why I 'm willing t o accept syst em s wit h som ewhat lower t heoret ical perform ance if I t hink t hey have t he propert y of being different from what I believe m ost ot her syst em t raders are using. When I raise t he point wit h would- be syst em designers t hat m uch hist orical research m ay be invalidat ed by t he changing nat ure of fut ures m arket s, t hey invariably reply t hat t he solut ion is t o develop syst em s based on r ecent dat a- as if it were t hat easy. There's a serious problem wit h t his approach. Recent dat a has t o be less st at ist ically significant t han long- t erm hist orical dat a sim ply because t here is a lot less of it . Syst em s developed solely on recent dat a are flim sily support ed. There's no way around t his basic fact . = = = = I f you were st art ing out again, what would you do different ly? = = = = I would concent rat e m ore on m oney m anagem ent . To m y regr et , it was som et hing t hat I ignored in m y early years. I ronically, even t hough m oney m anagem ent is m ore im port ant t han t he price m odel, m at hem at ically, it 's t he m ore t ract able problem . = = = = I s t here anyt hing unique about your approach t o m oney m anagem ent ? = = = = One drawback t o m any m oney m anagem ent schem es is t hat t hey are wedded t o t he assum pt ion of a logarit hm ic ut ilit y funct ion. Essent ially, t his m odel assum es t hat t he increase in people's ut ilit y for addit ional wealt h rem ains const ant for equal percent age incr eases in wealt h. The problem wit h t his m odel is t hat it is unbounded; event ually it will t ell you t o bet t he ranch. There is a t echnical obj ect ion t o unbounded ut ilit y funct ions, which is known as t he St . Pet ersburg Paradox. I can give t he t hrust of it wit h a sim plified exam ple. Suppose you have a billion dollars. I f your ut ilit y funct ion is unbounded, t her e has t o be an am ount of m oney t hat would have such large ut ilit y t hat you'd be willing t o flip a coin for it against your ent ire billion- dollar net wort h. There's no am ount of m oneyalt hough t here m ay be nonm onet ary considerat ions ( perhaps an ext ra hundred years of life) - for which a sane person would gam ble away a billion- dollar net wort h on t he flip of a coin. Ther efore, t here m ust be som et hing wrong wit h unbounded ut ilit y funct ions. We use only bounded ut ilit y funct ions in our work on risk m anagem ent . The part icular ut ilit y funct ions we use also have t he desirable t echnical charact erist ic of opt im al invest m ent fract ions being independent of absolut e wealt h level. = = = = How m uch do you risk on a single t rade? Do you have a form ula you go by? = = = = You shouldn't plan t o risk m ore t han 2 percent on a t rade. Alt hough, of course, you could st ill lose m ore if t he m arket gaps beyond y our int ended exit point . On t he subj ect of bet size, if you plot perform ance against posit ion size, you get a graph t hat resem bles one of t hose right ward- facing, high- foreheaded car t oon whales. The left side of t he graph, corresponding t o relat ively sm all posit ion size, is nearly linear; in t his range an increase in t rading size yields a propor t ionat e increase in perform ance. But as you increase size beyond t his range, t he upward slope flat t ens out ; t his is because increasingly large drawdowns, which force you t o t rade sm aller, inhibit your abilit y t o com e back aft er st rings of losses. The t heoret ical opt im um is reached right about where t he whale's blowhole would be. To t he right of t his opt im um , t he graph plum m et s; an average posit ion size only m odest ly larger t han t he t heoret ical opt im um gives a negat ive perform ance. Trading size is one aspect you don't want t o opt im ize. The opt im um com es j ust before t he precipice. I nst ead, your t rading size should lie at t he high end of t he range in which t he graph is st ill nearly st raight . = = = = How im port ant is int elligence in t rading? = = = = I haven't seen m uch cor relat ion bet ween good t rading and int elligence. Som e out st anding t raders are quit e int elligent , but a few aren't . Many out st andingly int elligent people are horrible t raders. Average int elligence is enough. Beyond t hat , em ot ional m akeup is m ore im port ant = = = = I assum e you were probably involved in developing t he syst em s t hat were t aught t o t he t urt les. [ See next chapt er for background det ails.] = = = = Yes, I was. = = = = As I underst and it , t he cat alyst for t he t urt le t raining program was a disagreem ent bet ween you and Richard Dennis as t o whet her successful t rading could be t aught . = = = = Yes. I t ook t he point of view t hat it sim ply couldn't be t aught . I argued t hat j ust because we could do it

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53 didn't necessarily m ean t hat we could t each it . I assum ed t hat a t rader added som et hing t hat couldn't be encapsulat ed in a m echanical program . I was proven wr ong. The Turt le program proved t o be an out st anding success. By and large, t hey learned t o t rade exceedingly well. The answer t o t he quest ion of whet her t rading can be t aught has t o be an unqualified yes. = = = = Do you believe t hat t he syst em s t hat Dennis and you present ed t o t he Turt les have degraded because t here are now t went y new disciples using t he sam e approaches? = = = = Wit h hundreds of m illions under m anagem ent , if t hey were st ill t rading t he sam e way it 's hard t o see how t hat could fail t o be t rue. However, it 's difficult t o say t o what ext ent t he Turt les are st ill t rading t he sam e syst em . I would assum e m any of t hem are doing t hings different ly now. = = = = I f t rading can be t aught , can it be t aught t o anyone wit h reasonable int elligence? = = = = Anyone wit h average int elligence can learn t o t rade. This is not rocket science. However, it 's m uch easier t o leam what you should do in t rading t han t o do it . Good syst em s t end t o violat e norm al hum an t endencies. Of t he people who can leam t he basics, only a sm all percent age w ill be successful t raders. I f a bet t ing gam e am ong a cert ain num ber of part icipant s is played long enough, event ually one player will have all t he m oney. I f t here is any skill involved, it will accelerat e t he process of concent rat ing all t he st akes in a few hands. Som et hing like m is happens in t he m arket . There is a persist ent overall t endency for equit y t o flow from t he m any t o t he few. I n t he long run, t he m aj orit y loses. The im plicat ion for t he t rader is t hat t o win you have t o act like t he m inorit y. I f you bring norm al hum an habit s and t endencies t o t rading, you'll gravit at e t oward t he m aj orit y and inevit ably lose. = = = = Can you expand on what you consider t he norm al hum an habit s t hat lead t o losing? = = = = Decision t heorist s have perform ed ex perim ent s in which people are given various choices bet ween sure t hings ( am ount s of m oney) and sim ple lot t eries in order t o see if t he subj ect s' preferences are rat ionally ordered. They find t hat people will generally choose a sure gain over a lot t ery wit h a higher expect ed gain but t hat t hey will shun a sure loss in favor of an even worse lot t ery ( as long as t he lot t ery gives t hem a chance of com ing out ahead) . These evident ly inst inct ive hum an t endencies spell doom for t he t rader- t ake your profit s, but play wit h your losses. This at t it ude is also cult urally reinforced, as ex em plified by t he advice: Seize opport unit ies, but hold your ground in adversit y. Bet t er advice t o t he t rader w ould be: Wat ch idly while profit - t aking opport unit ies arise, but in adversit y run like aj ackrabbit . One com m on adage on t his subj ect m at is com plet ely wrongheaded is: You can't go broke t aking profit s. That 's pr ecisely how m any t raders do go broke. While am at eurs go broke by t aking large losses, professionals go broke by t aking sm all profit s. The problem in a nut shell is t hat hum an nat ure does not operat e t o m axim ize gain but rat her t o m axim ize t he chance of a gain. The desire t o m axim ize t he num ber of winning t rades ( or m inim ize t he num ber of losing t rades) w orks against t he t rader. The success rat e of t rades is t he least im port ant perform ance st at ist ic and m ay even be inversely relat ed t o perform ance. = = = = Are t here any ot her nat ural hum an t endencies t hat you t hink t end t o sabot age success in t rading? ==== There is what I refer t o as " t he call of t he count ert rend." There's a const ellat ion of cognit ive and em ot ional fact ors t hat m akes people aut om at ically count ert rend in t heir approach. People want t o buy cheap and sell dear; t his by it self m akes t hem count ert rend. But t he not ion of cheapness or deam ess m ust be anchored t o som et hing. People t end t o view t he prices t hey'r e used t o as nor m al and prices rem oved from t hese levels as aberrant . This perspect ive leads people t o t rade count er t o an em erging t rend on t he assum pt ion t hat prices will event ually ret urn t o " norm al." Therein lies t he pat h t o disast er. = = = = What ot her aspect s of hum an nat ure im pede t rading success? = = = = What really m at t ers is t he long- run dist ribut ion of out com es from your t rading t echniques, syst em s, and procedur es. But , psychologically, what seem s of param ount im port ance is whet her t he posit ions t hat you have right now are going t o w ork. Current posit ions seem t o be crucial beyond any st at ist ical j ust ificat ion. I t 's quit e t em pt ing t o bend- your rules t o m ake your current t rades work, assum ing t hat t he favorabilit y of your long- t erm st at ist ics will t ake care of fut ure profit abilit y. Two of t he cardinal sins of t rading- giving losses t oo m uch rope and t aking profit s prem at urely- are bot h at t em pt s t o m ake current posit ions m ore likely t o succeed, t o t he severe det rim ent of long- t erm perform ance. = = = = Having seen people who have survived as t raders and t hose who haven't , what do you t hink are t he charact erist ics t hat different iat e t hese t wo groups? = = = = The people who survive avoid snowball scenarios in which bad t rades cause t hem t o becom e em ot ionally dest abilized and m ake m ore bad t rades. They are also able t o feel t he pain of losing. I f you don't feel m e pain of a loss, t hen you're in t he sam e posit ion as t hose unfort unat e people who have no pain sensors. I f t hey leave t heir hand on a hot st ove, it will bum off. There is no w ay t o survive in t his world w it hout pain. Sim ilarly, in t he m arket s, if t he losses don't hurt , your financial survival is t enuous. I know of a few m ult im illionaires who st art ed t rading wit h inherit ed wealt h. I n each case, t hey lost it all because t hey didn't feel t he pain when t hey were losing. I n t hose form at ive first few years of t rading, t hey felt t hey could afford t o lose. You're m uch bet t er off going int o t he m arket on a shoest ring, feeling t hat you can't afford t o lose. I 'd rat her bet on som ebody st art ing out wit h a few t housand dollars t han on som ebody who cam e in wit h m illions. = = = = What can a losing t rader do t o t ransform him self? = = = = I can address t wo sit uat ions. I f a t rader doesn't know why he's losing, t hen it 's hopeless unless he can

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54 find out what he's doing wrong. I n t he case of t he t rader who knows what he's doing wrong, m y adv ice is decept ively sim ple: He should st op doing what he is doing wrong. I f he can't change his behavior, t his t ype of person should consider becom ing a dogm at ic syst em t rader. = = = = Were t here any t rades in your experience t hat proved especially difficult on an em ot ional level? ==== One day in m y first year of t rading, I went long soybeans j ust a few I cent s from lim it - up. The m arket proceeded t o go from lim it - up t o lim it - down wit hout an upt ick. I t t ook about t hree m inut es. This display convinced m e t o get short at lim it - down. Two m inut es lat er, t he m arket was lim it - up again. = = = = What did t hat experience t each you? = = = = I t was m y first lesson in risk m anagem ent . I lost m ore t han half m y equit y on t hose t wo t rades in five m inut es. = = = = How did you recover from t hat loss? = = = = Trading sm all, m aking a lot of lit t le decisions rat her t han t rying t o m ake a few blockbust er t rades. = = = = Do you find it difficult t o deal wit h t he em ot ional im pact of large losses? = = = = I n m any ways, large profit s are even m ore insidious t han large losses in t erm s of em ot ional dest abilizat ion. I t hink it 's im port ant not t o be em ot ionally at t ached t o large profit s. I 've cert ainly m ade som e of m y worst t rades aft er long periods of winning. When you're on a big winning st reak, t here's a t em pt at ion t o t hink t hat you're doing som et hing special, which will allow you t o cont inue t o propel yourself upward. You st art t o t hink t hat you can afford t o m ake shoddy decisions. You can im agine what happens nex t . As a general rule, losses m ake you st rong and profit s m ake you weak. = = = = Allow m e t o broaden m y quest ion t hen. Do you find it difficult t o deal wit h t he em ot ionalit y of t rading- whet her due t o large losses or large profit s? = = = = Trading can be a posit ive gam e m onet arily, but it 's a negat ive gam e em ot ionally. On a few occasions, I 've had t he following experience: A group of m arket s t o which I 'm heavily com m it t ed open sharply against m e, alm ost at m y loss cut off point . The loss seem s crushing; I m ay even be wondering if m y risk hasn't been set t oo high. Then, m iraculously, I 'm not st opped out , and by m idday t hese m ar ket s have gone roughly as m uch wit h m e as t hey were against m e earlier. How does t his feel? There's not hing in t he elat ion t hat would approach com pensat ing for t he m orning's dist ress. The profit seem s large, of course, but it doesn't seem t o help nearly as m uch as t he earlier loss hurt . To som e ex t ent , t he foregoing exam ple m ay sim ply be em ot ional exaggerat ion, but asym m et rical responses are perfect ly valid. For exam ple, if a price m ove brings t he m arket t o your st op point , you shouldn't be t hinking in t erm s of ret racem ent s. This is t he kind of hopeful t hinking t hat m akes a t rader keep giving a loss a lit t le m ore room . Of course, t he m arket m ay be ret racing ( as opposed t o having reversed t rend) , but t hat 's not what you should be t hinking about when it 's t im e t o get out . Now consider t he case where t he m arket is sharply wit h you, rat her t han against you. Here it is quit e appropriat e t o t hink about ret racem ent s. The sharpness of t he m ove indicat es t hat volat ilit y has j ust increased; hence, even a windfall profit m ight dissipat e rapidly. The sit uat ion is asym m et rical. When you're losing and t he t hought t hat t he m arket is ret racing m ight be com fort ing, t he concept is off lim it s for considerat ion. On t he ot her hand, when you have a large profit and t he idea of a ret racem ent is a discom fort ing t hought , it should be in t he forefront of considerat ion. Trading is full of such asym m et ries t hat m ake it an em ot ionally negat ive- sum proposit ion. = = = = I f t rading is so em ot ionally unsat isfying, is t he only rat ionale for doing it financial? = = = = I can't im agine why anyone would do it if it weren't financially posit ive. This is one of t he few indust ries where you can st ill engineer a rags- t o- riches st ory. Richard Dennis st art ed out wit h only hundreds of dollars and ended up m aking hundreds of m illions in less t han t wo decades- t hat 's quit e m ot ivat ing. I f you're playing for t he em ot ional sat isfact ion, you're bound t o lose, because what feels good is oft en t he wrong t hing t o do Richar d Dennis used t o say, som ewhat facet iously, " I f it feels g- ood, don't do it ." I n fact , one rule w e t aught t he Turt les w as: When all t he crit eria are in balance, do t he t hing you least w ant t o do. You have t o decide early on whet her y ou're playing for t he fun or for t he success. Whet her you m easur e it in m oney or in som e ot her way, t o win at t rading you have t o be playing for t he success. Trading is also highly addict ive. When behavioral psychologist s have com pared t he r elat ive addict iveness of various reinforcem ent schedules, t hey found t hat int erm it t ent reinforcem ent - posit ive and negat ive dispensed random ly ( for exam ple, t he rat doesn't know whet her it will get pleasure or pain when it hit s t he bar) - is t he m ost addict ive alt ernat ive of all, m ore addict ive t han posit ive reinforcem ent only. I nt erm it t ent reinforcem ent describes t he experience of t he com pulsive gam bler as well as t he fut ures t rader. The difference is t hat , j ust perhaps, t he t rader can m ake m oney. However, as wit h m ost of t he " affect ive" aspect s of com m odit y t rading, it s addict iveness const ant ly t hreat ens ruin. Addict iveness is t he reason why so m any players who m ake fort unes leave t he gam e broke. = = = = What advice do you have for dealing wit h t he em ot ional pit falls inherent in t rading? = = = = Som e people are good at not expending em ot ional energy on sit uat ions over which t hey have no cont rol. ( I am not one of t hem .) An old t rader once t old m e: " Don't t hink about what t he m arket 's going t o do; you have absolut ely no cont rol over t hat . Think about what you're going t o do if it get s t her e." I n part icular, you should spend no t im e at all t hinking about t hose roseat e scenarios in which t he m arket goes your way, since in t hose sit uat ions, t here's not hing m ore for you t o do. Focus inst ead on t hose t hings you want least t o happen and on what your response should be. = = = = Any advice about handling t he losing periods? = = = =

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55 I t helps not t o be preoccupied wit h your losses. I f you're worried, channel t hat energy int o research. Over t he years at C&D [ t he com pany at which Dennis and Eckhardt were part ners] , we m ade our best research br eakt hroughs when we were losing. = = = = Do you t hink t hat ` s because t hose are t he t im es you have t he great est m ot ivat ion t o im prove your approach? = = = = That 's probably t rue. = = = = Am ong t he observat ions you have m ade about m arket s and t rading over t he years, do any st and out as being part icularly surprising or count erint uit ive? = = = = Som e years back, a com pany ran an annual chart ing cont est . The cont est ant s had t o predict t he set t lem ent prices of several fut ures for a cert ain dat e by a given deadline. Som eone in our office [ Dale Dellut ri] decided, I believe prankishly, t o use t he r andom walk m odel. I n ot her words, he sim ply used t he set t lem ent prices of t he deadline as his predict ion. He fell j ust short of becom ing a prizewinner wit h t his procedure. His nam e was am ong t he first five of a list of fift y or so close runners- up. This cont est had hundreds of ent rant s. Therefore, m ore t han 95 per cent , and probably m ore t han 99 percent , of t he cont est ant s scored wor se t han blind random ness. This is no m ean feat . The ext rem eness of t he out com e in t his st ory seem s t o support an apparent phenom enon t hat I 've observed m any t im es over t he years, but for which I have no hard evidence: The m aj orit y of people t rade worse t han a purely random t rader would. = = = = Your hypot hesis im plies t hat m ost t raders would be bet t er off t hrowing dart s t han using t heir exist ing m et hod- a provocat ive t hought . How do you explain t his phenom enon? = = = = The m arket behaves m uch like an opponent who is t rying t o t each you t o t rade poorly. I don't want t o suggest t hat t he m arket act ually has int ent ions, because it doesn't . An appropriat e analogy is evolut ionary t heory, in which you can t alk as t hough evolut ion has a purpose. For exam ple, birds evolved wings in order t o fly. Technically, t hat 's wrong. Birds aren't Darwinians, and you can be sure no bird or prot obird ever int ended t o evolve a wing. Nevert heless, nat ural select ion act s very m uch like it int ends for species t o evolve t hings t hat are beneficial. You can t alk about t he m arket s in a sim ilar fashion. Anybody who has t raded for a while begins t o feel t hat t he m arket s have cert ain personal charact erist ics. Very oft en t he feeling you get is t hat " t hey are out t o get you," which is sim ply a personalizat ion of t he process. This illusion is well founded. The m arket does behave very m uch like a t ut or who is t rying t o inst il] poor t rading t echniques. Most people learn t his lesson only t oo well. = = = = Please elaborat e. What kind of lessons is t he t ut or t eaching? = = = = Since m ost sm all t o m oderat e pr ofit s t end t o vanish, t he m arket t eaches you t o cash m em in before t hey get away. Since t he m arket spends m ore t im e in consolidat ions t han in t rends, it t eaches you t o buy dips and sell rallies. Since t he m arket t rades t hrough t he sam e prices again and again and seem s, if only you wait long enough, t o ret urn t o prices it has visit ed befor e, it t eaches you t o hold on t o bad t rades. The m arket likes t o lull you int o t he false securit y of high success rat e t echniques, which oft en lose disast rously in t he long run. The general idea is t hat what works m ost of t he t im e is nearly t he opposit e of what works in t he long run. A basic t hem e t hat runs t hrough Eckhardt 's com m ent s is t hat what feels good is usually t he wrong t hing t o do. As one exam ple, decision t heorist s have dem onst rat ed t hat people consist ent ly prefer t o lock in a sure win rat her t han accept a gam ble wit h a higher expect ed payoff. They also prefer t o gam ble wit h a loss, even when t he bet has a worse expect ed out com e t han a sure loss alt ernat ive- These inst inct ive prefer ences run count er t o perhaps t he m ost fundam ent al principle of successful t rading: Cut your losses short and let your profit s run. Just because t his aphorism has becom e a cliche m akes it no less valid. Anot her exam ple of count erproduct ive inst inct s is what Eckhardt t erm s " t he call of t he count ert rend." Selling on st r engt h and buying on weakness appeals t o people's desire t o buy cheap and sell dear. While such t rades m ay feel bet t er at t he m om ent of im plem ent at ion, following a count ert rend st rat egy is alm ost inevit ably doom ed t o failure. ( This cont ent ion does not , however, im ply t hat t he reverse st rat egy- t rend following- is assured success, since bot h approaches incur t ransact ion cost s.) Traders' excessive concern regarding t heir current posit ions involves yet anot her exam ple of t he det rim ent al im pact of gravit at ing t oward com fort able act ions. Taking profit s before int ended obj ect ives are reached so t hat t he m arket won't t ake away t he gains, holding posit ions beyond int ended loss liquidat ion point s in t he hopes t hat t he m arket is only wit nessing a ret racem ent , and liquidat ing posit ions before st oploss point s are reached because of t he fear of losing are all exam ples of act ions int ended t o m ake current posit ions feel bet t er. However, all of t hese act ions are likely t o negat ively im pact long- t erm perform ance. People's nat ural inclinat ions also lead t hem ast ray in syst em s t rading. The m ore closely a syst em is fit t o past price behavior, t he m ore im pressive t he hist orical sim ulat ions will appear and t he bet t er t he t r ader will feel about using t he syst em . Yet , ironically, beyond a very lim it ed point , t he m ore effort expended t o m ake a syst em fit past price behavior m ore closely, t he worse act ual fut ure perform ance is likely t o be. The desire t o design a syst em t hat looks great also leads people t o accept favorable sim ulat ed result s wit hout sufficient scrut iny. Very oft en, great result s are sim ply t he consequence of error or naive m et hodology. Eckhardt 1 s advice is t hat syst em designers should believe t heir result s only aft er t hey have done ever yt hing possible t o disprove t hem . Eckhardt proposes t hat t he t endency t o do what is com fort able will act ually lead m ost people t o experience even worse t han random r esult s in t he m arket s. I n effect , he is saying t hat m ost people don't lose sim ply because t hey lack t he skill t o do bet t er t han random but also because nat ural hum an t rait s ent ice

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56 t hem int o behavioral pat t erns t hat will act ually lead t o worse t han random result s- a part icularly com pelling observat ion. I f Eckhardt is right - and I believe he is- t he crit ical im plicat ion is t hat our nat ural inst inct s w ill m islead us in t rading. Therefore, t he first st ep in succeeding as a t rader is reprogram m ing behavior t o do what is correct rat her t han what feels com fort able.

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57 The Silence of the Turtles Pict ure an oak- paneled English drawing room . Two obviously wealt hy gent lem en sit in t heir arm chairs facing a roaring fire, puffing on t heir pipes and discussing t heir philosophy of t rading. " I t is m y proposit ion, Colin, t hat anyone can be t aught t o be a superior t rader. Ther e is not hing m agical about it . There is no rare t alent involved. I t is sim ply a m at t er of being t aught t he appropriat e rules and following t hose rules. There is no quest ion in m y m ind t hat I could t rain virt ually anyone t o m ake a fort une t rading." " That is nonsense, Duncan. You j ust t hink your t rading success is due t o your syst em . What you do not realize is t hat you have a special t alent . You could print out your rules in t welve- inch- high let t ers and have people read t hem every day for a year, and t hey st ill would not be able t o do what you do in t he m arket s. Your success is a funct ion of your t alent . I t cannot be t aught ! " " Well, Colin, t his m ust be t he hundredt h t im e we've had t his discussion. Let 's set t le it once and for all. Why don't we j ust pick t en people, t each t hem m y syst em , give t hem each £1 m illion t o t rade and see what happens." " That 's an ex cellent idea, Duncan. Pick your t en people, t rain t hem , and if by t he end of one year t hey are not ahead, on average, by at least 25 percent - a m odest figure considering t hat you norm ally m ake t wo t o t hree t im es t hat per year- you pay m e £1 m illion. I f t hey are up by m ore t han 25 percent , I will pay you t he sam e am ount ." Duncan and Colin t hen proceed t o t he window, wat ching t he passersby for pot ent ial candidat es for t heir experim ent . Each t im e t hey agree on an individual, t hey send t heir but ler out t o sum m on t he person. The above m ay sound like a fanciful plot for a st ory or m ovie. ( Act ually, it is a very loose adapt at ion inspired by t he delight ful Mark Twain st ory, " The £1,000,000 Bank- Not e. " ) However, change t he set t ing from London t o Chicago, elim inat e t he m onet ary elem ent of t he bet , and subst it ut e a m ore sophist icat ed m et hod for screening candidat es, and you act ually have a t rue st ory. The legendary t rader Richard Dennis, who reput edly t ransform ed an init ial st ake of several t housand dollars int o a fort une est im at ed at $200 m illion, essent ially had t he sam e argum ent wit h his part ner, William Eckhardt ( int erviewed in t he previous chapt er) . I t was Dennis's cont ent ion t hat t rading success could be t aught , while Eckhardt scoffed at t he idea. To set t le t heir ongoing argum ent , Dennis and Eckhardt decided t o run a version of t he above experim ent . They placed an ad in t he Wall St reet Journal seeking persons int erest ed in being t rained as t raders. Through a process of reviewing writ t en applicat ions, evaluat ing t he result s of an exam , and int erview ing select ed finalist s, approxim at ely one t housand respondent s were event ually whit t led down t o a gr oup of t hirt een. Over a period of about t wo weeks, Dennis and Eckhardt t aught t his fort unat e group som e of t heir syst em s. No holds barred, t hey gave t he group all t he specifics. Aft er t he t raining, Dennis t hen funded t his group and sent t hem off t o t rade on t heir own. The first group perform ed so w ell during t he init ial year t hat Dennis repeat ed t he experim ent t he following year wit h a second group of t en. These t wo groups of t raders collect ively becam e known in t he indust r y as t he Turt les. This rat her curious nam e had it s origins in a t rip Richard Dennis t ook t o t he Orient during t his period of t im e. At one point , he visit ed a t urt le farm , in which t urt les were raised in huge vat s. I n Dennis's m ind, t he im age of growing t housands of squirm ing t urt les in a huge vat was a perfect analogy for t raining t raders. The nam e st uck. Was Richard Dennis right ? Could people act ually be t rained t o be except ionally successful t raders? To answer t his quest ion, let 's pick up t he scene six year s lat er, when I am preparing t o do t his book. My first j ob is t o research possible candidat es t o be int erview ed. I n t he ar ea of fut ures t rader s, one reference source I used was t he quart erly sum m ary provided by Managed Account s Report s. This report sum m arizes t he perform ance of a large num ber of com m odit y t rading advisors ( CTAs) , providing a single synopsis sheet for each advisor. At t he bot t om of each sheet is a sum m ary t able wit h key st at ist ics, such as average annual percent age r et urn, largest drawdown, Sharpe rat io ( a ret urn/ risk m easure) , percent age of winning m ont hs, and t he probabilit ies of wit nessing a 50 percent , 30 percent , and 20 per cent loss wit h t he given CTA. To be obj ect ive, I flipped t hrough t he pages, glancing only at t he t ables ( not t he nam es at t he t op of t he sheet s) and checking off t he nam es of t hose advisors whose except ional perform ance seem ed t o j um p off t he page. By t he end of t his process, I had checked off eight een of t he m ore t han one hundred CTAs surveyed. Eight of t hese eight een nam es ( 44 per cent ) t urned out t o be Turt les. Absolut ely ast ounding! Richard Dennis was obviously right . ( Adm it t edly, t he result s would have been less dr am at ic a year lat er, as 1991 prov ed t o be a t ough year for m any of t he Turt les.) I t seem ed clear t o m e t hat if I were going t o pur sue t he quest for t he ingr edient s in t rading success, I should be t alking t o t he Turt les- The uniqueness of Dennis's experim ent seem ed t o provide an unusual opport unit y t o see how different individuals exposed t o t he sam e t raining differed in t he way t hey approached t he m arket s. Alt hough t he idea looked good on paper, t he execut ion proved t o be very difficult . First of all, I found t hat a num ber of t he Turt les sim ply refused t o t alk. " Look," I would say, ''I underst and your ret icence. However, I assure you t hat I will not print anyt hing unt il you have seen it , and if you fee! t hat you have inadvert ent ly divulged any t rade secr et s, I prom ise not t o use t hat m at erial. The risk is all m ine. I can go t hrough t he ent ire int erview and edit ing process, only in t he end t o have you refuse t o grant m e per m ission t o use t he copy. What do you have t o lose?" Despit e t hese assurances, a num ber of t he Turt les sim ply refused even t o consider part icipat ing. Those who refused t o t alk at all were only part of t he problem . The m aj or problem was t hat t he rem ainder of t he group was largely t ight - lipped about anyt hing of int erest . I was well aware t hat t he group had signed agreem ent s not t o divulge any part s of t he syst em , and I hardly expect ed t hem t o share t hese secr et s wit h

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58 t he world, let alone bet ray a t rust . Ther efore, in t he int erviews, I avoided any specific quest ions regarding t he syst em . Unfort unat ely, t he Turt les' caut ion was so ext rem e t hat t hey avoided t alking about anyt hing even rem ot ely connect ed wit h t he syst em . ( I couldn't help but be rem inded of t he World War I I m ovies where t he downed Am erican pilot responds t o all t he int errogat or's quest ions by repeat ing his rank, file, and serial num ber.) The following is a represent at ive segm ent int ended t o provide a flavor of t he t ypical int erview. = = = = How do you pick your t rades? = = = = I basically use t he syst em , but I can't say m uch m ore t han t hat . = = = = I know we can't discuss t he specifics of t he syst em , but can you j ust t ell m e in general t erm s why t his syst em t ends t o do so m uch bet t er t han t he vast m aj orit y of t rend- following syst em s t hat are out t here? ==== I really don't know t he ot her syst em s. = = = = Well, for purposes of com parison, let ` s j ust use t he t ypical m oving average syst em , which is essent ially a t rend- following approach. Wit hout divulging any specific t rade secret s, in a general concept ual sense, how do t he syst em s t hat Dennis t aught you differ from t hese m ore st andard approaches? = = = = I 'd rat her not answer t hat . = = = = What are t he t rading rules you live by? = = = = The sam e general rules I 'm sure you've heard ever ywhere. I don't t hink m ere's anyt hing new I could add. = = = = Let 's t alk about a specific t rading sit uat ion. The recent st art of t he U.S. air war against I raq result ed in a num ber of huge overnight price m oves. Were you in any of t hose m arket s? Were you wat ching t hose m arket s during t he night t im e session? = = = = I was lucky- I was out of t he crude oil m arket at t he t im e. = = = = How about a m arket like gold, which also had a huge price reversal at t he t im e? = = = = Yes, I had a posit ion in gold. = = = = I t 's no secret t hat Dennises approach was t rend- following in nat ure. Obviously t hen, since t he m arket had been rising for a while prior t o t he out break of t he air war, you m ust have been long at t he t im e. The war st art ed at night , and alt hough gold prices init ially rose, by t he next m orning t hey were down over $30. Were you wat ching t he m arket during t he night session? And if so, how did you react ? = = = = I got out . = = = = Was t his because t he m arket received news t hat should have been bullish- t hat is, t he out break of war- m oved slight ly higher, and t hen st art ed t rading lower? = = = = I can't say. = = = = I m hardly t alking t rade secr et s here. The concept t hat a m arket 's failure t o respond appropriat ely t o im port ant news is a significant price act ion clue is som et hing t hat I put in a book six years ago. And I 'm sure I was not t he first or last person t o t alk about t his idea. All I 'm asking is whet her t his was t he reasoning behind t aking t he loss quickly or whet her t here was m ore t o it = = = = There was m ore, but I can't t alk about it . = = = = I s t here anyt hing t hat we haven't discussed concerning t he concept s and philosophy of successful t rading t hat you would care t o com m ent on? = = = = [ Long pause. ] No, not really. I can't t hink of anyt hing. OK, you get t he idea. Applying t he appropriat e t rading principle, I decided t o cut m y losses short and st op request ing addit ional Turt le int erviews aft er t he first few. Obviously, t he ext raordinary sensit ivit y of t he Turt les t o t he possibilit y of revealing anyt hing about what Richard Dennis had t aught t hem , even inadvert ent ly, provided a seem ingly insurm ount able im pedim ent t o achieving t he t ype of relat ively open discussions I had enj oyed wit h ot her t raders. I have, how ever, select ed short excerpt s from t w o of t he Turt le int erviews I conduct ed. The follow ing m at erial offers som e feel for t he Turt le experience and provides a few insight s in t erm s of useful t rading lessons or advice. = = = Michael Carr = = = Aft er t he near paranoia, and even rudeness, I encount ered in som e of m y prelim inary int erview request s am ong t he Turt les, Michael Carr's at t it ude cam e as a pleasant relief. ( He not only graciously accept ed t he int erview request but , upon learning t hat I was a hiking ent husiast , was t hought ful enough t o send m e a brochure on t he I ce Age Tr ail, which passes near his house.) Carr was in t he first group of Turt les t rained by Richard Dennis. He began t rading in 1984, arid in his four years of t rading for Dennis, Carr averaged 57 percent annually ( he was down m oderat ely for t he first t hird of 1988, when Dennis t erm inat ed t he pr ogram ) . Carr did not begin t rading again unt il August 1989, when he launched his own CTA com pany. As of lat e 1991, Carr was up 89 percent from t hat st art ing point . I int erviewed Carr at his Wisconsin hom e, which virt ually sit s in a lake and is connect ed t o t he m ainland by a very long driveway. I arrived j ust as it began t o st orm . Carr's office, which has windows all around, offers views of t he wat er in every direct ion. The com binat ion of t he all- encom passing wat er views and t he st orm provided a spect acular backdrop. Unfort unat ely, t he set t ing was far m ore dram at ic t han our conversat ion. Alt hough Can- was quit e friendly, our int erchange was st ym ied by t he sam e caut iousness t hat charact erized all t he Turt le int erviews.

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59 = = = = How did you becom e a Turt le? = = = = I was on t he creat ive m anagem ent st aff of TSR, t he gam e com pany of Dungeons and Dragons fam e. I st art ed wit h TSR when t here were only a few em ployees. I n t he ensuing years, t he com pany went t hrough a spect acular growt h phase, which culm inat ed wit h over t hree hundred people on t he payroll. The com pany t hen hit hard t im es and m ade drast ic cut backs in order t o survive. I lost m y j ob along wit h t wo hundred ot her workers. I t was around t his t im e t hat I picked up a copy of t he Wall St reet Journal. I ronically, t hat was t he sam e day t hat Richard Den- , nis ran his ad seeking t rading t rainees. = = = = Did you have any prior experience in t he com m odit y m arket s at t he t im e? = = = = Cert ainly no t rading experience. However, while I was working for TSR, I cam e up w it h t he idea of creat ing a com m odit y gam e. I t hought t hat t he com m odit y m arket s had all t he necessary ingredient s for m aking a successful gam e. To get t he back ground inform at ion, I had sent away for lot s of exchange publicat ions. I also t ook an ext ension course, which involved six evening sessions t aught by a com m odit y broker. So I had a rudim ent ary underst anding of t he com m odit y m arket s, but not hing m ore. = = = = As I underst and it , t here were over a t housand applicant s and only t hirt een candidat es were select ed. Why do you believe you were chosen? = = = = To m y knowledge, I was t he only candidat e t hat had worked for a gam e com pany. I believe t he fact t hat m y background was different from t he ot hers helped m e get not iced. Also, a lot of com m odit y t rading is based on gam e t heory and probabilit y. Therefore, it 's not m uch of a j um p t o believe t hat som eone wit h experience in t hat area m ight bring som et hing t o t he t able. = = = = Who int erviewed you? = = = = Richard Dennis and a couple of his associat es. = = = = Can you recall any of your responses during t he int erview t hat m ight have helped you get t he j ob? ==== Not hing in part icular. I t hink, however, despit e m y having had no back ground in t he business, I was able t o ask int elligent quest ions and respond appropriat ely. However, t here was one except ion. [ He laughs at t he recollect ion.] I w as probably one of t he only candidat es w ho knew virt ually not hing about Richard Dennis. Alt hough I didn't know it , Richard Dennis was fam ous for being one of t he world's great t echnical t raders. During t he int erview I asked, " Do you t rade t he m ar ket s fundam ent ally or t echnically?" That got a good chuckle. He answered, " We t rade t echnically." I responded by asking, "I s fundam ent al analysis dead?" Dennis answered, wit h a sm ile, " We cert ainly hope not ." = = = = Obviously your lack of experience didn't hurt you. = = = = As it t urned out , of t he t hirt een people select ed, one- t hird had no experience, one- t hird had significant experience, and t he rem aining one- t hird had a lit t le bit of experience. = = = = I know you can't divulge any of t he specifics about t he t raining course. However, are t here any general lessons t hat cam e out of t hose sessions t hat you could t alk about ? = = = = One nugget of advice t hat I believe is valuable t o anyone t rading t he m arket s is: Don't worry about what t he m arket s are going t o do, worry about what you are going t o do in response t o t he m arket s. = = = = Any ot her advice regarding psychology or at t it ude? = = = = I n m y opinion, a large segm ent of t he populat ion should never t rade t he m arket s. Alt hough I hesit at e t o use gam bling as an exam ple, I believe it provides a close analogy. Those people who are wise and pr udent gam blers would probably also be wise and pm dent invest ors, because t hey have a som ewhat det ached view of t he value of m oney. On t he ot her hand, t hose people who get caught up in t he excit em ent of t he am ount of t he wager, whet her it 's gam bling or invest m ent , are likely t o be dest abilized by losses. = = = = Why do you t rade? = = = = Part of it , of course, is t o m ake a living. However, t rading has m any of t he elem ent s of a gam e. For som eone like m e who has always been int erest ed in gam es, I don't t hink t here could be a bet t er j ob. = = = Howard Seidler = = = Howard Seidler was cert ainly t he m ost ebullient of t he Turt les I int erviewed. He exuded a general sense of enj oym ent in t rading, in em ot ion , as well as in word. During our int erview, his at t it ude t oward t rading was so upbeat t hat I nat urally assum ed he m ust have been enj oying a profit able st reak in t he m arket s. To m y surprise, I lat er discovered t hat t he half- year period preceding our int erview was act ually his second worst six- m ont h perform ance ev er ( he was down 16 percent ) . Seidler cert ainly wins m y award for t he m ost happy Turt le. As t o perform ance, he has averaged 34 percent ( on an annual com pounded basis) since he began t rading in 1984. = = = = When did you first becom e involved in t he m arket s? = = = = My first exposure was act ually as a child, since m y fat her dabbled in t he m arket s. When I was in high school, I becam e aware of t he fut ures m arket s. Fut ures fascinat ed m e because of t he sym m et ry of being able t o go short as well as long. I was also at t ract ed by t he pot ent ial for leverage. As I began t o read about t he fut ures m arket s, t he general descript ion seem ed t o be: " Here's m is gam e, and by t he way, hardly anyone ever succeeds at it ." To m e, t hat was like t hrowing down t he gaunt let . = = = = When did you first act ually begin t o t rade t he m arket s? = = = = I n high school. Of course, I was t oo young t o open m y own account , so I opened an account under m y fat her's nam e.

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60 = = = = How large was t he account ? = = = = One t housand dollars. I had saved up t hat m oney by doing chores, such as shoveling snow and m owing lawns. I t t ook m e a lit t le over a year before I lost it all. = = = = That 's act ually a pret t y long ride considering t he m inuscule size of t he account and t he fact t hat you were a com plet e novice* = = = = Of course, I wasn't t oo t hrilled about it at t he t im e. However, as I got older, I realized t fiat I had really done pret t y well considering t he circum st ances. I cert ainly did get m y m oney's wort h in t erm s of experience. = = = = Do any t rades from t hat t im e stand out as a learning experience? = = = = One t rade t hat I t hink was quit e fort unat e was act ually a m issed profit opport unit y. Based on som e t rading ideas I had developed, I t hought t hat t he pot at o m arket was going t o break shar ply. I went short one cont ract , and t he m arket st art ed going in m y direct ion. Once I had a sm all profit , I decided t o double m y posit ion. Now, m y account was so t iny t hat even a one- cont ract posit ion was pushing it . I really had no business adding t o t his posit ion. Short ly aft er I had sold t he second cont ract , t he m arket st art ed t o go up. I becam e concerned about losing m y equit y, and I liquidat ed t he cont ract t hat I had added, t aking t he loss on t he t rade. However, because of t hat loss, I also ended up get t ing out of m y original cont ract way before t he m arket reached m y obj ect ive. Two days aft er I liquidat ed m y posit ion, t he m arket began a st eep collapse, j ust as I had originally ant icipat ed. = = = = I don't underst and why you t erm ed t hat t rade " fort unat e." = = = = I f I had st ayed wit h t he ent ire posit ion and ended up m aking several hundred percent on t he t rade, I would have t hought t hat I knew it all. There ar e cer t ain lessons t hat you absolut ely have t o learn t o be a successful t rader. One of t hose lessons is t hat you can't win if you're t rading at a leverage size t hat m akes you fearful of t he m arket . I f I hadn't learned t hat concept t hen, I would have at som e lat er point when I was t rading m ore m oney, and t he lesson would have been far m ore expensive. = = = = Did you event ually ret urn t o t rading before you becam e a Turt le? = = = = Short ly before I saw Richard Dennis's ad in t he Wail St reet Journal, I had left m y j ob as an econom ic consult ant t o becom e a full- t im e t rader. = = = = Only about one out of a hundred respondent s t o t he ad were ult im at ely chosen for t he t raining program . Do you have any idea why you m ade t he final select ion cut ? = = = = Alt hough t hey weren't looking for people wit h t rading experience, by t he sam e t oken, being a t rader didn't rule you out eit her. I t hink t hat insofar as I did have t he t rading backgr ound, t he fact t hat m y philosophy about t he m arket s was sim ilar t o Dennis's probably helped out . Also, and I 'm j ust speculat ing, I t hink t hat Dennis m ight have been curious t o see how som ebody wit h m y academ ic background- an MI T engineering degr ee- would work out . = = = = What advice would you give som eone in regards t o being successful in t he m arket s? = = = = I t hink t he single m ost im port ant elem ent is having a plan. First , a plan forces discipline, which is an essent ial ingredient t o successful t rading. Second, a plan gives you a benchm ark against which you can m easure your perform ance. = = = = Doesn't your bot t om line equit y give you t hat inform at ion? = = = = Over t he long run, sure. However, you can be following your rules exact ly and st ill lose m oney, hi t hat sit uat ion, you cert ainly haven't per form ed poorly as a t rader. The basic idea is t hat if you follow your rules over t he long run, t he probabilit ies will be in your favor, and you'll com e out ahead. I n t he short run, however, conform ance t o a t rading plan is m ore significant t han short - t erm equit y fluct uat ions. = = = = What else is im port ant t o succeed as a t rader? = = = = You need t o have t he persist ence t o st ay wit h your ideas day aft er day, m ont h aft er m ont h, year aft er year, which is hard work. = = = = Why would t hat be difficult ? Why would you want t o st ray from a winning approach? = = = = Because hum an beings ar e hum an beings. I f you get enough negat ive feedback over t he short m n, you're going t o be t em pt ed t o respond t o it . = = = = Any ot her t rading advice? = = = = I t 's im port ant t o dist inguish bet ween r espect for t he m arket and fear of t he m arket . While it 's essent ial t o respect t he m arket t o assure preserv at ion of capit al, you can't win if you're fearful of losing. Fear will keep you from m aking correct decisions. I realize t hat t his chapt er has not provided any definit ive answers as t o what m ade t he Turt les such a successful t rading group. Nevert heless, it does offer an incredibly im port ant m essage t o t hose int erest ed in t rading: I t is possible t o develop a syst em t hat can significant ly beat t he m arket . Mor eover, if you can discover such a syst em and exercise t he discipline t o follow it , you can succeed in t he m arket s wit hout being a born t rader .

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Monroe Trout: The Best Return That Low

61 Risk Can Buy

I first m et Monroe Trout several years ago, when a broker in m y firm , who was t rying t o land Tr out 's account , brought him by as part of t he com pany t our. I knew t hat Trout was a com m odit y t rading advisor ( CTA) new t o t he business, but I didn't know m uch else. Subsequent ly, I oft en heard Trout 's nam e m ent ioned as one of t he younger CTAs who was doing very well. I didn't realize how well unt il I st art ed t o work on t his book. I n consult ing t he quart erly issue of Managed Account s Report s while doing research for t his book, I found t hat in t erm s of ret urn/ risk m easurem ent s, Trout 's perform ance was t he best of t he m ore t han one hundred m anagers covered. There were a few who exhibit ed a larger average annual ret urn, and fewer st ill wit h sm aller drawdowns ( alt hough t hese CTAs had dram at ically lower ret urns) , but no one cam e close t o m at ching his com binat ion of ret urn t o risk. Over t he five- year period surveyed, his average ret urn was 67 percent but , ast oundingly, his largest drawdown during t hat ent ire period was j ust over 8 percent . As anot her dem onst rat ion of his consist ency, he had been pr ofit able in 87 percent of all m ont hs. I was part icularly surprised t o discover t hat for t he period in which Trout has been t rading ( he becam e a public m oney m anager in 1986) , even such legendary and ext raordinary t raders as Paul Tudor Jones did not approach his ret urn/ risk perfor m ance figures. One of t he t hings I like about Trout is t hat he does not t rum pet his successes. For exam ple, he was already doing quit e well as a t rader when I first m et him several years ago, but , as I recall, he m ade no m ent ion of his perform ance. Trout sees him self as a businessm an whose j ob it is t o m ake m oney for his cust om ers. As he expresses it , " Som e people m ake shoes. Som e people m ake houses. We m ake m oney, and people ar e willing t o pay us a lot t o m ake m oney for t hem ." = = = = When did you first get int erest ed in t he m arket s? = = = = When I was sevent een years old, I got a j ob for a fut ures t rader nam ed Vilar Kelly who lived in m y hom et own of New Canaan, Connect icut . He had an Apple com put er, and at t he t im e ( 1978) , you couldn't buy dat a on disket t e- or at least he didn't know where t o buy it if it w as available. He had ream s of price dat a t hat he had collect ed from newspapers and want ed t yped int o his com put er. He hired m e and paid m e a couple of bucks an hour t o t ype in t his dat a. = = = = That sounds like real grunt work. = = = = Yes, it was. But he also t aught m e a few t hings about t he fut ures m arket s and com put er program m ing. The com put er experience was part icularly valuable because, at t he t im e, PCs were sort of novel. That sum m er j ob spark ed m y int erest in t he m arket s. By m y sophom ore year at Harvard, I knew t hat 1 want ed t o be a t rader. I t ook what ever courses t hey had on t he m arket s. I did m y senior t hesis on t he st ock index fut ures m arket . = = = = What was t he conclusion of your t hesis? The m ost im port ant conclusion w as t hat t he probabilit y of very large price changes, w hile st ill sm all, w as m uch great er t han m ight be assum ed based on st andard st at ist ical assum pt ions. Therefore, a risk cont rol m et hodology m ust be pr epared t o deal wit h sit uat ions t hat st at ist ically m ight seem nearly im possible, because t hey're not . = = = = I assum e t he st ock m arket on t he high- volat ilit y days in Oct ober 1987 and Oct ober 1989 is a perfect exam ple. = = = = Absolut ely. I f you assum e t h a t price changes ar e norm ally dist ribut ed, t he probabilit y of daily price m oves of t hat m agnit ude would be virt ually zero, which, of course, it was not . = = = = I assum e t hat t heoret ical realizat ion m ade you t rade sm aller t han you m ight have been inclined t o ot herwise. = = = = Yes. I don't use t hat m uch leverage. = = = = Did your t hesis reach any ot her significant conclusions? = = = = I found t hat prices were not independent . That is, t here were som e st at ist ically significant pat t erns. = = = = Did you go on t o graduat e school? = = = = No. = = = = You graduat ed wit h honors from Harvard. I assum e t hat you probably could have had your pick of any graduat e school in t he count ry. Didn't you hesit at e giving up t hat opport unit y? = = = = Not at all. I knew what I want ed t o do- t rade. Gr aduat e school would only have delayed t hat goal. I never considered it . = = = = How did you break int o t he business? = = = = The at hlet ic direct or at Harvard, Jack Reardon, knew Vict or Niederhoffer, who headed N CZ Com m odit ies, a New York t rading firm . Vict or had gr aduat ed from Harvard in 1964 and was a gr eat squash player. ( I n fact , at one t im e he was t he world's best .) Jack knew I was int erest ed in t rading and suggest ed t hat I t alk t o Vict or. We hit it off, and he offered m e a j ob. I t was a great j ob because I got a lot of responsibilit y very quickly. = = = = Doing what ? = = = = Wit hin t wo weeks I was t rading on t he floor of t he New York Fut ures Exchange [ t rading t he st ock index] , Vict or owned seat s all over t he place and needed people t o t rade on t he floor for him .

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62 = = = = Execut ing his orders? = = = = A lit t le. But m ost ly I j ust scalped for m yself. I had a profit - sharing t ype of deal. [ Scalping refers t o floor brokers t rading t he m ark et for very quick, sm all profit s. There are t wo principal m et hods: ( 1) capt uring t he bid/ ask spread by t aking t he opposit e side of cust om er orders; ( 2) t aking advant age of t em porary, sm all price discrepancies bet ween relat ed posit ions ( e.g., t he March st ock index cont ract being out of line wit h t he June cont ract ) .] = = = = You were fresh out of school. How did you learn t o becom e a scalper overnight ? = = = = You ask a lot of quest ions. You st and in t he pit and t alk t o t he people around you. I t 's act ually a great place t o leam quickly. At som e point , you hit a plat eau. But when you first get int o t he business, it 's a gr eat place t o st ar t , because t here are hundreds of t raders. I f you find t he ones who know som et hing about t he m arket s and are willing t o t alk t o you about it , you can learn quickly. = = = = Do you rem em ber what you learned in t hose early days? = = = = I learned how quickly you can lose m oney if you don't know what you're doing. = = = = Did you see t hat happen t o som e people? = = = = Sure. One day som ebody will be st anding next t o you in t he pit , t he next day t hey're gone. I t happens all t he t im e. I also learned a lot about t ransact ion cost s. I 'm able t o est im at e t ransact ion cost s fairly accurat ely on various t ypes of t rades. This inform at ion is essent ial in evaluat ing t he pot ent ial perform ance of any t rading m odel I m ight develop. = = = = Give m e a pract ical exam ple. = = = = Let 's t ake bonds. The average person off t he floor m ight assum e t hat t he t ransact ion cost s beyond com m issions is at least equal t o t he bid/ ask spread, which in t he bond m arket is one t ick [ $31.25] . I n realit y, if you have a good brok er, it 's only about half a t ick, because if he's pat ient , m ost of t he t im e he can get filled at t he bid. I f you have a bad br oker, m aybe it 's one t ick. So t he t ransact ion cost in m at case isn't as high as you m ight t hink. Therefore, a T- bond t rading syst em t hat you m ight discard because it has a sm all expect ed gain m ight act ually be viable- assum ing, of course, t hat you have good execut ion capabilit ies, as we do. The S&P m arket , on t he ot her hand, is j ust t he opposit e. You m ight assum e a bid/ ask spread of 1 t ick [ 5 point s = $25] , but very oft en it 's higher, because when you t ry t o buy at t he offer, it disappears. = = = = What else did you learn on t he floor? = = = = I learned about where people like t o put st ops. = = = = Where do t hey like t o put st ops? = = = = Right above t he high and below t he low of t he previous da y. = = = = One t ick above t he high and one t ick below t he low? = = = = Som et im es it m ight be a couple of t icks, but in t hat general area. = = = = Basically, is it fair t o say t hat m arket s oft en get drawn t o t hese point s? I s a concent rat ion of st ops at a cert ain area like waving a red flag in front of t he floor brokers? = = = = Right . That 's t he way a lot of locals m ake t heir m oney. They t ry t o figure out where t he st ops are, which is perfect ly fine as long as t hey don't do it in an illegal way. = = = = Given t hat experience, now t hat you t rade off t he floor, do you avoid using st ops? = = = = I don't place very m any act ual st ops. However, I use m ent al st ops. We set beepers so t hat when we st art losing m oney, a warning will go off, alert ing us t o begin liquidat ing t he posit ion. = = = = What lesson should t he average t rader draw from knowing t hat locals will t end t o m ove m arket s t oward st op areas? = = = = Traders should avoid put t ing st ops in t he obvious places. For exam ple, rat her t han placing a st op 1 t ick above yest er day's high, put it eit her 10 t icks below t he high so you're out before all t hat act ion happens, or 10 t icks above t he high because m ay be t he st ops won't bring t he m arket up t hat far. I f you're going t o use st ops, it 's pr obably best not t o put m em at t he t y pical spot s. Not hing is going t o be 100 percent foolproof, but t hat 's a generally wise concept . = = = = Do you believe your floor experience helps explain your superior perform ance? = = = = I believe so. For exam ple, I have a pr et t y good eye for picking out where st ops are going t o be, even from off t he floor. I t ry t o get in t he m arket a bit before t hat point is reached, som et im es even t rying t o set t he st ops off m yself- and t hen t he m arket will be off t o t he races. = = = = The exam ple of a com m on st op point you m ent ioned earlier- t he area right beyond a prior high or lowis kind of obvious. Are t here any ot her less obvious exam ples of popular st op point s? = = = = Round num bers. For inst ance, when t he Dow Jones st art s cr eeping up t oward 3,000, I 'll st art buying som e in ant icipat ion of it going t hrough 3,000. The 3,000 level act s like a m agnet . = = = = So t he m arket s are drawn t o round num bers. Do m arket s usually reach t he round num ber, or do t hey oft en st op j ust short of it ? = = = = I believe m arket s alm ost always get t o t he round num ber. Therefore, t he best place t o get in is before t hat num ber is reached and play what I call t he " m agnet effect ." For exam ple, I m ight buy t he st ock index m arket s when t he Dow is at 2,950, looking for it t o go t o 3,000. When t he m arket get s close t o 3,000, t hings get m ore difficult . When t hat happens, I like t o have everybody in t he t rading room get on t he phone wit h a different broker and list en t o t he noise level on t he floor. How excit ed does it sound down t here? What size t rades are hit t ing t he m ar ket ? I f it doesn't sound t hat loud and order sizes ar e sm all, t hen I 'll st art dum ping our posit ion because t he m arket is pr obably going t o fall off. On t he ot her hand, if it sounds crazy and t her e

62

63 are large orders being t r ansact ed, I 'll t end t o hold t he posit ion. = = = = Give m e a recent exam ple of t he noise level on t he floor being a good indicat or. = = = = When crude oil reached $20 [ during t he Persian Gulf crisis] , t here was a lot of noise on t he floor and t he m arket cont inued t o m ove higher. = = = = What else did you learn from your floor t rading experience? = = = = I learned what are t he m ost liquid t im e periods of t he day. When you're t rading one cont ract , t hat 's not im port ant . But when you're t rading t housands of cont ract s, it can be crit ical. = = = = What are t he m ost liquid t im es of t he day? = = = = The m ost liquid period is t he opening. Liquidit y st art s falling off pret t y quickly aft er t he opening. The second m ost liquid t im e of day is t he close. Trading volum e t ypically form s a U- shaped cur ve t hroughout t he day. There's a lot of liquidit y right at t he opening, it t hen falls off, reaching a nadir at m idday, and t hen it st art s t o clim b back up, reaching a secondary peak on t he close. Generally speaking, t his pat t ern holds in alm ost every m arket . I t 's act ually pret t y am azing. I t 's also im port ant t o know when t he illiquid periods occur, because t hat 's a good t im e t o support y our posit ion. For exam ple, if I 'm long one t housand S&P cont ract s and it 's 11: 30 Chicago t im e, I 'm probably going t o want t o put in som e sort of scale- down buy orders, like buying t en lot s every t ick down, t o hold t he m arket in m y direct ion. I t doesn't cost m e t hat m any cont ract s at t hat t im e of day t o support t he m arket , because t her e are not a lot of cont ract s t rading. The longer you can keep t he m arket up, t he bet t er off you're going t o be. = = = = I sn't support ing t he m arket a fut ile effort ? I n ot her words, isn't t he m arket ult im at ely going t o go where it want s t o go, whet her you support it or not ? = = = = Over t he long run, sure. But for t he short t erm , single t raders can definit ely m ove t he m arket . There's no doubt about it . I m ove t he m arket every single day. The idea is t o do it in a sm art way. For exam ple, if t he S&P is near yest erday's high and I 'm long a lot of cont ract s and want t o get out , I m ay t ry t o push prices t hrough yest erday's high t o generat e excit em ent and boost t he t rading volum e. The increased volum e will m ake it a lot easier for m e t o dum p m y posit ion. = = = = Why did you leave t he floor? = = = = I found t hat what I did best on t he floor was posit ion t rading. I had experience developing com put er m odels in college. Each day when I finished on t he floor, I would go back t o t he office and develop t rading m odels. Vict or was kind enough t o let m e t rade off som e of t hese m odels, and I st art ed m aking fairly consist ent m oney. Since on t he floor I could only direct ly t rade one m arket , it was m ore efficient for m e t o t rade off t he floor. = = = = What is t he t ypical lengt h of a t rade generat ed by your m odels? = = = = A holding period of about a day t o a week. = = = = My experience wit h t rading m odels is t hat t he ones t hat generat e very short - t erm signals- for exam ple, average t rade lengt hs of one week or less- don't beat t ransact ion cost s. I see you nodding your head, so yon obviously know what I 'm t alking about . What is it about your m odels t hat 's different ? = = = = First , our m odels t end t o be m ore st at ist ically orient ed. Second, we have lower t ransact ion cost s t han virt ually anyone in t he business. Our round- t rip com m ission is probably lower t han 99 percent of t he funds. = = = = Why is t hat ? = = = = Because t he com binat ion of several hundred m illion dollars under m anagem ent and frequent t urnover m eans t hat we generat e m ore t rades t han virt ually anyone else. This large t rading volum e m akes it possible for us t o negot iat e pret t y low com m ission rat es. Also, I believe we get som e of t he best ex ecut ions of any offt he- floor t rader. We use m any different brokers in each pit , and t here's a const ant select ion process going on. I f a broker isn't good, we get rid of him . Conversely, if a broker does a good j ob for us, we give him m ore business. I have t he m anpower t o call around. We can get t en people on t he phone calling a given pit if we need t o. We also carefully m onit or our slippage [ t he difference bet ween an est im at ed fair execut ion price and t he act ual ex ecut ion price] . At t he end of every single day, m y st aff gives m e a sum m ary sheet list ing t he slippage in each m arket . = = = = How do you det erm ine what t he execut ion price should be when you're ent ering an order? = = = = Every t im e an order leaves a t rader's m out h, he looks at t he last price on t he screen. Say t he price for bonds on t he screen is 17 and a buy order is filled at 18, we record t he slippage as I . = = = = How do you know if it 's slippage or if t he m arket really m oved since t he last screen print ? = = = = We m ake t he sim plifying assum pt ion t hat over t he long run it will work bot h ways- t hat is, t he m arket will t rade in t he direct ion of your order as well as away from it . Therefore, som et im es t he m arket will give you a m ore negat ive fill t han it probably should, but at ot her t im es you'll get a m or e posit ive one. Aft er you've done t housands of t rades, you get a pret t y good idea of who t he good brokers pr oviding t he best fills are, as well as what is a reasonable slippage fact or in each t rading pit . = = = = Basically t hen, since your t ransact ion cost s [ com m issions as well as slippage] are v ery low, som e m arginal syst em s t hat wouldn't work for a t ypical t rader m ight be profit able for you. = = = = Right . For exam ple, if t he average profit on a bond t rading syst em is $40 per lot and I 'm t rading under $10 com m ission wit h a slippage fact or of half a t ick [ $16] , I 'm going t o be able t o t rade t hat syst em for a consist ent pr ofit . On t he ot her hand, for som eone paying $30 a r ound m m and averaging a slippage fact or of one t ick, t hat sam e syst em would be a m oney drain.

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64 = = = = What port ion of your profit s would yon est im at e is a funct ion of your cont rol of t ransact ion cost s? = = = = I would guess t hat w e save about 6 percent per year in reduced slippage by carefully select ing and m onit oring our brokers and anot her 6 percent by paying $10 per round t urn inst ead of, say, $20. = = = = Why did you event ually leave Vict or's organizat ion? = = = = Two reasons. First , I want ed t o avoid t he daily com m ut e of one hour and fort y- five m inut es one way. Second, I felt t hat , over t he long run, I could probably m ake m ore m oney on m y own- alt hough t hat cer t ainly wasn't t rue over t he short run. = = = = How do you define success in t rading? = = = = I sincerely believe t hat t he person w ho has t he best daily Sharpe rat io at t he end of t he year is t he best t rader. [ The Sharpe rat io is a st at ist ical perform ance m easur e t hat norm alizes ret urn by risk, wit h t he variabilit y of ret urns being used t o m easure risk. Thus, for exam ple, assum e Trader A and Trader B m anaged ident ical- sized funds and m ade all t he sam e t rades, but Trader A always ent ered orders for double t he num ber of cont ract s as Trader B. I n t his case. Trader A would realize double t he per cent age r et urn, but because risk would also double, t he Sharpe rat io would be t he sam e for bot h t raders.' Norm ally, t he Sharpe rat io is m easured using m ont hly dat a. Thus, only equit y variabilit y t hat occurs on a m ont h- t o- m ont h basis would be considered, Trout is going a large st ep fur t her by saying t hat , by his definit ion, t rading perfor m ance should not only incorpor at e risk but should do so down t o day- t o- day v ariat ions of equit y.] t echnically speaking, t here would be a slight variat ion because t he risk- free ret urn ( e.g., T- bill rat e) would also ent er int o t he calculat ion. = = = = How do you explain your success as a t rader? = = = = ( A) We do good research, so we have an edge. ( B) We have a rat ional, pract ical approach t o m oney m anagem ent . ( C) We pay very low com m issions. ( D) Our execut ions are am ong t he best in t he business. ( E) Most of t he people who work here keep a large por t ion of t heir net wort h in t he fund we m anage. Per sonally, I have over 95 percent of m y net wort h in t he fund. = = = = I t ake it t hat you're not pulling out very m uch m oney. = = = = I don't pull out any m oney. I rent m y condo and I drive a cheap car. = = = = I s t he m oney you're m aking t hen m ore a m at t er of keeping score, or do you have som e sort of ult im at e goal? = = = = At t his point , it 's m ore a m at t er of keeping score, because I can ret ire t oday and live very com fort ably off t he int erest for t he r est of m y life. The fact is t hat I like t o t rade. When I was a kid, I loved t o play gam es. Now I get t o play a very fun gam e, and I 'm paid handsom ely for it . I can honest ly say t hat t here isn't anyt hing else I would rat her be doing. The m inut e I don't hav e fun t rading, or I don't t hink I can m ake a profit , I 'm going t o quit . = = = = Have t he m arket s changed since you st art ed in t he business? = = = = Volum e has gone up dram at ically, which is great . The m arket s also appear t o have becom e m ore efficient . Som e of t he pat t erns I used t o t rade off are st art ing t o get elim inat ed as ot her people st art picking up on t hem . = = = = Can you give m e an exam ple of a pat t ern t hat has becom e obsolet e? = = = = I used t o like t o put on posit ions in t he st ock m arket in t he sam e direct ion as t he price m ovem ent t wo days earlier. For exam ple, if t he m arket was up on Monday, I would be prone t o be a buyer on Wednesday. This is an exam ple of a pat t ern t hat I don't believe in m uch anym ore. = = = = Your t ype of syst em developm ent seem s t o be heavily based on past pat t erns. I f you t est enough pat t erns, aren^ t som e of t hem going t o be profit able a large per cent age of t he t im e j ust based on norm al probabilit y? Just like if you had t en t housand people t oss a coin t en t im es, som e of t hem are going t o get t en heads in a row. I t doesn't m ean t hat t hose coins have any bet t er chance of landing on heads on t he next t oss. How do you dist inguish bet ween pat t erns t hat reflect real inefficiencies in t he m arket and t hose m at are m erely coincident al, an inevit able consequence of looking at so m any pat t erns? = = = = A pat t ern has t o m ake sense. For exam ple, if I find t hat t he pr ice change of t he Brit ish pound fort y days ago is st at ist ically significant in predict ing t oday's price in t he S&P, I w ouldn't put any fait h in it . Why w ould t he Brit ish pound price fort y days ago affect t he S&P? So we t oss out a lot of t hese t ypes of pat t erns even if t hey have a high percent age of success. = = = = Why would you even bot her t est ing pat t erns like t hat ? = = = = I t 's act ually easier t o set up giant com put er runs t o t est every com binat ion of m arket and int erval relat ionships, and t hen consider t he relat ionships t hat appear st at ist ically significant , t han t o decide which individual com binat ions t o t est . = = = = I s a st at ist ical em phasis one of t he keys t o your t rading approach? = = = = Yes, because it keeps us r at ional. We like t o see t hat som et hing has worked in t he past before we use r eal m oney on it . = = = = How m any different m odels or pat t erns are you using at any given t im e t o t rade t he m arket s? = = = = Dozens. = = = = For diversificat ion reasons? = = = = Yes. We t ry t o diversify everyt hing we possibly can. We like t o diversify over bot h t rading st rat egies and t im e.

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65 = = = = By t im e diversificat ion, do you m ean you use t he sam e pat t ern for hourly dat a, daily dat a, and weekly dat a? = = = = Right . I t also m eans sim ply following t he m arket s t hroughout t he ent ire t rading session and being ready t o t rade if som et hing happens at any t im e in t he day. = = = = What percent age of your t rading is aut om at ically det erm ined by specific pat t erns or syst em s you use? ==== Roughly 50 percent . I t 's hard t o gauge because our syst em s m ay t ell us t o buy one t housand cont ract s on a given day but it 's m y discret ion as t o when t o buy t hem . = = = = So your skills in ent ering and exit ing posit ions are an im port ant elem ent in your t rading perform ance? ==== Absolut ely. = = = = I f you j ust followed t he syst em s blindly by placing orders using som e aut om at ic ent ry rule- for exam ple, buying on t he opening, or on t he close, or at som e fixed int ervals t hrough t he day- inst ead of t im ing t he ent ry of t he t rade, what would you guess would be t he degradat ion of result s per m ont h? = = = = I t 's very har d t o say, but if we blindly followed t he syst em s we m ight m ake half of what we do now. Maybe even less. I could give t en CTAs t he exact syst em s we use, and som e of t hem st ill wouldn't m ake any m oney. = = = = You said t hat roughly 50 percent of your t rades are not syst em det erm ined. Give m e an exam ple of t hat t ype of t rade. = = = = My favorit e is t he m agnet effect , which we spok e about earlier. When t he m arket approaches a round num ber or a crit ical point , I like t o play for t he m arket t o get t o t hat price. = = = = Have you ever t ried syst cm at izing t hat concept ? = = = = No, because I don't t hink it can be syst em at ized. I m ay suddenly realize t hat a cert ain level is a key point , or t he inform at ion m ay com e from one of our floor cont act s. We're always asking our floor people, " What num bers are people looking for?" = = = = Any ot her exam ples of a discret ionary [ i.e., nonsyst em ] t ype of t rade? = = = = We get const ant inform at ion from t he floor. We probably get a call a m inut e from our clerks. = = = = Telling you who is doing what ? = = = = Right . = = = = I s t hat helpful? = = = = I f, for inst ance, a lot of players whom we respect seem t o be doing t he sam e t hing, it m ight prom pt us t o t ake a sim ilar posit ion or increase our posit ion if we're already on t he sam e side. = = = = Any ot her exam ples of nonsyst em t rades? = = = = Anot her t rade I like t o do is t o find out when a price m ove has been caused prim arily by locals- we have very good floor cont act s, so we get t hat t ype of inform at ion- and t hen go in t he opposit e direct ion. The reasoning is t hat t he locals are going t o want t o cover t heir posit ion before t he end of t he day, which is going t o bring t he m arket back from whence it cam e. [ Most locals go hom e flat .] = = = = I not iced t hat you have a whole crew of t raders working for you. Yet , it 's m y im pression t hat you are t he only one here who m akes discret ionary t rading calls. How do you ut ilize t hose people? Couldn't you j ust wat ch t he m arket s on your own and use som e clerical st aff t o help you ent er t he orders? = = = = There's so m uch inform at ion flowing in here t hat I can't possibly follow and analyze it all. My t raders are under inst ruct ions t o alert m e anyt im e som et hing im port ant happens. They also keep m e post ed as t o when m arket s are likely t o be part icularly volat ile based on fundam ent als or news announcem ent s. A recent exam ple of t hat t ype of an announcem ent was Jim Baker's st at em ent t o t he press on January 9. We were set up for a m ore peaceful t ype of an announcem ent . [ January 9, 1991, was t he day t hat Secret ary of St at e Jam es Baker m et wit h t he I raqi am bassador in an effort t o aver t a war. At t he t im e, t here was a reasonable degr ee of opt im ism going int o t he m eet ing because a cont inued hard- line st ance seem ed such folly for I raq. Addressing t he press aft er t he m eet ing, Baker began his st at em ent , " Regret t ably...." Traders didn't wait t o hear t he second word, and a wave of selling hit t he st ock and bond m arket s.] = = = = Did yon sell as soon as you heard t he word " Regret t ably" ? = = = = I t was t oo lat e for us. Wit h t he t ype of size we t rade, it was all over. For exam ple, we lost 1,200 point s in t he S&P in a half- hour, and m ost of t hat was in t he first t en seconds. We were long about seven hundred cont ract s. I f we had t ried t o sell int o t hat t ype of m arket , we would have am plified t he decline and probably would have ended up selling at t he low of t he day. = = = = When som e sudden news com es out , how do you decide when you should j ust get out im m ediat ely and when you should wait for t he init ial selling panic t o subside? = = = = There's a big difference bet ween sm all size and big size. I f I were t rading sm all size- for exam ple, t en lot s in t he S&P- t hen I probably would have got t en out right away. That is, I would have sold as soon as I heard t he word " Regret t ably." = = = = But obviously you're not in t hat posit ion anym ore. Now t hat you're always t rading larger size, do you j ust have t o grit your t eet h and wait when a surprise hit s t he m arket ? = = = = I w ait unt il t he m arket st abilizes a bit and t hen I st art get t ing out - part icularly if it 's past m y pain t hreshold in t erm s of dollar loss.

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66 = = = = What event ually happened on t hat day? Did you get out of your ent ire S&P posit ion? = = = = Yes. We basically phased out of t he posit ion over t he rest of t he day. There was no quest ion about what t o do because one of m y risk m anagem ent rules is t hat if we lose m ore t han 1.5 percent of our t ot al equit y on a given t rade we get out . = = = = What are your ot her risk m anagem ent rules? = = = = I f w e're dow n 4 percent on a single day, w e close out all posit ions and w ait unt il t he next day t o get int o anyt hing again. This rule has been act ivat ed only t wice in t he last t wo years, one of t hose days being January 9.1 dum ped m y whole port folio because I was down 4 percent . = = = = What was your dollar loss t hat day? = = = = About $9.5 m illion. = = = = And yon lost t hat am ount in a very short period of t im e? = = = = From all pract ical st andpoint s, I lost m ost of it in about t en seconds. = = = = Talk about your em ot ions when you're losing a m illion dollars a second. = = = = hi t his inst ance, it happened so quickly t hat I was a bit speechless. Norm ally when I lose m oney, I get angry. That 's usually t he first em ot ion t hat com es int o play. = = = = Angry at t he m arket , or angry at yourself? = = = = I guess m ore at t he m ark et , but , of course, t hat 's not really rat ional because t he m arket is not a per sonal t hing; it is not t rying t o get m e. I t ry t o keep m y anger in check as m uch as possible because I believe t hat t o be a good t rader it 's v ery im port ant t o be rat ional and have your em ot ions under cont r ol. I 've been t rying for years t o get rid of anger com plet ely when I lose m oney, and I 've com e t o t he conclusion t hat it is im possible. I can work t oward t hat goal, but unt il t he day I die, I don't t hink I 'm ever going t o be able t o look a big loss in t he face and not get angr y. = = = = Does anger affect your t rading? = = = = No. I 'd say t hat I 'm pret t y good about t hat . = = = = Going back t o January 9, aft er yon got past your speechless react ion, what did you do? = = = = Once I realized t hat we were down over 4 per cent , I devised an orderly plan t o exit all m arket s by t he close. I n t hat t ype of sit uat ion I t ry t o devise an exit plan and t hen get out of t he t rading room because I want t he liquidat ion done in a rat ional m anner. I leave it t o m y t raders t o handle t he execut ion. = = = = Did t he loss keep yon awake t hat night or did you sleep well? = = = = I n general, I don't sleep well at any t im e. Unfort unat ely, t hat 's one of t he prices you have t o pay for being a t rader. I wish I didn't have t o, but t hat 's t he way it is. = = = = Do yon sleep bet t er on days when you win t han on days when you lose? = = = = Not necessarily. I n fact , I probably sleep worse when I 'm doing well, because I get t oo excit ed. = = = = How long was it unt il you fully absorbed t he im pact of t hat day and were on t o t he next t hing? = = = = I st art ed forget t ing a bit about it t he next day. I t t ook m e a few days. = = = = When a loss like t his happens, do you t hink it 's going t o bot her you for a while? Are you surprised t hat you're com plet ely over it a week lat er? = = = = I guess I know t hat I 'm going t o be over it in a week. I never want t o get int o a sit uat ion where it 's so bad t hat I can't get over it . That 's one of t he reasons I t ry t o be conservat ive in m y risk m anagem ent . I want t o m ake sure I 'll be around t o play t om orrow. = = = = Once you get out , even t hough you've t aken a loss, do you feel bet t er because you're out ? = = = = Yes, because t he pain is over, and I know exact ly what I 've lost . There's a bit of a feeling of relief. = = = = I s it m eaningfully t ougher t o lose 4 percent when you are t rading $100 m illion t han when you're t rading $1 m illion? = = = = I t is t ougher. Dollars have a lot t o do wit h it , t oo. There are plent y of t raders I know who show t rack records wit h an am azing cum ulat ive winning percent age. I 've seen sit uat ions where t hey m ight be up 1,000 percent over a five- year period, but if you exam ine t heir t rack record in t erm s of net dollars m ade or lost , you discover t hey are act ually down. = = = = Because t hey m ade t he large percent age ret urns wit h sm all capit al and t hen lost m oney when t hey were m anaging large sum s? = = = = Exact ly. I 'm not in t he business of picking CTAs. But if I were, one of t he first screens I would use would be a person's t ot al dollar profit - how m any dollars did t he CTA pull out of t he m arket . I f t hat num ber w ere negat ive, I would elim inat e t he CTA from considerat ion, regardless of t he percent age ret ur n. = = = = Did your 4 percent m axim um daily loss rule help you on January 9? = = = = On t hat part icular occasion, no. We act ually would have been bet t er off grit t ing our t eet h and holding on for a while longer. = = = = But doesn't t hat change your fait h in t he rule? = = = = No, because if you don't have t hat t ype of rule, you can end up being long t he S&P on a day like Oct ober 19, 1987, when procrast inat ing in get t ing out would have been a disast er. = = = = So far you've m ent ioned a 1.5 percent m axim um loss lim it on a single posit ion and 4 percent on t he ent ire port folio for any given day. Are t here any ot her risk m anagem ent rules you use? = = = = We have a m axim um loss point of 10 percent per m ont h. I f we ever lost t hat am ount , we'd exit all our

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67 posit ions and wait unt il t he st art of t he next m ont h t o begin t rading again. Thankfully, t hat has never happened. We also have a fourt h risk m anagem ent rule: At t he beginning of each m ont h, I det erm ine t he m axim um posit ion size t hat I 'm willing t o t ake in each m arket , and I don't exceed t hat lim it , regardless of how bullish or bearish I get . This rule keeps m e in check. = = = = Do you use chart s? = = = = I look at chart s prim arily t o figure out where t raders are going t o get int erest ed in a m arket . I know t he t ypes of pat t erns t hey like t o look at . = = = = You use bot h discret ionary and syst em t rading. Do you have anyt hing t o say about t he m erit s or drawbacks of each approach? = = = = The bot t om line is t hat you need an edge. One of t he ways you can get an edge is t o find a successful syst em . However, if you're j ust a pur e syst em s player and you st a r t m anaging large am ount s of m oney, you're going t o find t hat your t ransact ion cost s st ar t t o elim inat e a good deal of your profit s. I n general, it 's probably best t o be som ewhere bet w een a pure discret ionary t rader and a pur e syst em t rader. As I m ent ioned before, you can help your syst em s by using som e discret ion in t he ent ry and exit of posit ions. = = = = Have you looked at com m ercial syst em s at all? = = = = Sure, we've bought lot s of t hem . I used t o evaluat e t he syst em s m yself, but now I have ot her people in t he office do it . We have never used any of t hese syst em s as is; we use t hem t o give us ideas in const ruct ing our own syst em s. = = = = Do you have any advice for t he public about syst em s offered for sale? = = = = Join Club 3000. [ This organizat ion issues a newslet t er com posed of m em ber s' let t ers t hat discuss syst em s and ot her aspect s of t rading. The nam e derives from it s origins. Club 3000 was form ed in frust rat ion by m em bers who had paid approxim at ely $3,000 for a syst em t hey felt was essent ially wort hless and decided t o get t oget her t o share inform at ion about various syst em s.] I would also subscribe t o such publicat ions as Fut ures, Technical Analysis a / St ocks and Com m odit ies, and Com m odit y Traders Consum ers Repor t for t heir reviews on syst em s. Also, once you buy a syst em , m ake sure you t est it on your own dat a. = = = = I n ot her words, don't t ake t he vendor's word for it . Do you t hink t hat m any of t he claim s for syst em s are overblown? = = = = Yes. = = = = I s t hat because of deliberat e m isrepresent at ion or are m ost of t he vendors act ually fooling t hem selves? = = = = Som e of t he syst em claim s m ay act ually be part ially legit im at e. However, I usually find t hese syst em s don't have enough observat ions t o be st at ist ically significant . Also, frequent ly, t he syst em s base t heir percent age r et urn claim s on t he m inim um exchange m argin requirem ent s. = = = = I underst and. Doing t hat gives t he syst em s ext raordinary leverage and t he ads only t alk about t he ret urn side; t hey don't discuss t he risk side. = = = = Right . I m ade t he sam e m ist ake in m y senior t hesis. I based m y percent age ret urns on t he assum pt ion of an account size equal t o double t he exchange m inim um m argin requirem ent , which was a grossly inadequat e sum . hi realit y, if you ever t ried t o t rade t hat way, you would go broke, because t he drawdowns are t oo big. = = = = Do you basically believe t hat if som ebody developed a really good syst em t hey wouldn't be selling it ? ==== To som e degree, I believe t hat . Sure, it 's possible t hat a syst em developer m ay not have any m oney, but if t he syst em is t hat good, he should be able t o convince friends, fam ily, anybody t o put som e m oney int o t he syst em and t rade it . = = = = Are t here any t echnical indicat ors in t he public dom ain t hat you find useful? = = = = Moving averages ar e useful. They'll work if you wat ch your risk m anagem ent . I believe you can m ake an above- average ret urn by using m oving averages, if you're sm art about it . = = = = Any indicat ors t hat yon consider overrat ed? = = = = Most of t he com m on ones: Fibonacci ret racem ent s, Gann angles, RSI , and st ochast ics. I haven't found anyt hing t here for any of t hese indicat ors. = = = = I f you have a st reak when you're doing very well, day aft er day, do you get t o t he point where you say, " This j nst can't keep on" ? And do you st art reducing your posit ion because of t hat ? = = = = Act ually, t he bet t er I 'm doing, m e bigger I play, and t he worse I 'm doing, t he sm aller I play. = = = = So you believe in st reaks? = = = = Yes, not j ust in t rading, but in m ost t hings in life. I f a t eam has won eight gam es in a row, you don't bet against m em winning t heir nint h gam e. = = = = Are t here t rading errors t hat you've learned t o avoid? = = = = I n general, I don't like placing st ops. I f you're a big player, you really have t o be careful about put t ing st ops int o t he m arket . = = = = Did yon learn t hat by get t ing burned in placing st ops? = = = = I never placed a lot of st ops t hroughout m y ent ire career, but I used t o place m ore t han I do now. = = = = I f you did place t he st op, did you find t here was a higher t endency of get t ing hit ? = = = = I f I put a large st op order in t he m arket , not only is it going t o have a t endency t o get hit , but when it

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68 does get act ivat ed, prices are likely t o run. So I will not only get st opped out , but I will get filled at an average price significant ly worse t han m y st op. = = = = At your current t rading size, I would assum e t hat you probably avoid ent ering explicit st op orders alt oget her. = = = = Right . Som et im es, if I want t he price t o m ove t oward a cert ain level, I m ay put in a st op and t hen cancel t he order once t he m arket get s close. I do st uff like t hat frequent ly. Act ually, I did it t oday . I t worked t oday, but som et im es it backfires, and you find yourself t he proud owner of som e bonds you don't want . = = = = You seem very confident about your abilit y t o t rade t he m arket s profit ably. Have you always had t hat confidence in t rading? = = = = Probably for about four years. = = = = Not speaking about yourself now, but in general, would you say t here is a st rong correlat ion bet ween t he degr ee of confidence and success in t rading? = = = = There is som e correlat ion, but it 's nowhere near 100 percent . Som e people are j ust confident , but if t hey don't have an edge in t he m arket , it doesn't m at t er ; t hey're st ill going t o lose m oney. = = = = What you're saying is t hat not all confident people are going t o be good t raders. However, are nearly all good t raders confident ? = = = = Yes, I would t hink t hat virt ually all good t raders ar e probably confident in t heir t rading abilit y. = = = = Do you rem em ber when you really becam e confident as a t rader? I s t here som e t ransit ion point t hat you can recall? = = = = I guess by t he t im e I decided t o go off on m y own I was fairly confident . I knew I had t o m ake m oney j ust t o pay m y rent . = = = = Was t hat confidence derived from t he consist ency of your ret nrns? = = = = Yes, I knew I was. get t ing st at ist ically significant result s. = = = = You com e from an academ ic background and even did your t hesis on a subj ect relat ed t o t he m arket s. I 'm sure you're quit e aware t hat m ost of t he academ ic com m unit y st ill holds t o t he efficient m arket hypot hesis. Obviously, what you're doing couldn't be done if t hat t heory were right ? = = = = The m arket s are clearly not a random walk. The m arket s are not even efficient because t hat assum pt ion im plies you can't m ake an above- average ret urn. Since som e people can do t hat , I disagree wit h t he assum pt ion. = = = = But st ill, I 'm sure a lot of your professors believe in t he efficient m arket hypot hesis. = = = = Right , and t hat 's probably why t hey're professors and why I 'm m aking m oney doing what I 'm doing. Also, I t hink it 's am azing what you can do when you have real m oney on t he line. A person in an academ ic set t ing m ight t hink t hat t hey have t est ed all possible t ypes of syst em s. However, when you have real m oney on t he line, you can st art t o t hink pret t y cr eat ively. There is always som et hing else t o t est . I t hink t hat t he academ ic com m unit y j ust hasn't t est ed m any of t he approaches t hat are viable. Cert ainly, if you j ust spend a short t im e doing an academ ic st udy, you're not going t o find anyt hing significant . I t can't be any ot her way. I f it were, everyone would be rich. But if you spend every day of your life researching t he m arket s and hav e adequat e com put er support , you can find st uff t hat works. = = = = What are t he t rait s of a successful t rader? = = = = A successful t rader is rat ional, analyt ical, able t o cont rol em ot ions, pract ical, and profit orient ed. = = = = What advice would you give t o a friend who want s t o be a t rader? = = = = Leam a lot of st at ist ics. Learn how t o use a com put er. Find som e syst em s t hat work. Develop som e sim ple risk m anagem ent rules. = = = = Are t here any books on t he m arket s t hat you would recom m end t o ot her people? = = = = We give our new t raders t hree books w hen t hey st ar t : your first book, The Com plet e Guide t o t he Fut ur es Market s [ Jack D. Schwager, John Wiley & Sons, 1984] , The Handbook of Fut ures Market s, by Perry Kaufm an [ John Wiley & Sons, 1984] , and The Com m odit y Fut ures Gam e: Who Wins? Who Loses? Why? by Richard J. Tewles and Frank J. Jones [ McGraw- Hill, 1987] . Then t here are som e fun books I recom m end, like your Market Wizards, which is a good m ot ivat ional work. We also have loads of ot her books in our library, and we let t raders choose which ot her ones t hey wish t o read. = = = = What kinds of m isconcept ions do people have about t he m arket s? = = = = They believe you can m ake t ons of m oney wit h lit t le work. They t hink you can m ake 100 percent a y ear doing a lit t le bit of research on t he weekends. That 's ridiculous. = = = = They underest im at e t he difficult y of t he gam e and overest im at e t he payoff? = = = = Exact ly. Also, som e people blam e everyone except t hem selves when t hey lose m oney. I t galled m e t o read in a recent Wall St reet Journal ar t icle t hat som e guy act ually won a lawsuit against his brokerage firm because he lost all t he m oney in his account . The point is t hat it w asn't even a m at t er of his broker giving him bad advice; he was calling his own t rades! He sued t he brokerage firm , saying t hat t hey shouldn't have allowed him t o t rade his account t he way he did. I believe it 's a free count r y, and if you want t o t rade, you should have every right t o do so, but if you lose m oney, it 's your own responsibilit y. = = = = What m ist akes do m ost people m ake in t he m arket s? I 'm t alking about act ual t rading m ist akes rat her t han m isconcept ions. = = = = First , m any people get involved in t he m arket s wit hout any edge. They get in t he m arket because t heir broker t old t hem t hat t he m arket is bullish. That is not an edge. However, t o t ell t he t rut h, m ost sm all spec-

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69 ulat ors will never be around long enough t o find out whet her t heir syst em could have worked, because t hey bet t oo m uch on t heir t rades, or t heir account is t oo sm all t o st art . = = = = So t here are people out t here who act ually m ight have a good idea t hat could m ake m oney, but t hey'll never find out because when t hey first t ry t o do I t , t hey bet t oo m uch and t hey're knocked out of t he gam e. = = = = Exact ly. = = = = Do you t rade overnight som et im es? = = = = We have a t went y- four- hour operat ion. I also have a hand- held quot at ion device t hat I use t o check t he m arket s when I 'm hom e. = = = = I sn't t hat kind of overbearing? = = = = Yes, it is. Alt hough I check t he quot es every night , I t ry not t o overdo it , because I do have a t endency t o becom e com pulsive. = = = = Are your night people under inst ruct ions t o call and wake you in t he m iddle of t he night if som et hing im port ant happens? = = = = Yes. = = = = How oft en does t hat happen? = = = = Not t hat oft en. Maybe four t im es a year. = = = = What do you do for recreat ion? = = = = I go t o a lot of sport ing event s, and I do a fair am ount of reading. I 'm int erest ed in psychology and philosophy. I also read lot s of self- im provem ent books. I probably overdo it , t hough. I not ice t hat t he m ore m em ory books I read, t he worse m y m em ory becom es. = = = = Do you st ill play basket ball yourself? [ Trout was capt ain of his college t eam .] Don't you m iss it ? I m ean, at one t im e it was obviously pret t y im port ant in your life. = = = = No, because I 'm on t o t he next big t hing: t rading. = = = = Did you ever ent ert ain t he possibilit y of m aking t he pros? = = = = Com ing out of m y senior year in high school, I had hoped t o play for t he pros, and I t hought t hat m aybe I could. However, aft er playing m y first year in college, I realized t hat t he people were t oo good. I could have played in Europe. I n fact , a lot of m y form er t eam m at es are playing professionally in Europe, but som e of t hem m ake j ust $10,000 a year. I didn't want t o do t hat . = = = = Do you t ake any vacat ion t im e? = = = = I have only had t hree day s off in a year and a half. = = = = I s t hat because w hen you go on vacat ion you're t hinking t hat every day you are away is cost ing you X am ount of dollars? = = = = To som e degree I do t hat . Also, I feel I need t o be around t o supervise m y st aff and m ak e sure t hat t he t rading is going properly. = = = = Do you som et im es feel t hat you've becom e a captive t o your own creat ion? Wouldn't you like t o be able t o j ust go away for a few weeks som ewhere and forget ever yt hing? = = = = I would, but t o t rade successfully you have t o do it full- t im e. I allot m yself t en vacat ion days a year, but I never t ake t hem . I firm ly believe t hat for every good t hing in life, t here's a price you have t o pay. = = = = What are t he t rading rules you live by? = = = = Make sure y ou have t he edge. Know what your edge is. Have rigid risk cont rol rules like t he ones we t alked about earlier. Basically, when you get dow n t o it , t o m ake m oney, you need t o have an edge and em ploy good m oney m anagem ent . Good m oney m anagem ent alone isn't going t o increase your edge at all. I f your syst em isn't any good, you're st ill going t o lose m oney, no m at t er how effect ive your m oney m anagem ent rules are. But if you have an approach t hat m akes m oney, t hen m oney m anagem ent can m ak e t he difference bet ween success and failure. = = = = What are your current goals? = = = = To m ake a 30 percent r et urn each year, wit h no peak- t o- valley drawdown gr eat er t han 10 percent . = = = = Any ot her final words? = = = = Just t hat I 'm excit ed and confident about t he fut ure. I f I ever don't feel t hat way, I will st op t rading. I had found Trout 's t rack record- a com binat ion of very high annualized ret urns and ext rem ely low drawdowns- alm ost m yst ifying. Of course, alt hough a com binat ion of high ret urn and low risk is rare, it is not unique; in fact , a num ber of t he ot her t rader s I int erview ed in t his book ( and in Market Wizards) also exhibit ed t his profile. Why t hen do I say " m yst ifying"? Because from what I had heard about Trout , I knew t hat his t rades were based largely on signals generat ed by com put erized t echnical t rading syst em s. I have spent m any years developing and evaluat ing t echnical t rading syst em s. Alt hough I have found syst em s t hat m ake nearly as m uch as Trout does ( based on average annualized ret urn) , t hese syst em s invariably exhibit m uch great er volat ilit y. Drawdowns of 25 percent in t hese syst em s are com m onplace, wit h worst - case drawdowns even exceeding 50 per cent - Cert ainly, t he volat ilit y of t hese syst em s could be reduced by cut t ing back t he leverage ( i.e., t he num ber of cont ract s t raded per $100,000) . Doing so, however, would lower t he ret urns down t o m ediocre levels. I have never found any syst em s t hat could even rem ot ely approach Tr out 's perfor m ance in t erm s of ret urn/ risk m easurem ent s. I n fact , every t rader I I nt erviewed who displayed a com binat ion of high ret urn

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70 and very low risk invariably proved t o be a discret ionary t rader ( i.e., a t rader who relies on his own int ernal synt hesis of m arket inform at ion t o m ake t rading decisions, as opposed t o using com put ergenerat ed t r ading signals) . How, t hen, does Trout do it ? I got t he answer t o t hat quest ion in t his int erview. Part of it has t o do wit h his reliance on syst em s t hat are based prim arily on st at ist ical analysis as opposed t o m ore st andard, t rend- following approaches. However, perhaps t he m aj or fact or is t hat Trout 's except ional skill in t im ing t he ent ry and exit of his posit ions, by his own est im at e, account s for fully half of his ret urn. " I could give t en CTAs t he exact syst em s we use, and som e of t hem st ill wouldn't m ake any m oney," he says. Thus, once again, we're t alking about synt hesis of inform at ion t hat can't be com put erized ( e.g., t he noise level on t he floors) account ing for t he superior perform ance. I n ot her words. Trout m ay reach his t rading decisions in a sim ilar fashion t o t hat of syst em t raders, but he execut es t hese decisions like a discret ionary t rader. Trout 's basic m essage is t wofold. First , you have t o have an edge t o beat t he m arket s. Everyt hing else is secondary. You can have great m oney m anagem ent , but if you don't have an approach t hat gives you an edge, t hen you can't win. This m ay seem obvious, but m any t raders ent er t he m arket s wit hout any evidence t hat t hey have an edge. Second, assum ing you have an edge, you m ust exercise rigid risk cont rol t o prot ect against t hose infrequent event s t hat cause enorm ous, abrupt price m oves t hat can quickly decim at e overleveraged account s. And, as dem onst rat ed in Trout 's own t hesis, t he probabilit y of sharp price m oves is far great er t han suggest ed by st andard st at ist ical assum pt ions. Hence, risk cont rol is essent ial. The t rader who get s wiped out by a sudden, large, adver se price m ov e is not sim ply unlucky, since such event s occur oft en enough t hat t hey m ust be planned for. I t is inst ruct ive t o com pare Monroe Tr out 's m essage wit h t hat of Blair Hull ( see Part VI ) . Alt hough t heir t rading m et hods are com plet ely different - Trout is a direct ional t rader, w her eas Hull is an arbi- t rageur- t heir assessm ent s of t he k ey t o successful t rading are v irt ually ident ical: a com binat ion of having an edge and using rigid m oney m anagem ent cont rols.

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71 AlWeiss: The Human Chart Encyclopedia I n t erm s of ret urn/ risk rat io, Al Weiss m ay well have t he single best long- t erm t rack record for a com m odit y t rading advisor. Since he began t rading in 1982 as AZF Com m odit y Managem ent , Weiss has averaged 52 percent annually. One t housand dollars invest ed wit h Weiss in 1982 would have been wort h alm ost $53,000 at t he end of 1991. However, ret urns are only half t he st ory. The t ruly im pressive elem ent in Weiss's t rack record is t hat t hese high gains were achieved wit h ext rem ely sm all equit y drawdowns. During t his ent ire period, t he largest single equit y drawdown wit nessed by Weiss was 17 percent in 1986. I n t he past four years ( 1988- 91) , Weiss has honed his risk cont rol t o t ruly ast ounding st andards: dur ing t his period, his worst annual drawdown averaged under 5 percent , while his average annual ret urn exceeded 29 percent . Despit e his exem plary t rack record, Weiss has k ept a v ery low profile. Unt il 1991, Weiss repeat edly refused t o gr ant any int erviews. He explains t his by saying, " I didn't feel m y m et hods wer e proven unt il I had realized at least a decade of superior perform ance." He also felt t hat int erviews would at t ract t he wrong t ype of invest ors. At t his point , t hat considerat ion is no longer a concern, as Weiss is handling as m uch m oney as he feels he can m anage wit hout negat ively affect ing his perform ance ( approxim at ely $100 m illion) . Alt hough Weiss now regularly t urns away new invest ors, he will occasionally m ake an except ion. As he explains, " Som et im es I t ake on a sm all account [ $100,000] if I feel t he person is t ruly sincere. I st ill get a kick out of t aking on a sm all account and m aking it com pound. Just recent ly, I accept ed a new invest or because I was im pressed t hat he had gone t hrough t he t rack records of five hundred CTAs before m aking a select ion. I ronically, at t he sam e t im e I was t alking t o t his person. I also received a call from a French bank t hat want ed t o invest $30 m illion. I t urned down t he bank, but I accept ed t he sm all account 's $100,000 invest m ent ." Weiss has also shunned publicit y because he is nat urally reclusive. He adm it s t hat , during t he decade he has been m anaging invest or funds, he has m et only five of his client s. Alt hough Weiss com es across as an ext rovert over t he phone, in person his shy side dom inat es. One of Weiss's hobbies is invest ing wit h ot her t raders. He devot es one or t wo days per m ont h t o t his endeavor. He est im at es t hat , over t he years, he has reviewed t he t rack records of approxim at ely eight hundred t raders. Out of t his large group, he has select ed about t went y t raders for personal invest m ent . His goal is not t o pick any individual supert raders but rat her t o blend t raders t oget her in a group whose com posit e perform ance reflect s bot h good ret urns and very low equit y drawdowns. I nt erest ingly, t he perform ance charact erist ics of t his group of t raders as a whole has t he appearance of a Weiss clone. During t he period 1988- 91, t he group realized an average annual ret urn of 19 percent , wit h an ext raordinarily low average m axim um annual drawdown under 3 percent . The r at io of t hese t wo num bers ( 19/ 3 = 6.3) is nearly ident ical t o t he rat io of Weiss's corresponding figures for t he sam e period ( 29/ 5 = 5.8) . My int erview of Weiss proved t o be one of t he m ost difficult I have conduct ed. Quit e frankly, had I been less im pressed wit h his t rack record, I would have given up on t his chapt er. Aft er virt ually every quest ion I posed, Weiss would go off on elaborat e t angent s and ult im at ely cat ch him self, st op t alking, and glance at m e wit h a look t hat seem ed t o say, " st op m e before I digress any furt her." The int erview was such an obvious flop t o bot h of us t hat we decided t o break and go for dinner. I n ot her int erviews, I have t aken m y t ape recorder along in such sit uat ions, and sect ions of past int erviews have, in fact , t ranspired over m eals. However, in t his inst ance, t he prospect s seem ed so unencouraging t hat I deliberat ely left t he recorder in m y room . I also felt t hat som e casual conversat ion m ight help break t he ice. Aft er dinner, we decided t o give it anot her shot by t rying t o cont inue t he int erview on an evening w alk. The at m osphere was conducive t o conversat ion, as we st rolled along t he quiet st reet s of a sm all island j ust off t he coast of Florida, on a m ild, wint er evening. Nevert heless, t he int erview st ill proceeded in very j agged fashion. I found m yself const ant ly t urning t he t ape recorder on and off. Following are excer pt s gleaned from our conver sat ions and som e addit ional m at erial from follow- up correspondence. = = = = How did you end up becom ing a t rader? = = = = I t was not an overnight process. I spent four years of solid research befor e doing any serious t rading. Aft er lit erally t housands of hours of poring over chart s, going back as far in hist ory as I could, I began t o recognize cert ain pat t erns t hat becam e t he basis of m y t rading approach. = = = = You spent four years doing research before you even st art ed t rading? = = = = Yes. I 'm a risk- averse per son. I want ed t o have confidence in m y approach before I st art ed. = = = = Precisely how far back did you go in your chart st udies? = = = = I t varied wit h t he individual m arket and t he available chart s. I n t he case of t he grain m arket s, I was able t o go back as far as t he 1840s. = = = = Was it really necessary t o go back t hat far? = = = = Absolut ely. One of m e keys in long- t erm chart analysis is realizing t hat m arket s behave different ly in different econom ic cycles. Recognizing t hese repeat ing and shift ing long- t erm pat t erns requires lot s of hist ory. I dent ifying where you are in an econom ic cycle- say, an inflat ionary phase ver sus a deflat ionary phase- is crit ical t o int erpret ing t he chart pat t erns evolving at t hat t im e. = = = = How did you support yourself during t he four years you devot ed t o researching t he m arket s? = = = = I n m y early t went ies, I had pioneered t he developm ent of t he uret hane skat eboard wheel, which was a

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72 great financial success. I invest ed t he m oney I m ade on t his vent ure int o t he real est at e m ark et , which also proved t o be very profit able. As a result , I had all t he m oney I needed and w as able t o devot e m y full t im e t o research. = = = = I underst and t hat you're basically a t echnical syst em s t rader. Why do you believe your t rack record is so m uch bet t er t han t hose of ot her com m odit y t rading advisors using sim ilar m et hods? I n part icular, I 'm int erest ed in how you have m anaged t o avoid t he large drawdowns t hat seem t o be alm ost int rinsic t o t his approach. = = = = Alt hough I em ploy t echnical analysis t o m ake m y t rading decisions, t here ar e a few im port ant differences bet ween m y m et hod and t he approaches of m ost ot her t rader s in t his group. First , I t hink very few ot her t echnical t raders have gone back m ore t han t hirt y years in t heir chart st udies, let alone m ore t han a hundred years. Second, I don't always int erpret t he sam e pat t ern in t he sam e way. I also fact or in where I believe we are at in t erm s of long- t erm econom ic cycles. This fact or alone can lead t o very subst ant ial differences bet ween t he conclusions I m ight draw from t he char t s versus t hose reached by t raders not incorporat ing such a perspect ive. Finally, I don't sim ply look at t he classical chart pat t erns ( head and shoulder s, t riangle, and so on) as independent form at ions. Rat her, I t end t o look for cert ain com binat ions of pat t erns or, in ot her words, pat t erns wit hin pat t erns wit hin pat t erns. These m ore com plex, m ult iple- pat t ern com binat ions can signal m uch higher probabilit y t rades. = = = = What popular chart pat t erns are accurat e only 50 percent of t he t im e? = = = = Most of t hem . But t hat 's not a drawback. A pat t ern t hat works 50 per cent of t he t im e can be quit e profit able if you em ploy it w it h a good risk cont rol plan. = = = = I s t echnical analysis an art or a science? = = = = I t 's bot h an art and a science. I t 's an art in t he sense t hat if you asked t en different t raders t o define a head- and- shoulders pat t ern, you'd com e up wit h t en different answers. However, for any individual t rader , t he definit ion can be m ade m at hem at ically precise. I n ot her words, chart t raders ar e art ist s unt il t hey m at hem at ically define t heir pat t erns- say, as part of a syst em st ruct ure- at which t im e t hey becom e scient ist s. = = = = Why have you chosen a purely t echnical approach in favor of one t hat also em ploys fundam ent als? ==== Many econom ist s have t ried t o t rade t he com m odit y m arket s fundam ent ally and have usually ended up losing. The problem is t hat t he m arket s operat e m ore on psychology t han on fundam ent als. For exam ple, you m ay det erm ine t hat silver should be priced at , say, $8, and t hat m ay well be an accurat e evaluat ion. However, under cer t ain condit ions- for exam ple, a m aj or inflat ionary environm ent - t he price could t em porarily go m uch higher. I n t he com m odit y inflat ion boom t hat peaked in 1980, silver reached a high of $50- a price level t hat was out of all proport ion t o any t rue fundam ent al value. Of course, event ually t he m arket ret urned t o it s base value- in fact , in t he hist ory of m arket s, I can't t hink of a single com m odit y t hat didn't event ually m ove back t o it s base value- but in t he int erim , anyone t rading purely on t he fundam ent als would have been wiped out . = = = = Do any part icularly m em orable t rades com e t o m ind? = = = = Whenever I 'm on vacat ion, I cont inue t o chart t he m arket s. I n t he sum m er of 1990, while on vacat ion in t he Baham as, I was updat ing m y chart s on a picnic t able beneat h t he palm t rees. I not iced pat t erns t hat indicat ed buy signals in all t he energy m arket s. These signals seem ed par t icularly odd because it 's very unusual t o get a buy signal in heat ing oil during t he sum m er. However, I didn't quest ion t he t rade and sim ply phoned in t he orders. Thr ee days lat er, I raq invaded Kuwait and oil prices exploded. = = = = Do you follow your syst em absolut ely, or do you som et im es override t he t rading signals? = = = = I follow t he syst em well over 90 percent of t he t im e, but occasionally I t ry t o do bet t er t han t he syst em . Since I em ploy such deviat ions from t he pure syst em very select ively, t hey have im proved perfor m ance overall. = = = = Give m e an exam ple of a sit uat ion in which you overrode t he syst em . = = = = I n Oct ober 1987 when t he st ock m ark et was in t he m idst of it s crash, I st art ed r eceiving anxious calls from m y client s w ho w ant ed t o know if t hey had suffered a large loss. I calm ly explained t hat w e w ere st ill up 37 percent for t he year and t hat t he t ot al risk on all our open posit ions was only 4 percent . I had a feeling t hat people would be very insecure in t he m arket s and t hat t here would be a result ing flight t o T- bills. I decided t o t ake off m y ent ire short posit ion in T- bills, even t hough m y syst em had not yet provided any reversal signal. That proved t o be t he right act ion, as t he T- bill m arket t ook off on t he upside alm ost im m ediat ely aft erwards. = = = = I t 's obvious from your earlier com m ent s t hat you consider cycles im port ant . Could you please elaborat e? = = = = There ar e cy cles in everyt hing- t he weat her, ocean waves, and t he m arket s. One of t he m ost im port ant long- t erm cycles is t he cycle from inflat ion t o deflat ion. About every t wo generat ions- roughly every fort yseven t o sixt y years- m ere's a deflat ionary m arket . For exam ple, in respect t o m e com m odit y m arket s, we're current ly in a deflat ionary phase t hat began in 1980. Over t he past t wo hundred years, t hese deflat ionary phases have t ypically last ed bet ween eight and t welve years. Since we're current ly in t he t welft h year of com m odit y price deflat ion, I t hink we're very close t o a m aj or bot t om in com m odit y prices. Anot her im port ant considerat ion in regard t o cycles is t hat t heir lengt hs vary great ly from m arket t o m arket . For exam ple, in t he grain m arket s, which are heavily weat her dependent , you m ay get m aj or bull m arket s about five t im es every t went y years. I n t he gold m arket , how ever, a m aj or bull cycle m ay occur

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73 only t hree t o five t im es in a cent ury. This considerat ion could m ake a m arket such as gold very frust rat ing for t raders t rying t o play for t he next bullish wave. = = = = What is t he single m ost im port ant st at em ent you could m ake about t he m arket s? = = = = The essent ial elem ent is t hat t he m ark et s are ult im at ely based on hum an psychology, and by chart ing t he m arket s you're m erely convert ing hum an psychology int o graphic represent at ions. I believe t hat t he hum an m ind is m ore powerful t han any com put er in analyzing t he im plicat ions of t hese price graphs. Weiss's highly individualist ic approach doesn't lend it self readily t o generalizat ions. Cert ainly his com m ent s should inspire t hose inclined t o cyclical analysis, but I would add t hat ot her ex pert t raders, such as Eck- hardt , argue t he opposit e viewpoint rat her persuasively. Perhaps his m ost significant input is t hat t he reliabilit y of chart analysis can be gr eat ly enhanced by viewing classic chart pat t erns as part s of m ore com plex com binat ions, rat her t han in isolat ion, as is t ypically done. Weiss also em phasizes t hat st udent s of chart analysis need t o conduct t heir research m uch furt her back in hist ory t han is usually t he case. I n m arket s in which he was able t o obt ain t he dat a, Weiss has ext ended his chart st udies as far back as 150 years ago. I n essence, I t hink Weiss is successful because of t he com binat ion of a vast am ount of research in analyzing chart s and a k nack for seeing relat ively com plex pat t erns. Ult im at ely, t hat line of reasoning leads t o t he conclusion t hat you, t oo, can be successful if you can read a chart wit h t he sam e skill as Weiss. Not very helpful inform at ion, is it ? However, Weiss's consist ent st reak of high annual ret urns and low m axim um drawdowns provides com pelling proof t hat pure chart analysis can yield an ext raordinarily effect ive t rading approach.

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74 PART IV Fund Managers and Timers

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75 Stanley Druckenmiller: The Art of Top-Down

Investing

St anley Druckenm iller belongs t o t he r arefied world of m anagers who cont rol m ult ibillion- dollar port folios. Achieving a near 40 percent ret urn on a $100 m illion port folio is im pressive, but realizing t hat perform ance level on a m ult ibillion- dollar fund is incredible. I n t he t hree years since he assum ed act ive m anagem ent cont rol of t he Quant um Fund from his m ent or and idol, George Soros, Druckenm iller has realized an average annual ret urn of over 38 percent on asset s ranging bet ween $2.0 billion and $3.5 billion. Druckenm iller has been on a fast t rack ever since he decided t o forsake graduat e school for t he real world. Aft er less t han one year as a st ock analyst for t he Pit t sburgh Nat ional Bank, Druckenm iller was prom ot ed t o t he posit ion of direct or of equit y research. Druckenm iller dism isses his sudden prom ot ion as t he act of an eccent ric, albeit brilliant , division m anager. However, one suspect s t here w as m ore t o it , part icularly in light of Druckenm iller's subsequent achievem ent s. Less t han one year lat er, when t he division head who had hired Druckenm iller left t he bank, Druckenm iller was prom ot ed t o assum e his slot , once again leapfrogging a host of senior m anagers m aneuvering for t he sam e posit ion. Two years lat er, in 1980, at t he young age of t went yeight , Druckenm iller left t he bank t o launch his own m oney m anagem ent firm , Duquesne Capit al Managem ent . I n 1986, Druckenm iller was recruit ed by Dreyfus as a fund m anager. As part of t he agreem ent , Dreyfus perm it t ed Druckenm iller t o cont inue m anaging his own Duquesne Fund. By t he t im e Drucken- m iller j oined Dreyfus, his m anagem ent st yle had been t ransform ed from a convent ional approach of holding a port folio of st ocks int o an eclect ic st rat egy incorporat ing bonds, currencies, and st ocks, w it h t he flexibilit y of t rading any of t hese m ar ket s from bot h t he short side and t he long side. Dreyfus was so enam ored wit h Druckenm iller's innat e m arket approach t hat t he com pany developed a few funds around him , t he m ost popular being t he St rat egic Aggressive I nvest ing Fund, which was t he best - perform ing fund in t he indust ry from it s dat e of incept ion ( March 1987) unt il Druckenm iller left Dreyfus in August 1988. Druckenm iller's popularit y at Dreyfus proved t o be t oo m uch of a good t hing. Event ually, he found him self m anaging seven funds at Dreyfus, in addit ion t o his own Duquesne Fund. The st rain of all t his act ivit y and his desire t o work wit h Soros, who Druckenm iller considers t he gr eat est invest or of our t im e, prom pt ed him t o leave Dreyfus for Soros Managem ent . Short ly t hereaft er, Soros t urned over t he m anagem ent of his fund t o Druckenm iller, as Soros left t o pursue his goal of helping t o t ransform t he closed econom ies of East ern Europe and t he form er Soviet Union. The longest - running m easure of Druckenm iller's perform ance in t he m arket s is his own Duquesne fund. Since it s incept ion in 1980, t he fund has averaged 37 percent annually. Druckenm iller st resses t hat t he early years of Duquesne's perform ance are not direct ly relevant since t he fund's st ruct ure changed com plet ely in m id- 1986 t o accom m odat e t he flexible t rading appr oach he now uses. Measur ed from t his lat er st art ing point , Druckenm iller's average annual ret urn has been 45 percent . I int erviewed Druckenm iller at his co- op apart m ent on a weekend day. I was surprised by his yout h; I had hardly expect ed som eone who had been m anaging one of t he world's largest funds for several years t o st ill be in his t hirt ies. As we relaxed in t he living room , our conversat ion began wit h Druckenm iller's st ory of how he got st art ed in t he business. I had enrolled in graduat e school t o st udy for an econom ics degr ee. However, I found t he program overly quant it at ive and t heoret ical, wit h lit t le em phasis on real- life applicat ions. I w as very disappoint ed and dropped out in t he second sem est er. I t ook a j ob as a m anagem ent t rainee at t he Pit t sburgh Nat ional Bank, wit h t he idea t hat t he program would provide m e wit h a broad overview t hat would help m e t o decide on an area of focus. I had been at t he bank for several m ont hs when I received a call from t he m anager in t he t rust depart m ent . " I hear you at t ended t he Universit y of Michigan," he said. When I confirm ed his st at em ent , he said, " Great ." He asked whet her I had an M.B.A. I t old him t hat I did not . He said, " That 's even bet t er. Com e on up; you're hired." = = = = What j ob did he give you? = = = = I was hired as a bank and chem ical st ock analyst . = = = = Was t hat t he t ype of posit ion you perceived yourself heading t oward? = = = = I really had no idea what kind of j ob I would end up wit h. Most of t he people who ent ered t he m anagem ent t raining program at t he bank had an im m ediat e goal of becom ing a loan officer. I t hought t hat I had been doing pret t y well when t he head of t he loan depart m ent inform ed m e t hat I would m ake a t errible loan officer. He said t hat I was t oo int erest ed in t he act ual funct ioning of t he com panies, whereas a loan officer's j ob was essent ially a sales posit ion. He t hought m y personalit y was t oo abrupt and generally unsuit able for sales. I rem em ber feeling quit e let dow n by being t old t hat I w as going t o be a failure, w hen all along I had t hought t hat I was doing quit e well in t he program . = = = = Tell m e about your early experiences as a st ock analyst . = = = = The direct or of invest m ent s was Speros Drelles, t he person who had hired m e. He was brilliant , wit h a great apt it ude for t eaching, but he was also quit e eccent ric. When I was t went y- five and had been in t he depart m ent for only about a year, he sum m oned m e int o his office and announced t hat he was going t o m ake m e t he direct or of equit y research- This was quit e a bizarre m ove, since m y boss was about fift y years old and had been wit h t he bank for over t went y- five years. Moreover, all t he ot her analyst s had M.B.A.'s and had been in t he depart m ent longer t han I had. " You know why I 'm doing t his, don't you?" he asked.

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76 " No," I replied. " For t he sam e reason t hey send eight een- year- olds int o war." " Why is t hat ?" I asked. " Because t hey're t oo dum b t o know not t o charge." Drelles cont inued, " The sm all cap [ capit alizat ion] st ocks have been in a bear m arket for t en years [ t his conversat ion t ranspired in 1978] , and I t hink t here's going t o be a huge, liquidit y- driven bull m arket som et im e in t he next decade. Frankly, I have a lot of scars from t he past t en years, while you don't . I t hink we'll m ake a great t eam because you'll be t oo st upid and inexperienced t o know not t o t ry t o buy everyt hing. That ot her guy out t here," he said, referring t o m y boss, t he exit ing direct or of equit y research, " is j ust as st ale as I am ." = = = = So, essent ially, you leapfrogged your boss. Was t here any resent m ent ? = = = = Very m uch so, and it was quit e unpleasant . Alt hough I now realize t hat m y boss handled him self very well given t he circum st ances. He was very bit t er, but I cert ainly underst and his sense of resent m ent m uch bet t er now t han I did t hen. I couldn't envision m yself responding any bet t er t welve years from now if som eone replaced m e wit h a t went y- five- year- old. = = = = Obviously, Drelles didn't j ust m ake you head of research because of your yout h. There m ust have been m ore t o it . = = = = I had a nat ural apt it ude for t he business, and I t hink he was im pressed wit h t he j ob I did analyzing t he banking indust ry. For exam ple, at t he t im e, Cit icorp was going cr azy w it h int ernat ional loans, and I had done a m aj or bear ish piece, which proved t o be correct . Alt hough I hadn't t aken a business course, I was fairly lucid in econom ics and probably m ade a good im pression wit h m y grasp of int ernat ional m oney flows. = = = = What was done wit h t he research t hat you generat ed? = = = = The analyst s present ed t heir ideas t o a st ock select ion com m it t ee, which consist ed of seven m em bers. Aft er t he present at ion, t here was an int ense quest ion- and- answer period in which t he analyst s defended t heir recom m endat ions. = = = = What happened t o t he recom m endat ions aft er t he present at ion? = = = = I f a m aj orit y of t he com m it t ee approved t he idea, it would be placed on t he st ock select ion list . Once a st ock was placed on t he list , t he port folio m anagers at t he bank were perm it t ed t o buy t hat st ock. They were not allowed t o purchase any st ocks t hat were not on t he list . = = = = What happened if you were bearish on a st ock? = = = = I f t he recom m endat ion was accept ed, t he st ock would be delet ed from t he approved list . = = = = Did you like being an analyst ? = = = = I loved it . I cam e in at six in t he m orning and st ayed unt il eight at night . Rem em ber, t his was a bank, not a brokerage firm at which such hours represent nor m al behavior. I nt erest ingly, even t hough Drelles had been at t he bank for t hirt y years, he kept sim ilar hours. = = = = What kind of analyt ical approach did you use in evaluat ing st ocks? = = = = When I first st art ed out , I did very t horough papers covering every aspect of a st ock or indust ry. Before I could m ake t he present at ion t o t he st ock select ion com m it t ee, I first had t o subm it t he paper t o t he research direct or. I part icularly rem em ber t he t im e I gave him m y paper on t he banking indust ry. I felt very proud of m y work. However, he read t hrough it and said, " This is useless. What m akes t he st ock go up and down?" That com m ent act ed as a spur. Ther eaft er, I focused m y analysis on seeking t o ident ify t he fact ors t hat were st rongly correlat ed t o a st ock's price m ovem ent as opposed t o looking at all t he fundam ent als. Frankly, even t oday, m any analyst s st ill don't know what m akes t heir part icular st ocks go up and down. = = = = What did you find was t he answer? = = = = Very oft en t he key fact or is relat ed t o earnings. This is part icularly t rue of t he bank st ocks. Chem ical st ocks, however, behave quit e different ly. I n t his indust ry, t he key fact or seem s t o be capacit y. The ideal t im e t o buy t he chem ical st ocks is aft er a lot of capacit y has left t he indust ry and t here's a cat alyst t hat you believe will t rigger an increase in dem and. Conversely, t he ideal t im e t o sell t hese st ocks is when t here are lot s of announcem ent s for new plant s, not when t he earnings t urn down. The r eason for t his behavioral pat t ern is t hat expansion plans m ean t hat earnings will go down in t wo t o t hr ee year s, and t he st ock m arket t ends t o ant icipat e such developm ent s. Anot her discipline I learned t hat helped m e det er m ine whet her a st ock would go up or down is t echnical analysis. Drelles was very t echnically orient ed, and I was probably m ore recept ive t o t echnical analysis t han anyone else in t he depart m ent . Even t hough Drelles was t he boss, a lot of people t hought he was a kook because of all t he chart books he kept . However, I found t hat t echnical analysis could be very effect ive. = = = = Did t he rest of t he analyst s accept you as t he research direct or, even t hough you were m uch younger and less experienced? = = = = Once t hey realized t hat Drelles had m ade a decision and was going t o st ick wit h it , t hey accept ed t he sit uat ion. However, lat er t hat sam e year, Drelles left t he bank, and I suddenly found m yself unprot ect ed. I was only t went y- five years old, while all t he ot her depart m ent heads were in t heir fort ies and fift ies. As soon as t he news broke t hat Drelles was leaving, a power st ruggle ensued am ong t he depart m ent heads vying for his posit ion. Every Monday m orning, I and t he ot her depart m ent heads would present our views t o t he head of t he t rust depart m ent , a lawyer wit hout any invest m ent background. I t was underst ood t hat he would use t hese present at ions as input in m aking an event ual decision on Drelles's replacem ent . Clearly, everyone assum ed t hat I was out of t he running. The general belief was t hat I would be lucky t o sim ply hold ont o m y j ob as

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77 research direct or, let alone inherit Drelles's posit ion. As it t urned out , short ly aft er Drelles left , t he Shah of I ran was overt hrown. Here's where m y inexperience really paid off. When t he shah was deposed, I decided t hat w e should put 70 percent of our m oney in oil st ocks and t he rest in defense st ocks. This course of act ion seem ed so logical t o m e t hat I didn't consider doing anyt hing else. At t he t im e, I didn't yet underst and diversificat ion. As research direct or, I had t he aut horit y t o allow only t hose recom m endat ions I favored t o be present ed t o t he st ock select ion com m it t ee, and I used t his cont rol t o rest rict t he present at ions largely t o oil and defense st ocks. I present ed t he sam e st rat egy t o t he head of t he t rust depart m ent each Monday m orning. Not surprisingly, t he ot her depart m ent heads argued against m y posit ion j ust for t he sake of t aking t he opposit e view. They would t ry t o put down anyt hing I said. However, t here are t im es in your career when every t hing t hat you do is right - and t his was one of t hose t im es. Of course, now I would never even dream of put t ing 70 percent of a port folio in oil st ocks, but at t he t im e I didn't know bet t er. Fort unat ely, it was t he ideal posit ion t o have, and our st ock select ion list out perform ed t he S&P 500 by m ult iples. Aft er about nine m ont hs, t o everyone's com plet e am azem ent , I was nam ed t o assum e Drelles's form er posit ion as t he direct or of invest m ent s. = = = = When did you leave t he bank? = = = = I n 1980 I went t o m ake a pr esent at ion in New York. Aft er t he t alk, one of t he audience m em bers approached m e and exclaim ed, " You're at a bank! What t he hell are you doing at a bank?" I said, " What else am I going t o do? Frankly, I t hink I 'm lucky t o be t here, given t he level of m y experience." Aft er about t wo m inut es of t alking, he asked, " Why don't you st art your own firm ?" " How can I possibly do t hat ?" I asked. " I don't have any m oney." " I f you st art your own firm ," he replied, " I 'll pay you $10,000 a m ont h j ust t o speak t o you. You don't even have t o writ e any report s." To put t his in perspect ive, when I st art ed at t he bank in 1977,1 was m aking $900 a m ont h. When I was prom ot ed t o t he research direct or posit ion, m y annual salary was st ill only $23,000, and all t he analyst s who report ed t o m e were m aking m ore t han I was. Even aft er m y prom ot ion t o Drelles's posit ion, I was st ill earning only $48,000 a y ear. I n t his cont ext , t he offer of $10,000 a m ont h, not count ing t he m oney I could pot ent ially earn on m anaging funds, seem ed ext rem ely at t ract ive. I figured t hat even if 1 fell com plet ely on m y face, I could st ill get anot her j ob t hat would pay m ore t han I was m aking at t he bank. hi February 1981, wit h one ot her analyst and a secret ary, I launched Duquesne Capit al Managem ent . We began wit h $1 m illion under m anagem ent , which generat ed $10,000 per y ear in fees. Most of our incom e cam e from t he $10,000 per m ont h consult ing fee arrangem ent . We st art ed off ext rem ely well, cat ching t he sharp upm ove in low cap st ocks. By m id- 1981, st ocks were up t o t he t op of t heir valuat ion range, while at t he sam e t im e, int erest rat es had soar ed t o 19 per cent . I t was one of t he m ore obvious sell sit uat ions in t he hist ory of t he m arket . We went int o a 50 per cent cash posit ion, which, at t he t im e, I t hought represent ed a really dram at ic st ep. Then we got oblit erat ed in t he t hird quart er of 1981. = = = = I don't underst and. How did you get oblit erat ed if you went int o a 50 percent cash posit ion? = = = = Well, we got oblit erat ed on t he 50 percent posit ion we st ill held. = = = = Yes, but you would have lost only half as m uch as everyone else. = = = = At t he bank, t he st andar d procedure had been t o always be nearly fully invest ed. Alt hough I wasn't working for a bank anym ore, I had obviously st ill m aint ained som e of t his sam e m ent alit y. You have t o under st and t hat I w as unbelievably bearish in June 1981. I w as absolut ely right in t hat opinion, but w e st ill ended up losing 12 percent during t he t hird quart er. I said t o m y part ner, " This is crim inal. We have never felt m ore st r ongly about anyt hing t han t he bear side of t his m arket and yet we ended up down for t he quart er." Right t hen and t here, we changed our invest m ent philosophy so t hat if we ever felt t hat bearish about t he m arket again we would go t o a 100 percent cash posit ion. During t he fourt h quart er of 1981, t he st ock m arket part ially rebounded. We were st ill ext rem ely bearish at t hat point , and w e dum ped our ent ire st ock posit ion. We placed 50 percent in cash and 50 percent in long bonds. We loved t he long bond posit ion because it was yielding 15 percent , t he Fed was ex t rem ely t ight , and inflat ion was already com ing down sharply. I t seem ed like a gift . We did very well, and by May 1982 our asset s under m anagem ent had grown t o $7 m illion. One m orning, I cam e int o work and discovered t hat Drysdale Securit ies- our consult ing client - had gone belly- up. I im m ediat ely called m y cont act at t he firm , but he was no longer t here. I realized t hat I had an im m ediat e pr oblem . My overhead was $180,000 per year and m y new revenue base was only $70,000 ( 1 per cent on t he $7 m illion we m anaged) . I had no idea how we could possibly survive. At t he t im e, our firm had asset s of j ust under $50,000, and I was absolut ely convinced t hat int erest rat es wer e com ing down. I t ook all of t he firm 's capit al and put it int o T- bill fut ures. I n four days, I lost everyt hing. The irony is t hat less t han a week aft er we went bust , int erest r at es hit t heir high for t he ent ire cycle. They've never been t hat high since. That was when I lear ned t hat you could be right on a m ark et and st ill end up losing if you use excessive leverage. At t he t im e, I had a client who had sold out a soft ware com pany at a very young age. He had given t he proceeds from t his sale, w hich w ere quit e subst ant ial, t o a broker who lost half t he am ount in t he opt ions m arket . I n desperat ion, t his broker had brought him t o m e, and I ended up doing ex t rem ely well for t he account . Since it was an individual account , whereas all m y ot her account s wer e pensions, I was act ually able t o go short in t he st ock m arket . I was also long bonds. Bot h posit ions did very well, and his account went up dram at ically.

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78 As a last resort , I w ent t o see t his client t o ask him if he m ight be int erest ed in funding us in exchange for a percent age of t he com pany, At t he t im e, it probably looked like one of t he dum best pur chases anybody could ever m ake. Here was a firm wit h a $40,000 negat ive net wort h and a built - in deficit of $110,000 per year, run by a t went y- eight - year- old wit h only a one- year t rack record and no part icular reput at ion. I sold him 25 percent of t he com pany for $150,000, which I figured would be enough t o keep us going for anot her t welve m ont hs. One m ont h lat er, t he bull m arket began, and wit hin about a year, our asset s under m anagem ent clim bed t o $40 m illion. I t hink 1983 was t he first year I had a quar t er in which I act ually m ade m ore t han m y secret ary. We had a bit of a set back during t he m id- ] 983 t o m id- 1984 period, but t he com pany cont inued t o do well t hereaft er, part icularly once t he bull m arket t ook off in 1985. = = = = Given t he success of your own t rading com pany, why did you leave t o j oin Dreyfus as a fund m anager? = = = = I n 1985 I m et Howard St ein, who offered m e a consult ing agr eem ent wit h Dreyfus. He event ually convinced m e t o officially j oin Dreyfus as a m anager of a couple of t heir funds. They even t ailored new Dreyfus funds around m y part icular st yle of invest m ent . As part of t he agreem ent , I was allowed t o cont inue t o m anage t he Duquesne Fund. I n fact , I 'm st ill m anaging Duquesne t oday. = = = = What were your personal experiences preceding, during, and aft er t he 1987 st ock m arket crash? ==== The first half of t he year was great because I was bullish on t he m arket , and prices went st raight up. I n June I changed m y st ripes and act ually went net short . The next t wo m ont hs were very rough because I was fight ing t he m arket , and prices were st ill going up. = = = = What det erm ined t he t im ing of your shift from bullish t o bearish? = = = = I t was a com binat ion of a num ber of fact ors. Valuat ions had got t en ext rem ely overdone: The dividend yield was down t o 2.6 percent and t he price/ book value rat io was at an all- t im e high. Also, t he Fed had been t ight ening for a period of t im e. Finally, m y t echnical analysis showed t hat t he breadt h wasn't t here- t hat is, t he m arket 's st rengt h was prim arily concent rat ed in t he high capit alizat ion st ocks, wit h t he broad spect r um of issues lagging well behind. This fact or m ade t he rally look like a blow- off. = = = = How can you use valuat ion for t im ing? Hadn't t he m arket been overdone in t erm s of valuat ion for som e t im e before you reversed from short t o long? = = = = I never use valuat ion t o t im e t he m ar ket . I use liquidit y considerat ions and t echnical analysis for t im ing. Valuat ion only t ells m e how far t he m arket can go once a cat alyst ent ers t he pict ure t o change t he m arket direct ion. = = = = The cat alyst being what ? = = = = The cat alyst is liquidit y, and hopefully m y t echnical analysis will pick it up. = = = = What was happening in t erm s of liquidit y in 1987? = = = = The Fed had been t ight ening since January 1987, and t he dollar was t anking, which suggest ed t hat t he Fed was going t o t ight en som e m ore. = = = = How m uch were you up during t he first half of 1987 befor e you swit ched from long t o short ? = = = = The result s varied depending on t he fund. I was m anaging five different hedge funds at t he t im e, each using a different t ype of st rat egy. The funds were up roughly bet ween 40 per cent and 85 percent at t he t im e I decided t o swit ch t o a bearish post ure. Perhaps t he st rongest perform er was t he Dreyfus St rat egic Aggressive I nvest ing Fund, which was up about 40 percent during t he second quart er ( t he first quart er of t he fund's operat ion) . I t had cert ainly been an excellent year up t o t hat point . Many m anagers will book t heir profit s when t hey'r e up a lot early in t he year. I t 's m y philosophy, which has been reinforced by Mr. Soros, t hat when you earn t he right t o be aggressive, you should be aggr essive. The years t hat you st art off wit h a large gain are t he t im es t hat you should go for it . Since I was well ahead for t he year, I felt t hat I could afford t o fight t he m arket for a while. I knew t he bull m arket had t o end, I j ust didn't know when. Also, because of m e m arket 's severe over valuat ion, I t hought t hat when t he bull m arket did end, it was going t o be dram at ic. = = = = Then I assum e t hat you held on t o your short posit ion unt il t he m arket act ually t opped a couple of m ont hs lat er. = = = = That 's right . By Oct ober 16, 1987, t he Dow had com e down t o near t he 2,200 level, aft er having t opped at over 2,700. I had m ore t han recouped m y earlier losses on t he short posit ion and was back on t rack wit h a very profit able year. That 's when I m ade one of t he m ost t ragic m ist akes of m y ent ire t rading career. The chart suggest ed t hat t here was t rem endous support near 2,200 based on a t rading range t hat had been built up during m ost of 1986.1 was sure t hat t he m arket would hold at t hat level. I was also playing from a posit ion of st rengt h, because I had profit s from m y long posit ions earlier in t he year, and I was now ahead on m y short posit ions as well. I went from net short t o a 130 percent long. [ A percent age great er t han 100 percent im plies t he use of leverage.] = = = = When did you m ake t his t ransit ion? = = = = On Friday aft ernoon, Oct ober 16,1987. = = = = You reversed from short t o a leveraged long posit ion on t he day before t he crash? You're kidding! ==== That 's right , and t here was plent y of liquidit y for m e t o swit ch m y posit ion on t hat day.

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79 = = = = I 'm not surprised, but I 'm som ewhat puzzled* You've repeat edly indicat ed t hat you give a great deal of weight t o t echnical input . Wit h t he m arket in a virt ual free- fall at t he t im e, didn't t he t echnical perspect ive m ake you apprehensive about t he t rade? = = = = A num ber of t echnical indicat ors suggest ed t hat t he m arket was oversold at t hat j unct ure. Moreover, I t hought t hat t he huge price base near t he 2,200 level would provide ext rem ely st rong support - at least t em porarily. I figured t hat even if I were dead wrong, t he m arket would not go below t he 2,200 level on Monday m orning. My plan was t o give t he long posit ion a half- hour on Monday m or ning and t o get out if t he m arket failed t o bounce. = = = = When did you realize t hat you were wrong? = = = = That Friday aft ernoon aft er t he close, I happened t o speak t o Soros. He said t hat he had a st udy done by Paul Tudor Jones t hat he want ed t o show m e. I w ent over t o his office, and he pulled out t his analysis t hat Paul had done about a m ont h or t wo earlier. The st udy dem onst rat ed t he hist orical t endency for t he st ock m arket t o accelerat e on t he downside whenever ail upward- sloping parabolic curve had been broken- as had recent ly occurred. The analysis also illust rat ed t he ext rem ely close cor relat ion in t he price act ion bet ween t he 1987 st ock m arket and t he 1929 st ock m arket , wit h t he im plicit conclusion t hat we were now at t he brink of a collapse. I was sick t o m y st om ach when I went hom e t hat evening. 1 realized t hat I had blown it and t hat t he m arket was about t o crash. = = = = Was it j ust t he Paul Tudor Jones st udy t hat m ade you realize t hat you were wrong? = = = = Act ually, t here's a second im port ant elem ent t o t he st ory. I n early August of t hat year, I had received a call from a wom an who was about t o leave for a vacat ion t o France. She said, " My brot her says t hat t he m arket is get t ing out of hand. I have t o go away for t hree weeks. Do you t hink t he m arket will be all right unt il I get back?" I t ried t o be reassuring, t elling her, " The m arket will probably go down, but I don't t hink it will happen t hat quickly. You can go on your vacat ion wit hout worry." " Do you know who m y brot her is?" she asked. " I have no idea," I answered. " He's Jack Dreyfus," she inform ed m e. As far as I k new, Dreyfus was busy running a m edical foundat ion and hadn't paid m uch at t ent ion t o t he m arket for t he past fift een or t went y years. The following week, Howard St ein brought a visit or t o m y office. " This is Jack Dreyfus," he announced. Dreyfus was wearing a cardigan sweat er and was very polit e in his conversat ion. " I would like t o know about t he S&P fut ures cont ract ,' 1 he said. "As you know, I haven't looked at t he m arket for t went y years. However, I 've been very concerned about t he conversat ions I 've been hearing lat ely w hen I play bridge. Everyone seem s t o be bragging about all t he m oney he's m aking in t he m arket . I t rem inds m e of everyt hing I read about t he 1929 m ar ket ." Dreyfus was looking for evidence of m argin buying t o confirm his conj ect ure t hat t he m arket was poised for a 1929- t ype crash. The st at ist ics on st ocks didn't reveal any abnorm ally high level of m argin buying. However, he had read t hat people were using S&P fut ures t o t ake long posit ions in t he st ock m arket at 10 percent m ar gin. His hypot hesis was t hat t he m argin- t ype buying act ivit y was now going int o fut ures. To check out t his t heory, he want ed m e t o do a st udy t o see if t her e had been any unusually heavy speculat ive buying of S&P fut ures. Since w e didn't have t he dat a readily available, it t ook us a w hile t o com plet e t he st udy. I ronically, w e finished t he analysis on Friday aft ernoon, Oct ober 16, 1987. Basically, t he dat a showed t hat speculat ors had been consist ent ly short unt il July 1987 and aft er t hat point had swit ched t o an increasingly heavy long posit ion. I went t o see Jack Dreyfus on Sat urday, Oct ober 17, t o show him t he result s of t he analysis. Rem em ber, he had expr essed all his concerns about t he m arket in August . At t his point , I was already very upset because Soros had shown m e Paul Tudor Jones's st udy. Dreyfus looked at m y st udy and said, " I guess we'r e a bit t oo lat e t o capit alize on m y fears." That was t he clincher. I was absolut ely convinced t hat I was on t he wrong side of t he m arket . I decided t hat if t he m arket opened abov e t he support level on Monday m orning, which was about 30 Dow point s lower, and didn't im m ediat ely rally, I would sell m y ent ire posit ion. As it t urned out , t he m arket opened ov er 200 point s lower. I knew I had t o get out . Fort unat ely, t here was a brief bounce short ly aft er t he opening, and I was able t o sell m y ent ire long posit ion and act ually go net short . That sam e aft ernoon, Five m inut es t o four, Dreyfus cam e by. He said, " Forgive m e for not t elling you before, but I had already sold S&P fut ures t o hedge m y exposure in t he st ock m arket ." " How m uch did you sell?" I asked. " Enough," he answered. " When did you go short ?" I asked. " Oh, about t wo m ont hs ago." I n ot her words, he had gone shor t at exact ly t he t op, right around t he t im e I had t old his sist er not t o worry about an im m inent t op in t he st ock m arket . He asked, " Do you t hink I should cover m y short posit ion here?" At t hat point , even t hough t he Dow had already fallen 500 point s t o near 1,700, t he fut ures were t rading at a level t hat was equivalent t o a Dow of 1,300. I said, " Jack, you have t o cover t he posit ion here. The S&P fut ures are t rading at a 4,500- point discount based on t he Dow! " He looked at m e and asked, " What 's a discount ?" = = = = So did he cover his posit ion at t hat point ? = = = = He sure did- right at t he absolut e low. = = = = Get t ing back t o your career pat h, why did you leave Dreyfus? = = = =

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80 I felt t hat I was m anaging t oo m any funds ( seven at t he t im e I left ) . I n addit ion t o t he act ual m anagem ent , each fund also required speaking engagem ent s and ot her act ivit ies. For exam ple, each fund held four board m eet ings per year. = = = = How could you possibly find t he t im e t o do all t hat ? = = = = I couldn't ; t hat 's why I left . During t his ent ire t im e period, I had been t alking t o Soros on an ongoing basis. The m ore I t alked t o him , t he m ore I began t o realize t hat everyt hing people had t old m e about him was wrong. = = = = What had t hey t old you? = = = = There wer e all t hese st ories about t urnover at t he firm . George had a reput at ion for paying people well but t hen firing t hem . Whenever I m ent ioned t hat Soros had t ried t o hire m e, m y m ent ors in t he business adam ant ly advised m e not t o go. Soros had act ually st art ed referring t o m e as his " successor" before I ever j oined t h e firm . When I went t o Soros's hom e t o be int erviewed, his son inform ed m e t hat I was his t ent h " successor." None of t he ot hers had last ed t oo long. He t hought it was hyst erical. And when I arrived at Soros's office t he next day, t he st aff all referred t o m e as " t he successor." They also t hought it was very funny. = = = = Did you consider sim ply going back and m anaging your Duquesne Fund full- t im e aft er you left Dreyfus? = = = = That was cert ainly an opt ion. I n fact , Duquesne's asset s under m anagem ent had grow n t rem endously w it hout any m arket ing at all sim ply because of all t he publicit y I had received from t he st rong perform ance of t he Dreyfus funds. = = = = Why didn't you go t hat rout e? = = = = Quit e sim ply, because George Soros had becom e m y idol. He seem ed t o be about t went y years ahead of m e in im plem ent ing t he t rading philosophy I had adopt ed: holding a core group of st ocks long and a core group of st ocks short and t hen using leverage t o t r ade S&P fut ures, bonds, and currencies. I had lear ned a t rem endous am ount j ust in m y conversat ions wit h Soros. I t hought it was a no- lose sit uat ion. The worst t hing t hat could happen was t hat I would Join Soros and he would fire m e ill a year- in which case I would have received t he last chapt er of m y educat ion and st ill have had t he opt ion of m anaging Duquesne. I n t he best case, it would all work out . = = = = Did your relat ionship wit h Soros change once you st art ed working for him ? = = = = The first six m ont hs of t he relat ionship were fairly rocky. While we had sim ilar t rading philosophies, our st rat egies never m eshed. When I st art ed out , he w as going t o be t he coach and he was an aggr essive coach. I n m y opinion, George Soros is t he gr eat est invest or t hat ever lived. But even being coached by t he world's great est invest or is a hindrance rat her t han a help if he's engaging you act ively enough t o break your t rading rhyt hm . You j ust can't have t wo cooks in t he kit chen; it doesn't work. Part of it was m y fault because he would m ake recom m endat ions and I would be int im idat ed. Aft er all, how do you disagree wit h a m an wit h a t rack record like his? Event s cam e t o a head in August 1989 when Soros sold out a bond posit ion t hat I had put on. He had never done t hat before. To m ake m at t ers worse, I really had a st rong convict ion on t he t rade. Needless t o say, I was fairly upset . At t hat point , we had our first let - it - all- out discussion. Basically, Soros decided t hat he was going t o st ay out of m y hair for six m ont hs. Frankly, I wasn't t oo opt im ist ic about t he arrangem ent because I t hought t hat he had been t rying t o do t hat all along but was sim ply incapable of it . The sit uat ion was saved, however, by event s heat ing up in East ern Europe in lat e 1989. As you m ay know, t ransform ing East ern Europe and t he Soviet Union from com m unist t o capit alist syst em s has been Soros's m ain endeavor in recent years. He has set up foundat ions in eleven count ries t o help achieve t his goal. Wit h George off in East ern Europe, he couldn't m eddle even if he want ed t o. Everyt hing st art ed t o com e t oget her at t hat t im e. Not only was I t rading on m y own wit hout any int erference, but t hat sam e East ern European sit uat ion led t o m y first t ruly m aj or t rade for Soros's Quant um Fund. I never had m ore convict ion about any t rade t han I did about t he long side of t he Deut sche m ark when t he Berlin Wall cam e dow n. One of t he reasons I w as so bullish on t he Deut sche m ark was a radical currency t heory proposed by Geor ge Soros in his book, The Alchem y of Finance. His t heory was t hat if a huge deficit were accom panied by an expansionary fiscal policy and t ight m onet ary policy, t he count ry's currency would act ually rise. The dollar provided a perfect t est case in t he 1981- 84 per iod. At t he t im e, t he general consensus was t hat t he dollar would decline because of t he huge budget deficit . However, because m oney was at t ract ed int o t he count ry by a t ight m onet ary policy, t he dollar act ually went sharply higher. When t he Berlin Wall cam e down, it was one of t hose sit uat ions t hat I could see as clear as day. West Germ any was about t o run up a huge budget deficit t o finance t he rebuilding of East Germ any. At t he sam e t im e, t he Bundesbank was not going t o t olerat e any inflat ion. I went headlong int o t he Deut sche m ark. I t t urned out t o be a t errific t rade. = = = = How large a posit ion did you put on? = = = = About $2 billion. = = = = Did you have any difficult y put t ing on a posit ion t hat size? = = = = No, I did it over a lew days' t im e. Also, put t ing on t he posit ion was m ade easier by t he generally bearish sent im ent at t he t im e. The Deut sche m ark act ually fell during t he first t wo days aft er t he wall cam e down because people t hought t hat t he out look for a growing deficit would be negat ive for t he currency. = = = = Any ot her m aj or t rades com e t o m ind? I 'm part icularly int erest ed in your reasoning for put t ing on a

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81 t rade. = = = = I n lat e 1989 I becam e ext rem ely bearish on t he Japanese st ock m arket for a variet y of reasons. First , on a m ult iyear chart , t he Nikkei index had reached a point of overext ension, which in all previous inst ances had led t o sell- offs or, in t he worst case, a sideways consolidat ion. Second, t he m arket appeared t o be in a huge speculat ive blow- off phase. Finally, and m ost im port ant - t hree t im es as im port ant as everyt hing I j ust saidt he Bank of Japan had st art ed t o dr am at ically t ight en m onet ary policy. Here's what t he Japanese bond m arket was doing at t he sam e t im e. [ Druckenm iller shows m e a chart depict ing t hat at t he sam e t im e t he Nikkei index was soaring t o record highs, t he Japanese bond m ar ket was plum m et ing.] Short ing t he Japanese st ock m arket at t hat t im e was j ust about t he best risk/ reward t r ade I had ev er seen. = = = = How did you fare at t he st art of t he air war against I raq when t he U.S. st ock m arket abrupt ly t ook off on t he upside and never looked back? Were you short because t he m arket had been in a prim ary downt rend before t hat point ? I f so, how did you handle t he sit uat ion? = = = = I cam e int o 1991 wit h posit ions t hat couldn't have been m ore poorly suit ed t o t he m ar ket pr ice m oves t hat unfolded in t he ensuing m ont hs. 1 was short approxim at ely $3 billion in t he U.S. and Japanese st ock m arket s, and I was also heavily short in t he U.S. and world bond m arket s. 1 st art ed t o change m y m arket opinion during t he first t wo weeks of 1991. On t he way down, t he pessim ism regarding t he U.S. st ock m arket had becom e ext r em e. Everybody was t alking about how t he m arket would crat er if t he Unit ed St at es went t o war against I raq. Also, t he breadt h was not t her e. Even t hough t he Dow Jones index had fallen t o a new recent low, only about eight y of t he sevent een hundr ed New York St ock Exchange st ocks had m ade new lows. By January 13,1 had covered m y short S&P fut ures posit ion, but I was st ill short st ock. On t hat day, I spoke t o Paul Tudor Jones, who had j ust ret urned fr om part icipat ing in a roundt able discussion sponsored by Barron's. He t old m e t hat eight out of t he eight part icipat ing m oney m anagers had said t hey were holding t heir highest cash posit ion in t en years. I 'll never forget t hat t he S&P was near 310 and Paul said, " 340 is a chip shot ." I was already t urning bullish, but t hat conversat ion gave m e an ext ra push in t hat direct ion. I was convinced t hat once t he war st art ed, t he m arket had t o go up, because ever yone had already sold. = = = = Why didn't you wait unt il t he war had act ually st art ed before you began buying? = = = = Because ever ybody was wait ing t o buy aft er t he war st art ed. I t hought it was necessary t o st art buying before t he January 15 deadline set by t he Unit ed St at es. = = = = Had you swit ched com plet ely from short t o long before t he huge rally on t he m orning following t he st art of t he air war? = = = = I had in t he Duquesne Fund because it was m ore flexible. I n Soros's Quant um Fund, we had swit ched our S&P fut ures posit ion from short t o long, but we st ill had a huge short posit ion in act ual st ocks. A large port ion of t his posit ion was in t he bank and real est at e st ocks, which were difficult t o cover. We were fully long wit hin a few days aft er t he st art of t he war. = = = = How did you fare aft er t he sm oke cleared? = = = = As incredible as it m ay seem , we ended up having an up January aft er going int o t he m ont h wit h a $3 billion short posit ion in equit ies worldwide, a $3 billion short posit ion in t he dollar versus t he Deut sche m ark, and a large short posit ion in U.S. and Japanese bonds- all of which proved t o be t he exact wrong posit ions t o hold. = = = = Why did you have such a large short posit ion in t he dollar versus t he Deufsche m ark? = = = = This was t he sam e posit ion we had held on and off for over a year since t he Berlin Wall had com e down. The basic pr em ise of t he t rade was t hat t he Germ ans would adhere t o a com bined expansionary fiscal policy and t ight m onet ary policy- a bullish com binat ion for t heir currency. = = = = What caused you t o abandon t hat posit ion? = = = = There were t wo fact ors. First , t he dollar had been support ed by safe- haven buying during t he U.S. war wit h I raq. One m orning, t here was a news st ory t hat Hussein was going t o capit ulat e before t he st art of t he ground war. The dollar should have sold off sharply against t he Deut sche m ark on t he news, but it declined only slight ly. I sm elled a rat . A second fact or w as t he t alk t hat Germ any w as going t o raise t axes. I n ot her words, t hey were going t o reverse t heir expansionary fiscal policy, which would elim inat e one of t he prim ary reasons for our being long t he Deut sche m ark in t he first place. I n one m orning, we bought about $3.5 billion against t he Deut sche m ar k. = = = = The Unit ed St at es is experiencing a prot ract ed recession and ext rem ely negat ive consum er sent im ent [ at t he t im e of t his int erview, Decem ber 1991] . Do you have any t hought s about t he long- t erm econom ic prospect s for t he count ry? = = = = I n m y view, t he 1980s were a ridiculous repeat of t he 1920s. We had built up t he debt - t o- GNP rat io t o unsust ainable levels. I becam e m ore convinced about t he seriousness of t he problem wit h all t he leveraged buyout s of t he lat e 1980s, which m ade t he overall debt sit uat ion get worse and worse. I have never believed t hat t he curr ent econom ic downt urn was a recession; I have always viewed it as a debt liquidat ion, which som e people call a depression. I t 's not sim ply a m at t er of a t wo- quart er r ecession. I t 's a problem where you build up years of debt , w hich will act as a depr essant on t he econom y unt il it get s work ed off over a long period of t im e. A debt liquidat ion t ends t o last for years. = = = = Given your very negat ive long- t erm view of t he U.S. econom y, are you holding a m aj or long posit ion in bonds? = = = = I was long unt il lat e 1991. However, an at t ract ive yield should be t he last reason for buying bonds. I n

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82 1981 t he public sold bonds heavily, giving up a 15 percent r et ur n for t hirt y years because t hey couldn't resist 21 per cent short - t erm yields. They weren't t hinking about t he long t er m . Now, because m oney m arket rat es are only 4.5 percent , t he sam e poor public is back buying bonds, effect ively lending m oney at 7.5 percent for t hirt y years t o a governm ent t hat 's running $400 billion deficit s. The current sit uat ion is Just t he inverse of 1981. I n 1981 t he public should have seen Volcker's j acking up of short - t erm rat es t o 21 percent as a very posit ive m ove, which would bring down long- t erm inflat ion and push up bond and st ock prices. I nst ead, t hey were lured by t he high short - t erm yields. I n cont rast , now wit h t he econom y in decline, t he deficit ballooning, and t he adm inist rat ion and t he Fed in a st at e of panic, t he public should be w ary about t he risk in holding long- t erm bonds. I nst ead, t he sam e people w ho sold t heir bonds in 1981 at 15 percent rat es are now buying t hem back at 7.5 percent because t hey don't have anyt hing bet t er t o do wit h t heir m oney. Once again, t hey're not focusing on t he long t erm . = = = = Your long- t erm perform ance has far surpassed t he indust ry average. To what do you at t ribut e your superior t rack record? = = = = George Soros has a philosophy t hat I have also adopt ed: The way t o build long- t erm ret urns is t hrough preservat ion of capit al and hom e runs. You can be far m ore aggressive when you're m aking good pr ofit s. Many m anagers, once t hey're up 30 or 40 per cent , will book t heir year [ i.e., t rade very caut iously for t he rem ainder of t he year so as not t o j eopardize t he v ery good ret urn t hat has already been realized] . The way t o at t ain t m ly superior long- t erm ret urns is t o grind it out unt il you're up 30 or 40 percent , and t hen if you have t he convict ions, go for a 100 per cent year. I f you can put t oget her a few near- 100 percent years and avoid down years, t hen you can achieve really out st anding long- t erm ret urns. = = = = What else have you learned from Soros? = = = = I 've learned m any t hings from him , but perhaps t he m ost significant is t hat it 's not w het her you're right or wrong t hat 's im port ant , but how m uch m oney you m ake when you're right and how m uch you lose when you're wrong. The few t im es t hat Sor os has ever crit icized m e was when I was really right on a m ar ket and didn't m axim ize t he opport unit y. As an exam ple, short ly aft er I had st art ed working for Soros, I w as very bearish on t he dollar and put on a large short posit ion against t he Deut sche m ark. The posit ion had st art ed going in m y favor, and I felt rat her proud of m yself. Soros cam e int o m y office, and we t alked about t he t rade. " How big a posit ion do you have?" he asked. " One billion dollars," I answered. " You call t hat a posit ion?" he said dism issingly. He encouraged m e t o double m y posit ion. I did, and t he t rade went dram at ically furt her in our favor. Soros has t aught m e t hat when you have t rem endous convict ion on a t rade, you have t o go for t he j ugular. I t t akes courage t o be a pig. I t t akes courage t o ride a profit wit h huge leverage. As far as Soros is concerned, when you're right on som et hing, you can't own enough. Alt hough I was not at Sor os Managem ent at t he t im e, I 've heard t hat prior t o t he Plaza Accord m eet ing in t he fall of 1985, ot her t raders in t he office had been piggybacking Geor ge and hence were long t he yen going int o t he m eet ing. When t he yen opened 800 point s higher on Monday m or ning, t hese t raders couldn't believe t he size of t heir gains and anxiously st art ed t aking profit s. Supposedly, George cam e bolt ing out of t he door, direct ing t he ot her t rader s t o st op selling t he yen, t elling t hem t hat he would assum e t heir posit ion. While t hese ot her t raders w ere congrat ulat ing t hem selves for having t aken t he biggest profit in t heir lives, Soros was looking at t he big pict ure: The governm ent had j ust t old him t hat t he dollar was going t o go down for t he next year, so why shouldn't he be a pig and buy m ore [ yen] ? Soros is also t he best loss t aker I 've ever seen. He doesn't care whet her he wins or loses on a t rade. I f a t rade doesn't work, he's confident enough about his abilit y t o win on ot her t rades t hat he can easily walk away from t he posit ion. There are a lot of shoes on t he shelf; wear only t he ones t hat fit . I f you're ext rem ely confident , t aking a loss doesn't bot her you. = = = = How do you handle t he pressure of m anaging a m ult ifrt 'ffion dollar port folio? = = = = I 'm a lot less nervous about it now t han I was a few years ago. The wonderful t hing about our business is t hat it 's liquid, and you can wipe t he slat e clean on any day. As long as I 'm in cont rol of t he sit uat ion- t hat is, as long as I can cover m y posit ions- t here's no reason t o be nervous. According t o Druckenm iller, superior perform ance requires t wo key elem ent s: preservat ion of capit al and hom e runs. The first principle has been quit e w ell publicized, but t he second is far less appreciat ed. From a port folio perspect ive, Druckenm iller is saying t hat in order t o really excel, you m ust t ake full advant age of t he sit uat ions when you are well ahead and running a hot hand. Those are t he t im es t o really press, not rest on your laurels. Great t rack records are m ade by avoiding losing years and m anaging t o score a few highdouble- digit - or t riple- digit - gain years. On an individual t rade basis, going for hom e runs m eans really applying leverage in t hose infrequent circum st ances when you have t rem endous confidence. As Druckenm iller put s it , " I t t akes courage t o be a pig," . Anot her im port ant lesson t o be drawn from t his int erview is t hat if you m ake a m ist ake, respond im m ediat ely! Druckenm iller m ade t he incredible error of shift ing from short t o 130 per cent long on t he very day before t he m assive Oct ober 19, 1987, st ock crash, yet he finished t he m ont h wit h a net gain. How? When he realized he was dead wrong, he liquidat ed his ent ire long posit ion during t he first hour of t rading on Oct ober 19 and act ually went short . Had he been less open- m inded, defending his original posit ion when confront ed w it h cont rary evidence, or had he procr ast inat ed t o see if t he m arket would recover, he would have suffered a t rem endous loss. I nst ead, he act ually m ade a sm all profit . The abilit y t o accept unpleasant

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83 t rut hs ( i.e., m arket act ion or event s count er t o one's posit ion) and respond decisively and wit hout hesit at ion is t he m ark of a great t rader. Alt hough Druckenm iller em ploys valuat ion analysis and believes it is im port ant in gauging t he ext ent of a pot ent ial fut ure price m ove once t he current m arket t rend rever ses, he em phasizes t hat t his approach cannot be used for t im ing. The key t ools Druckenm iller applies t o t im ing t he broad m arket are liquidit y analysis and t echnical analysis. I n evaluat ing individual st ocks, Druckenm iller recalls t he advice of his first boss, who m ade him realize t hat t he init ial st ep in any analysis is det erm ining t he fact ors t hat m ake a part icular st ock go up or dow n. The specifics will vary for each m arket sect or, and som et im es even wit hin each sect or. Druckenm iller's ent ire t rading st yle runs count er t o t he ort hodoxy of fund m anagem ent . There is no logical reason why an invest or ( or fund m anager) should be nearly fully invest ed in equit ies at all t im es. I f an invest or's analysis point s t o t he probabilit y of an im pending bear m arket , he or she should m ove ent irely t o cash and possibly even a net short posit ion. Recall Druckenm iller's frust rat ion at being ext rem ely bearish in m id- 1981, absolut ely correct in his forecast , and st ill losing m oney, because at t he t im e, he was st ill wedded t o t he idea t hat a st ock m anager had t o be net long at all t im es. There is lit t le quest ion t hat Druckenm iller''s long- t erm gains would have been dr am at ically lower and his equit y drawdowns significant ly wider if he rest rict ed him self t o t he long side of t he st ock m ar ket . The flexibilit y of Druckenm ilt er's st yle- going short as well as long and also diversifying int o ot her m aj or global m arket s ( e.g., bonds and curr encies) - is obviously a key elem ent of his success. The queen in chess, which can m ove in all direct ions, is a far m ore powerful piece t han t he pawn, which can only m ove forward. One basic m arket t rut h ( or, perhaps m ore accurat ely, one basic t rut h about hum an nat ure) is t hat you can't win if you have t o w in. Druckenm iller's plunge int o T- bill fut ures in a desperat e at t em pt t o save his firm from financial ruin provides a classic exam ple. Even t hough he bought T- bill fut ures wit hin one week of t heir all- t im e low ( you can't pick a t rade m uch bet t er t han t hat ) , he lost all his m oney. The very need t o win poisoned t he t rade- m t his inst ance, t hrough grossly excessive leverage and a lack of planning. The m arket is a st em m ast er t hat seldom t olerat es t he carelessness associat ed wit h t rades born of desperat ion.

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84 Richard Driehaus: The Art of Bottom-Up

Investing

Richard H. Driehaus got hooked on t he st ock m ark et as a kid, and JAJlis ent husiasm for t he m arket has never flagged since. While st ill in his early t eens, Driehaus discovered t he folly of following t he recom m endat ions of financial colum nist s. As a result , he decided t o educat e him self by devouring all t he st ock newslet t ers and financial m agazines he could find at t he local branch library. I t was during t hose childhood years t hat he began t o develop m e basic m arket philosophy t hat would serve as t he core of his approach in his lat er years as a securit ies analyst and port folio m anager. Upon college graduat ion, Driehaus set out t o find a m arket - relat ed j ob and landed a slot as a r esear ch analyst . Alt hough he liked t he j ob, he was frust r at ed by seeing his best r ecom m endat ions ignored by t he sales force. Driehaus got his first chance t o m anage m oney in 1970 while working in t he inst it ut ional t rading depart m ent at A. G. Becker. To his pleasant surpr ise, Driehaus discovered t hat his t rading ideas wer e even bet t er in pract ice t han he dared t o believe. I n his t hree years as a m anager at A. G. Becker, he was rat ed in t he t op 1 percent of all port folio m anagers surveyed by Becker 's Fund Evaluat ion Service, t he largest fund rat ing service at t he t im e. Aft er leaving A. G. Becker, Driehaus worked as a direct or of research for Mullaney, Wells and Com pany, and t hen Jessup and Lam - ount , before st art ing his own firm in 1980. For t he t welve- year period since 1980, Driehaus averaged an annual ret urn in excess of 30 percent ( net of brokerage and m anagem ent fees) , nearly double t he S&P 500 ret urn of 16.7 percent during t he sam e period. The S&P 500, however, is not t he appropriat e benchm ark, as Driehaus focuses on sm all cap ( capit alizat ion) st ocks. I n case you t hink t hat Driehaus's superior per form ance is relat ed t o t he bet t er perform ance of t he low cap st ocks, not e t hat t he Russell 2000 index, which t racks t he perform ance of t he 1,001st t hrough 3,000t h largest U.S. com panies ( a group represent at ive of t he st ocks in Driehaus's port folio) , was up only 13.5 percent , com pounded annually, during t he sam e t welve- year period. One dollar invest ed in t he Russell index in 1980 would have been wort h $4.56 at t he end of 1991; one dollar invest ed in Driehaus's Sm all Cap Fund would have grown t o $24.65 during t he sam e t im e fram e. Alt hough Driehaus's flagship invest m ent vehicle has been sm all cap st ocks, he has broadened his scope t o include ot her t ypes of funds as well. He is part icularly fond of t he concept m at underlies his Bull and Bear Part nership Fund. This fund seeks t o rem ove t he im pact of t he general st ock m arket t rend by approxim at ely balancing long and short posit ions on an ongoing basis. I n ot her words, t he fund's m arket direct ional exposure is near zero at all t im es, wit h perform ance ent irely dependent on individual st ock select ion. I n it s first t wo years of operat ion, 1990 and 1991, t his fund realized back- t o- back annual ret urns of 67 percent and 62 percent ( before a 20 percent profit incent ive fee payout ) , wit h only t hree out of t w ent y- four m ont hs regist ering a loss ( t he largest being a m ere 4 percent ) . Over t he years, philant hropy has becom e an increasingly im port ant force in Driehaus's life. I n 1984, he st art ed t he Richard H. Driehaus Foundat ion wit h a $1 m illion cont ribut ion of TCBY ( The Count ry's Best Yogurt , originally This Can't Be Yogurt ) st ock. He m anages t he foundat ion's funds, dist ribut ing 5 percent of t he t ot al equit y annually t o a variet y of charit ies. By t he end of 1991, t he foundat ion's capit alizat ion had grown t o approxim at ely $20 m illion. I m et Driehaus on one of his periodic j aunt s t o New York Cit y for an art auct ion. The int erview was conduct ed over a leisurely breakfast ( apparent ly far t oo leisurely as far as t he st aff was concerned) in t he cavernous dining room of a m idt own hot el. Event ually, we m oved on t o cont inue t he int erview at a quiet lounge at a nearby hot el, where t he dark, floor- t o- ceiling wood- paneled walls and ant ique fixt ures provided a cent ury- old at m osphere. = = = = When did you first becom e int erest ed in t he st ock m arket ? = = = = When I was t hirt een years old I decided t o invest $ 1,000 saved up from m y newspaper rout e in t he st ock m arket . My early invest m ent s, which were guided by financial colum nist and broker recom m endat ions, fared poorly. I had t hought t hat if I followed t he adv ice of professionals, I would m ake m oney. I found t he experience very disheart ening. I decided t o t ry t o figure out what m ade st ock prices m ove. I st art ed going down t o t he local library on a regular basis and reading a variet y of financial periodicals and new slet t ers. One let t er t hat had a part icularly st rong im pact on m e was John Herold's Am erica's Fast est Grow ing Com panies. = = = = What appealed t o you about t hat let t er? = = = = I t was m y favorit e let t er for t wo reasons. First , it showed m e t he success t hat could be achieved by buying growt h st ock s. Herold had st ocks in his newslet t er t hat he had recom m ended t en year s earlier t hat were up t enfold and t went yfold. These wer e incredible m oves t o m e. Second, Herold's approach of focusing on earnings growt h m ade a lot of sense t o m e. I t seem ed logical t hat if a com pany's earnings were growing over a long period of t im e, it s st ock price had t o go in t he sam e direct ion. I n his newslet t er, Herold displayed chart s t hat superim posed a st ock's price and it s earnings over a t en- year period, wit h bot h graphs showing dram at ic growt h. These chart s, which basically dem onst rat ed t hat a st ock's price was in harm ony wit h it s long- t erm earnings growt h, becam e a very powerful im age t o m e. = = = = Was your first j ob m arket relat ed? = = = = Yes. Aft er college, I landed a j ob as a securit ies analyst for a sm all Midwest ern broker age firm . To m y dism ay, I discovered t hat m any of m y recom m endat ions were never im plem ent ed in t he cust om ers' port folios. = = = = Why was t hat ? = = = =

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85 Because t he P/ E m ult iples [ t he rat ios of prices t o earnings] were t oo high. Many of t he best growt h st ocks have high m ult iples and are psychologically difficult t o buy. I f t he brokers weren't t urned off by t he high P/ Es, t heir client s were. Also, I realized t hat m any brokers weren't port folio m anager s but w ere pr im arily sales orient ed. I found it very discouraging t hat m any of m y best recom m endat ions were not being ut ilized. Aft er about t wo years, I left t his com pany t o j oin t he inst it ut ional t rading depart m ent of A. G. Becker, which at t he t im e was a very st rong force in t he Midwest ern brokerage business. I published m y own inhouse recom m endat ion let t er for t he cust om ers of t hat depart m ent . The com pany m anagem ent began t o not ice t hat m y recom m endat ions were significant ly out perform ing t he st ocks in t heir ot her port folios, as well as t heir own research recom m endat ions. At t he beginning of 1970, t hey gav e m e approxim at ely $400,000 of t he A. G. Becker Profit - Sharing Fund t o personally m anage. This was m y first opport unit y t o im plem ent m y invest m ent philosophy. I was elat ed. = = = = Did you find t hat t here were differences bet ween act ually m anaging m oney and sim ply m aking recom m endat ions? = = = = No, not really. However, t he period when I st art ed m anaging t his account coincided wit h a bear m arket in st ocks. Consequent ly, I had t o suffer t hrough som e early, large losse s. This is a good ex am ple of why you have t o have fait h in your approach in order t o succeed. For exam ple, one of t he first st ocks 1 bought was Bandag, which I purchased at $37. The st ock first went down t o $22, but t hen in t he ensuing 1971- 72 bull m arket , it went up t enfold. = = = = Did you hold on t o t he st ock for t hat ent ire m ove? = = = = No, unfort unat ely, I didn't . About a year lat er, I was on a business t rip and I called m y office t o check on m y st ocks. I found out t hat Bandag was up $5 t hat day, reaching a new high of $47- I decided t o t ake m y profit s, wit h t he idea of buying t he st ock back lat er. Bandag t hen proceeded t o cont inue t o go st raight up t o a high of $240 over t he next year. That experience t aught m e t hat it 's not t hat easy t o buy back a good st ock once you've sold it . I t reinforced t he idea t hat t here's great advant age and com fort t o being a long- t erm invest or. = = = = Yet I underst and t hat your average holding period t ends t o be significant ly short er t han t hat of m ost ot her m oney m anagers. Why is t hat ? = = = = Alt hough m any of t he equit ies in our port folios are held for a very long period if t hey're doing well, you have t o be willing t o t urn over your port folio m ore frequent ly t han t he convent ional norm t o get superior perform ance. I always look for t he best pot ent ial perform ance at t he current t im e. Even if I t hink t hat a st ock I hold will go higher, if I believe anot her st ock will do significant ly bet t er in t he int erim , I 'll swit ch. = = = = I n ot her words, you want t he fast est horse, even if your first horse is st ill t rot t ing in t he right direct ion. = = = = Yes, but even m ore im port ant ly, I want t o m ake sure I get off t he horse if it st art s heading in t he wrong direct ion. Most people believe high t urnover is risky, but I t hink j ust t he opposit e. High t urnover reduces risk when it 's t he result of t aking a series of sm all losses in order t o avoid larger losses. I don't hold on t o st ocks wit h det eriorat ing fundam ent als or price pat t erns. For m e, t his kind of t urnover m akes sense. I t reduces risk; it doesn't increase it . = = = = How long did you st ay wit h A. G. Becker? = = = = I left in t he fall of 1973 t o becom e t he research direct or for Mullaney, Wells and Com pany, a sm all regional brokerage firm . = = = = Did t hey give you m oney t o m anage? = = = = No, but A. G. Becker let m e cont inue t o m anage t he account I had t raded for t hem . I n addit ion t o t hat , t he wom an who reconciled t he t rades in t he A. G. Becker office had seen t hat I was good at picking st ocks. She gave m e $104,000 of her own m oney t o m anage, which const it ut ed m ost of her liquid asset s. = = = = As I recall, lat e 1973 would have been a part icularly poor t im e t o st art a st ock account . = = = = That 's right . The 1973- 74 bear m arket was t he worst decline since t he 1930s. = = = = Were you fully invest ed? = = = = Yes. Then I assum e t he account m ust have t aken a fairly large hit At t he worst point , I believe t he $104,000 went down t o under $60,000. = = = = Did your client 's confidence ever flag? = = = = That 's t he beaut y of it . Her confidence never wavered. She had t he st rengt h t o st ay in. I n fact , she's st ill wit h m e t oday. I 'll always be grat eful t o her for st icking wit h m e when I was young and unpr oven. = = = = What is her account wort h t oday? = = = = The account is now up t o $5.8 m illion- and t hat 's aft er t axes. This st uff really works! = = = = Any t rades st and out in your long t rading hist ory? = = = = My largest posit ion ever was Hom e Shopping Net work [ HSN] , which I purchased in 1986. I heard about t he st ock from one of m y analyst s whom I had sent t o a cable t elevision conference sever al weeks before t he com pany went public. As you probably know. Hom e Shopping Net work sells low- priced m erchandise- clot hes, j ewelry, and so on- over cable t elevision. They had st art ed t his vent ure about a year befor e t he offering, and in t heir first six m ont hs t hey had sold $64 m illion in m erchandise and earned $7 m illion fully t axed. These were about t he best result s I had ever seen for a new com pany. Even bet t er, t he com pany st ill had incredible pot ent ial. At t he t im e of t he offering, t hey were reaching only a lim it ed num ber of subscribers but were adding new

85

86 subscribers v ery quickly. The cable sy st em s liked t he service because t hey got par t of t he profit s, so it was easy for HSN t o get picked up by new cable net works. = = = = Did you buy t he st ock on t he init ial offering? = = = = I wish I could have, but it was very hard t o get st ock on t he deal. I believe we got only one hundred shares. The offering price was $18 per share and t he first t rade was in t he low $40s. I bought m ost of m y posit ion in a range bet w een t he low $40s and low $50s. = = = = Wasn` t it hard t o buy t he st ock when it was up so m uch? = = = = No, because t he growt h was t rem endous, t he com pany was m aking lot s of m oney, and t he pot ent ial at t he t im e seem ed open- ended. I act ually felt very good buying st ock at t hose levels. Wit hin five m ont hs, t he st ock was at $100. During t his t im e, t he com pany cont inued t o build it s subscriber base and even purchased t elevision st at ions t o reach m ore viewers. The revenues and earnings rem ained very st rong. = = = = How long did you hold t he st ock? = = = = By early 1987, t he st ock had reached $200.I sent m y analyst down t o Florida t o an invest or m eet ing host ed by t he com pany. Alt hough t he m anagem ent was very opt im ist ic, at t he m eet ing t hey adm it t ed t hat alm ost aU t he growt h was com ing from new subscribers and t hat t he growt h in order rat es from cust om ers on exist ing cable syst em s was not t hat great . About t his t im e, t he st ock had also st art ed t o break down t echnically. That w as all I needed. I sold t he st ock aggressively and elim inat ed m y ent ire posit ion over t he next few weeks. = = = = Any ot her exam ples of st ock picks t hat exem plify your invest m ent st yle? = = = = A recent exam ple is U.S. Surgical [ USSj . Alt hough by now USS has becom e an inst it ut ional favorit e, I was fort unat e t o uncover t his st ory in lat e 1989, before it really t ook off. At t hat t im e, USS didn't yet have t he great st ock charact erist ics t hat it lat er showed in 1990 and 1991 accelerat ing sales and earnings, high relat ive st rengt h, and inst it ut ional sponsorship. But it did have a very powerful, fundam ent al st ory. I t had developed t he best pipeline of noninvasive surgical product s- an innovat ive sect or t hat I t hought would becom e t he fast est growing m edical m arket of t he ninet ies. USS is probably a good exam ple of what I t ry t o do because t he key t o buying t his st ock was early recognit ion of t he noninvasive surgery m arket . This new procedur e was not heavily covered by Wall St reet back in 1989. I t didn 1 ! have t hat m uch t o do wit h what I call " left brain" ( m icro) fact ors, which would be growt h rat es, m ult iples, m argins, and so on. This st ock was a " right brain" ( m acro) st ory. You had t o appr eciat e t he pot ent ial of t his m arket before t he num bers cam e t hrough so powerfully. Danek Group [ DNKG] , a m anufact urer of spinal im plant s, is anot her good ex am ple. I st art ed buying DNKG as soon as it went public in May 1991. I t had every t hing I look for in a growt h st ock: accelerat ing revenues and earnings and propriet ary product s in a rapidly expanding m arket . Even bet t er, from a t rading point of view, DNKG was a st rong m edical product s com pany at a t im e when t he m arket couldn't wait t o buy such issues. Anyt hing healt hcare- relat ed was m oving in 1991, and DNKG forcefully part icipat ed in t his m ove, exploding from $19 t o $43 during it s first t hree m ont hs aft er going public. But t hen a rum or began circulat ing m at DNKG was going t o run int o som e t rouble at t he PDA. Alt hough t his news was unsubst ant iat ed, t he st ock cracked from $43 t o $34 in j ust a couple of days. This was m y second largest posit ion. Usually, I sell a port ion of m y posit ion when t here's a problem - and t rouble at t he FDA cert ainly qualifies as a big problem . But in t his case, I j ust didn't believe t he rum ors, and m edical st ocks were in st rong dem and in t he m arket place, so I st ayed wit h m y full posit ion. This proved t o be t he right decision, as DNKG not only recovered but went on t o hit new highs, exceeding $60 by t he end of 1991. I n t his inst ance, t he key t o m aking m oney in t he st ock was t rading t he posit ion properly. Som e port folio m anagem ent decisions are invest m ent orient ed and som e are t rading orient ed. This was a t rading decision. Also, I m ight have m ade a different decision if ot her fact ors were different . For exam ple, if t he m arket weren't st rong, or if t he m edical product s group had been weakening, t hen I m ight have sold t he ent ire posit ion. There are a lot of different input s t hat can affect a decision, and t here are no universal decision rules. = = = = Any ot her illust rat ive case hist ories? = = = = Anot her int erest ing com pany was Blockbust er Ent ert ainm ent [ BVj , which operat es and franchises video rent al st ores. This is a franchise expansion st ory. I first learned of t his com pany from a very bullish research report issued by a Texas brokerage firm . The est im at ed r evenues and earnings growt h rat es left m e a lit t le skept ical at first , but t he t echnical indicat ors were im proving and t he concept was unbelievable. The st ory had good cr edibilit y because t he com pany was being launched by Wayne Huizenga, who was already a successful businessm an. He was one of t he founders and form er chairm an of Wast e Managem ent , anot her com pany in which I was an early invest or aft er t he com pany went public in t he early 1970s. The Blockbust er st ory st art ed t o appeal t o m e even m ore w hen t he com pany m ade it s next quar t erly earnings announcem ent . The growt h r at es wer e im pressive and m ade m e believe t hat t he st reet est im at e I had frowned upon earlier was not only achievable but m aybe even conser vat ive. I inst ruct ed one of m y analyst s t o increase his research effort s. Huizenga planned t o cont inue opening com pany- owned and franchised video r ent al st ores under t he Blockbust er nam e. I learned t hat t hese wer e superst ores t hat st ocked t housands of videocasset t es. I felt t he concept would work because VCR sales were st ill growing quit e subst ant ially and Blockbust er's m ain com pet it ion cam e from m om - and- pop video ret ailers t hat had a m uch sm aller select ion of videocasset t es. We cont inued t o increase our posit ion in t he st ock over t he nex t few m ont hs and m ade a lot of m oney, as t he st ock m ore t han doubled. = = = = I n any t hese exam ples, it sounds like you bought t he st ock and t he st ock t ook off. Can you t hink of a

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87 m aj or winner t hat first headed sout h aft er you bought it ? = = = = I n m e sum m er of 1984, a broker friend called m e and said, " I have a good st ock for you." " Okay, what is it ?" I asked. " This Can't Be Yogurt [ TCBY1," he answered. " I don't know," I said. " I don't really like yogurt ." " No," he said, " t his yogurt really t ast es good. Let m e send you a prospect us." He sent over not only a prospect us but a sam ple of t he product as well. The prospect us looked very int erest ing, showing about 70 t o 80 per cent growt h in earnings, but per haps even m ore im port ant ly, I t hought t he product t ast ed great - j ust like ice cream . When t he com pany went public, I bought a large am ount of st ock at t he init ial offering price of $7. Aft er I bought it , t he st ock went down t o $4[ frl/ 4] . At t hat point , I got a call from one of m y client s, quest ioning t he advisabilit y of m aint aining our large holding in t he st ock. The com pany's earnings growt h was so spect acular t hat I t old him I t hought t he st ock was st ill a buy. = = = = Did you buy m ore? = = = = As a m at t er of fact , I did, but I wait ed unt il t he st ock st art ed t o upt ick. = = = = Did you have any idea why t he st ock was going down? = = = = I couldn't figure it out . My best guess was t hat t he m arket was so negat ive for sm all cap st ocks t hat TCBY was probably j ust get t ing dragged dow n wit h t he rest of t he group. = = = = What ult im at ely happened t o t he st ock? = = = = Event ually it went up t o $200. = = = = What was t he cat alyst t hat t urned it around? = = = = The environm ent changed. The m arket began t o appreciat e growt h st ocks. I t was part ly t he com pany and part ly ( he environm ent . There's a saying, " You can't m ake a harvest in t he wint ert im e.'" That was t he sit uat ion init ially. I t was wint ert im e for sm all cap, high growt h st ocks. The m arket j ust wasn't int erest ed. Once t his general at t it ude changed, t he m ar ket focused on t he com pany's excellent earnings, and t he st ock t ook off. = = = = Were t here any sit uat ions in which you bought a st ock very heavily because of good earnings growt h and prices went down and never recovered? = = = = Sure, t hat happens a lot . We probably have m ore losers t han winners, but we cut our losses. = = = = How do you decide where t o cut your losses? = = = = I t could be a change in t he fundam ent als, such as a disappoint ing t urn in earnings, or it could be due t o t he price act ion. = = = = Wouldn't negat ive price act ion have got t en you out of a st ock like TCBY? Where do you draw t he line? ==== I t 's not purely det erm inist ic; t here's an elem ent of art involved. Ult im at ely, you have t o balance your underlying fait h in t he com pany wit h t he price act ion. = = = = Was it t hen a m at t er of your confidence in t he fundam ent als for TCBY being so st rong t hat it overrode everyt hing else? = = = = Exact ly. I t was a m at t er of m y convict ion on t he st ock. = = = = What do you look for in t erm s of t he price act ion? = = = = I look at t he t ot al im age. I t 's m ore t he visual im pression t han whet her t he st ock breaks a part icular point . = = = = I t ake t hat t o m ean t hat you use chart s. = = = = Absolut ely. Technical analysis is vit al for success. = = = = How long have you been using chart s? = = = = About t went y- five years. That pr obably says as m uch as anyt hing about how helpful and reliable I have found t hem . They give you a very unem ot ional insight int o a st ock in an ot herwise em ot ional m arket . = = = = Do you always check t he chart before you buy a st ock? = = = = Absolut ely. I won't buy a st ock when it 's dropping even if I like t he fundam ent als. I have t o see som e st abilit y in t he price act ion before I buy t he st ock. Conversely, I m ight also use a st ock's chart t o t rigger t he sale of a current holding. Again, t he chart s are a very unem ot ional way t o view a st ock's behavior and pot ent ial. = = = = I s it fair t o say t hat you det erm ine your t rading ideas based on fundam ent al analysis but t hat you t im e your t rade ent ry using t echnical analysis? = = = = Generally speaking, t hat 's probably t rue. However, oft en t he t rigger for buying a st ock is fundam ent al news. For ex am ple, recent ly I purchased a st ock called Dat aram Corporat ion following t he release of a very posit ive earnings report . The com pany, which m akes m em ory product s for per sonal com put er s and workst at ions, report ed quart erly earnings up from $.32 t o $.75 and revenues up from $7 m illion t o $11 m illion. The st ock, which had closed at $26 3/ 8 on t he previous day, shot up $4 on t he news. We purchased t went y- five t housand shares at an average cost of $30 1/ 4. = = = = Do you put a lim it on t he order in t hat t ype of sit uat ion? = = = = Oh no! We would never have got t en filled. I felt very com fort able buying t he st ock, ev en aft er it s large price m ove t hat day, because t he num bers were very st rong and t he m arket was m oving t oward t echnology st ocks anyway. We ult im at ely ended up purchasing alm ost 4 percent of t his com pany at an average cost of $31 1/ 2. The st ock now sells at $58.

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88 = = = = I s it generally t rue t hat st ocks t hat wit ness a huge, one- day m ove t end t o keep going in t he sam e direct ion over t he near t erm ? = = = = That has been m y observat ion over t he years. I f t here's a large m ove on significant news, eit her favorable or unfavorable, t he st ock will usually cont inue t o m ove in t hat direct ion. = = = = So you basically have t o bit e t he bullet and buy t he st ock. = = = = Yes, but it 's hard t o do. = = = = Were you always able t o do t hat ? = = = = I t 's t aken t im e t o get good at it . = = = = Does a st ock have t o be st ronger t han t he overall m arket in order for you t o buy it ? = = = = Generally speaking, yes. I like t o see t he st ock's relat ive st rengt h in t he t op 10 percent of t he m arket , or at least t he t op 20 per cent . = = = = You im plied earlier t hat you'll oft en buy st ocks wit h high P/ E rat ios. Does t his im ply t hat you believe P/ E rat ios are irrelevant ? = = = = The P/ E rat io m ight show st at ist ical significance for broad st ock groups, but for t he t ype of st ocks we buy, it 's usually not a key variable. St ocks wit h long- t erm , high- growt h pot ent ial oft en sell at higher m ult iples, part icularly if t hey're newer com panies. The P/ E rat io really m easures invest ors' em ot ions, which swing wildly from fear t o greed, and is only significant at ext rem es. = = = = Do you feel t here's an advant age t o buying stocks t hat are not t oo heavily covered by t he st reet ? ==== Absolut ely! There's a definit e m arket inefficiency t here. Typically, t he m ore t he st reet cov ers a st ock, t he less opport unit y t here is. = = = = What are t he m aj or m isconcept ions people have about t he st ock m arket ? = = = = They t end t o confuse short - t erm volat ilit y wit h long- t erm risk. The longer t he t im e period, t he lower t he risk of holding equit ies. People focus t oo m uch on t he short t erm - week- t o- week and m ont h- t o- m ont h price changes- and don't pay enough at t ent ion t o t he long- t erm pot ent ial. They look at all m ovem ent as negat ive, whereas I look at m ovem ent as a const ruct ive elem ent . For m any invest ors, t he lack of sufficient exposure t o high- ret urning, m ore volat ile asset s is t heir great est risk. I n m y opinion, invest m ent vehicles t hat provide t he least short t er m volat ilit y oft en em body t he gr eat est long- t erm risk. Wit hout significant price m ovem ent , you can't achieve superior gains. One m arket paradigm t hat I t ake except ion t o is: Buy low and sell high. I believe t hat far m ore m oney is m ade buying high and selling at even higher prices. That m eans buying st ocks t hat have already had good m oves and have high relat ive st rengt h- t hat is, st ocks in dem and by ot her invest ors. I would m uch rat her invest in a st ock t hat 's increasing in price and t ake t he risk t hat it m ay begin t o decline t han invest in a st ock t hat 's already in a decline and t ry t o guess when it will t urn around. Finally, anot her m aj or t rap people fall int o is t rying t o t im e m e m arket . Since January 1980, t he m ar ket has realized an average annual com pounded ret urn of 17 percent . I f you wer e out of t he m arket on t he fort y best days, which represent only 2 percent of t he t rading days, t he ret urn would drop t o under 4 percent . The m oral is t hat t he penalt y for being out of t he m ark et on t he wrong days is severe- and hum an nat ure being what it is, t hose are exact ly t he days t hat m ost people are likely t o be out of t he m arket . = = = = What are t he t rait s of t he people who are successful in t his business? = = = = They're open- m inded and flexible. They're also risk t akers, because t hey believe in what t hey're doing. = = = = I underst and t hat you have several people at your firm t rading t heir own sm all funds. Did you t rain t hese people? = = = = Yes, none of t hem had a n y previous experience in t he business before st ar t ing wit h us. There ar e t hree people involved, and t hey're all doing very well. = = = = I guess t hat m eans t hat you believe successful t rading can be t aught ? = = = = I t can be t aught as long as t he per son has an open m ind. I like t o say t hat t he m ind is like a parachut e- it 's only good when it 's open. Of course, each person m ust st ill develop an individual philosophy and t ailor basic t rading concept s t o his or her own personalit y. = = = = How did you fare during t he Oct ober 1987 crash? = = = = We had a v ery t ough m ont h. The Sm all Cap Fund was down 34 percent . For t unat ely, t he fund was up 46 percent com ing int o Oct ober. We finished t he year down 3 percent . About one week before t he crash, I sensed som et hing significant ly negat ive was going t o happen in t he m arket . = = = = How did you realize t hat ? = = = = Buying had dried up, t here was a sense of fear in t he m arket , and I was also worried about t he burgeoning use of port folio insurance. Because of m y concern about t he increased risk exposure in t he m arket , I had a subst ant ial port ion of m y port folio up for sale on t he Thursday and Friday before t he crash. Unfort unat ely, I wasn't able t o liquidat e as m uch st ock as I want ed t o. = = = = You were unable t o liquidat e your posit ion because t he t one of t he m arket was so bad? = = = = The at m osphere was horrible. = = = = When we were t alking about ent ering orders on ext rem e price m oves, you m ent ioned t he necessit y of using m arket orders inst ead of lim it orders, which are unlikely t o get filled in such sit uat ions. I f you felt t hat st rongly, why did you use lim it orders inst ead of m arket orders in t his case? = = = = We were t rying t o sell t he st ocks at t he m arket . However, m any of t he issues we hold are very t hin and

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89 t he size we want ed t o sell was j ust t oo large relat ive t o what t he m arket could handle. For exam ple, one st ock we held was nom inally t rading at $36 bid/ $38 offered, and while we were willing t o sell our ent ire t hirt y- t housand- share posit ion at $34, t here were no bids of any size even well below t he m arket . = = = = Did you com e in on Monday, Oct ober 19, knowing t hat it was going t o be a very bad day? = = = = Yes, but I had no idea how ext rem e it would be. = = = = Were you st ill t rying t o sell st ock t hat day? = = = = We m anaged t o sell som e. = = = = Did you st op t rying t o sell as t he day wore on? = = = = Aft er a while t he break was so severe t hat it didn't seem t o m ake any sense t o t ry t o sell unless t he financial world was com ing t o an end. = = = = Could you describe your em ot ions on t hat day? = = = = I was act ually very calm . I felt det ached- as if I had t ranscended t he sit uat ion. I alm ost had a sense of observing m yself and everyt hing t hat was going on. = = = = Aft er t he sm oke cleared on Oct ober 19, you m ust have realized t hat you had Just lost one- t hird of your wealt h in one day's t im e. [ Driehaus keeps alm ost all his m oney in his own funds.] I s t here a feeling t hat goes wit h t hat ? = = = = Yes, get it back! [ He laughs loudly.) Act ually, I had lost m uch m ore t han t hat in 1973- 74. = = = = Did t hat help? = = = = Yes, it did help. I t showed m e t hat you could survive t hat t y pe of break. I had t he confidence t hat I could m ake it back and t he com m it m ent t o do it . As Niet zsche said. " What does not dest r oy m e, m akes m e st ronger." = = = = I get t he im pression t hat you really don't suffer any m aj or m arket - relat ed st ress, even in ext rem e sit uat ions such as t he Oct ober 1987 crash. I s t hat because you believe t hat t hings will work out in t he = = = = e n d? I believe t hat 's exact ly right . = = = = When did you get t hat degree of confidence? = = = = I believed in m y invest m ent philosophy from t he very beginning, but I acquired t he t rue confidence when I applied t his philosophy t o t he fund I m anaged at A. G. Becker and found t hat I had placed in t he t op 1 percent of all funds surveyed. I couldn't believe how well t he approach work ed. My confidence in t his t rading philosophy has never wavered. = = = = You've been a port folio nianager for nearly t went y years, during which t im e you out perform ed t he indust ry averages by a wide m ar gin wit h enviable consist ency. What do you consider t he key t o your sust ained success over such a long period? = = = = The essent ial elem ent is having a core philosophy. Wit hout a core philosophy you're not going t o be able t o hold on t o your posit ions or st ick wit h your t rading plan during really difficult t im es. You m ust fully underst and, st rongly believe in, and be t ot ally com m it t ed t o your t rading philosophy. I n order t o achieve t hat m ent al st at e, you have t o do a great deal of independent r esearch. A t rading philosophy is som et hing t hat cannot j ust be t ransferred from one person t o anot her; it 's som et hing t hat you have t o acquire yourself t hrough t im e and effort . = = = = Any final advice? = = = = I f you reach high, you j ust m ight am aze yourself. Driehaus's basic philosophy is t hat pr ice follows growt h and t hat t he k ey t o super b per form ance in t he st ock m arket is picking t he com panies wit h t he best pot ent ial earnings growt h. Everyt hing else is secondary. I nt erest ingly, t he high growt h st ocks t hat m eet Driehaus's crit eria oft en sell at ext rem ely high P/ E rat ios. Driehaus cont ends t hat t he so- called prudent approach of buying only st ocks wit h average t o below- average P/ Es will aut om at ically elim inat e m any of t he best perform ers. The st ocks t hat Driehaus t ends t o buy ar e also oft en com panies t hat are not followed by, or only light ly followed by, indust ry analyst s, a charact er ist ic t hat Driehaus believes leads t o great er inefficiencies and hence great er profit opport unit ies. Driehaus's st ock select ion ideas are fundam ent ally based. However, t o confirm his select ion and t o aid in t he t im ing of purchases, Driehaus is a great believer in t echnical analysis. Wit h rare except ion, before he buys a st ock, Driehaus want s t o see it s price rising and high relat ive st rengt h ( i.e., a st ock t hat is perform ing significant ly st ronger t han t he broad m arket ) . These t echnical charact erist ics m ean t hat when Driehaus buys a st ock, it is frequent ly near it s recent high. He believes t hat fort unes are m ade by j um ping on board t he st rongest fundam ent al and t echnical perform ers, not by picking bargains. Most invest ors would find t he t ypical st ock in Driehaus's port folio hard t o buy. Think of a broker espousing t he sam e st rat egy in a t elephone solicit at ion. " Hello, Mr. Sm it h. I have a real int erest ing st ock for you t o consider." ( Pause) " What is t he P/ E rat io? Well, it 's 60 t o I ." ( Pause) " How far is it from it s low? Well, it 's m aking new highs. Mr. Sm it h? Hello? Mr. Sm it h?" Driehaus's m et hod provides yet anot her exam ple of t he principle t hat successful st rat egies oft en r equire doing w hat m ost people find inst inct ively uncom fort able. Quit e sim ply, t he nat ural inclinat ion of m ost people t oward com fort able approaches ( e.g., buying st ocks t hat are near t heir lows, buying st ocks wit h low P/ Es) is one of t he reasons t he vast m aj orit y of invest ors experience such poor result s. Anot her exam ple in which Driehaus's abilit y t o do what is uncom fort able enhances his profit abilit y is his willingness t o buy a st ock on ext rem e st rengt h following a significant bullish news it em . I n such sit uat ions,

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90 m ost invest ors will wait for a react ion t hat never com es, or at t he very least will place a price lim it on t heir buy order. Driehaus realizes t hat if t he news is sufficient ly significant , t he only way t o buy t he st ock is t o buy t he st ock. Any m ore caut ious approach is likely t o result in m issing t he m ove. I n sim ilar fashion, Driehaus is also willing t o im m ediat ely liquidat e a holding, even on a sharp one- day decline, if he feels a negat ive news it em has changed t he out look for t he st ock. The rule is: * * Do what is right , not what is com fort able.* * Anot her im port ant point t o em phasize is t hat a sm all percent age of huge winners account for t he bulk of Driehaus's superior perform ance. You don't have t o be right t he m aj orit y of t he t im e, but you do have t o t ake advant age of t he sit uat ions when you are right . Achieving t his dict at e requires t wo essent ial elem ent s: t aking larger posit ions when one has a high degree of confidence ( e.g., Hom e Shopping Net work was Driehaus's largest posit ion ever) and holding such posit ions long enough t o realize m ost of t he pot ent ial. The lat t er condit ion m eans avoiding t he t em pt at ion t o t ake profit s aft er a st ock has doubled or even t ripled, if t he fundam ent al and t echnical condit ions st ill point t o cont inued higher prices. The st eely pat ience necessary t o hold such posit ions t o fm it ion is one of t he at t ribut es t hat dist inguishes t he Market Wizards from less skilled t rader s. Even t hough Driehaus and Druckenm iller em ploy dram at ically different approaches, " hom e run" t rades are an essent ial ingredient t o t he success of each. Perhaps Driehaus's m ost fundam ent al piece of advice is t hat in order t o succeed in t he m arket ( any m arket ) , you m ust develop your own philosophy. Carefully researching and rigorously verifying a t rading philosophy is essent ial t o developing t he confidence necessary t o st ay t he course during t he difficult t im esand t here will always be such t im es, even for t he m ost successful approaches.

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91 Gil Blake: The Master of Consistency Gil Blake calls his m anagem ent com pany Twent y Plus. This nam e t ies int o t he logo on his business card and st at ionery, which shows a probabilit y curve wit h a + 20 percent ret urn falling t wo st andard deviat ions t o t he left of t he m ean. For t hose not st at ist ically inclined, t he im plicat ion is t hat he has a 95 percent probabilit y of realizing an annual ret urn of at least 20 percent . The sket ch of t he probabilit y curve does not ext end t o a 0 percent ret urn, let alone int o negat ive ret urns- which says a great deal about Blake's confidence. Blake's confidence is obviously not m isplaced. I n t he t welve years since he began t rading, he has averaged a 45 percent annual ret urn. Alt hough t his is an im pressive figure, t he m ost st riking elem ent of Blake's perform ance is his consist ency. True t o his logo, he has never had a year wit h a ret urn below 20 percent . I n fact , his worst perfor m ance was a 24 percent gain in 1984. But even in t hat subpar year, Blake had a consolat ion- he m ade m oney in all t welve m ont hs! To really appreciat e Blake's consist ency, you have t o look at his m ont hly ret urns. An am azing 134 m ont hs ( ninet y- six percent ) in his 139- m onm t rack recor d were eit her breakeven or profit able. He even had one st reak of 65 m ont hs wit hout a loss- a feat t hat would qualify him as t he Joe DiMaggio of t rading ( Joe's st reak ended at 56) . Blake's confidence in his approach also perm eat es his unique fee arrangem ent . He charges his client s 25 percent of t ot al annual profit s, but and here's t he unusual part - he also agrees t o pay 25 percent of any losses and 100 per cent of losses incurred in a new account during t he first t welve m ont hs. Obviously, he has not had t o pay out on t hese guarant ees yet . By now you probably want t o know where t o send your check- Save your st am p. Blake st opped accept ing client funds five years ago. He has m ade only t wo except ions since t hen; bot h t im es for close friends. Blake is a m ut ual fund t im er. Generally speaking, m ut ual fund t im ers at t em pt t o enhance t he yield ret urn on a st ock or bond fund by swit ching int o a m oney m arket fund whenever condit ions are deem ed unfavorable. I n Blake's case, he doesn't m erely swit ch back and fort h bet ween a single m ut ual fund and a m oney m arket fund but also m akes t he addit ional decision of which sect or in a group of sect or funds provides t he best opport unit y on a given day. Blake uses purely t echnical m odels t o generat e signals for t he opt im um daily invest m ent st rat egy. His holding period t ends t o be very short , t ypically ranging bet ween one and four days. By using t his m et hodology, Blake has been able t o show consist ent m ont hly profit s even in t hose m ont hs when t he funds in which he invest ed regist ered significant declines. Blake prides him self on being a Wall St reet out sider. Aft er graduat ing from Cornell, he served t hree years as a naval officer on a nuclear subm arine. He subsequent ly at t ended t he Whart on Business School, graduat ing w it h highest honors. Following business school, Blake spent t hr ee year s as an account ant wit h Price Wat erhouse and nine years as chief financial officer for Fab- field Opt ical. During t his ent ire t im e, he • had no serious t hought s about t rading. I ndeed, he st ill generally believed in t he t rut h of t he random walk t heory, which he had been dut ifully t aught in school. ( This t heory basically im plies t hat t rying t o beat t he m arket s is a fut ile endeavor.) Blake's life changed when he st rolled int o his friend's office one day and was present ed wit h som e evidence of nonrandom m arket behavior t hat he assum ed m ust have been a fluke. I n doing t he research t o prove t his point , he inst ead convinced him self t hat t here were indeed subst ant ial pocket s of nonrandom behavior m t he m arket s t hat provided unbelievable profit opport unit ies. Thus, fift een years aft er graduat ing from college, Gil Blake becam e a t rader. Are great t raders born or m ade? I n Blake's case, t he following not e from his nursery school t eacher, which his m ot her proudly saved, provides som e insight s: His claywork, paint ing, and carpent ry all show an am azing m et iculous precision. He enj oys working wit h sm all t hings, and is a perfect ionist about it . Hveryt hing he does is m ade up of m any sm all part s inst ead of one, big splashy form t hat is m ore usual for a child of his age. He has an ext raordinary int erest and grasp of num bers, and shows a real t alent t oward t hings m at hem at ical. I int erviewed Blake at his suburban Massachuset t s hom e on a Sat urday aft ernoon during t he peak of t he fall season. I arrived t here short ly aft er hm cht im e. Thought fully, assum ing t hat I would not have eat en, he had picked up sandwiches. I found Blake t o be very low- key and unassum ing. He seem ed genuinely flat t ered t hat I considered him wort hy enough t o be included in a book of t op t raders. I n t erm s of ret urn relat ive t o risk, Blake has few. if any, peers, but you would never guess t hat from his dem eanor. = = = = You becam e a m ut ual fund t im er long before it becam e popular. What was your original inspirat ion? ==== Well, I really owe it t o a friend. I rem em ber t he day as if it were yest er day. I wandered int o a colleague's office, and he said, " Hey, Gil, t ake a look at t hese num bers." He had invest ed in a m unicipal bond fund t o t ake advant age of t he pr evailing high int erest rat es, which at t he t im e were about 10 t o 11 percent t ax free. Alt hough he was get t ing a high int erest rat e, he discovered t hat his t ot al ret urn was act ually declining rapidly because of t he st eady at t rit ion in t he net asset value [ NAV] . He handed m e a sheet wit h about a m ont h's wort h of num bers, and I not iced t hat t he t rend was very persist ent : t he NAV had declined for approxim at ely t went y- t wo consecut ive days. He said, " Fidelit y allows you t o swit ch int o a cash fund at any t im e at no charge. Why couldn't I j ust swit ch out of t he fund int o cash when it st art ed t o go dow n and t hen swit ch back int o t he fund when it st art ed t o go back up?" My react ion was, " Nick, I don't t hink t he m arket s work t hat way. Have you ever read A Random Walk Down Wall St reet ?" I pooh- poohed his idea. I said, " The problem is t hat you don't have enough dat a. Get som e m ore dat a, and I bet t hat you'll find t his is not som et hing you

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92 could m ake any m oney on over t he long run." He did get m ore dat a, and, am azingly, t he persist ency of t rends seem ed t o hold up. I quickly becam e convinced t hat t here was definit ely som et hing nonrandom about t he behavior of m unicipal bond funds. = = = = How did you perceive t hat nonrandom ness? = = = = I n fact , it was t he sim plest approach t hat proved t he best . We called it t he " one penny" rule. I n t he t wo years' wort h of dat a we had obt ained, we found t hat t here was approxim at ely an 83 percent probabilit y t hat any upt ick or downt ick day would be followed by a day wit h a price m ove in t he sam e direct ion. I n t he spring of 1980, I began t o t rade Fidelit y's m unicipal bond fund in m y own account based on t his obser vat ion. = = = = And t hat worked? = = = = Yes, it worked exceedingly well. = = = = That 's alm ost hard t o believe. I know t hat in t he bond m arket , swit ching a posit ion each t im e t here's a daily price change in t he opposit e direct ion is a disast rous st rat egy. = = = = That m ay well be t rue. However, you have t o keep in m ind t wo t hings. First , t here wer e no t ransact ion cost s involved in swit ching in and out of t he fund. Second, t here seem ed t o be som e sort of sm oot hing process oper at ing in t he NAV num bers of t he m unicipal bond fund. For exam ple, t here was one t hree- m ont h period around early 1981 when t here were virt ually no upt icks in t he NAV of t he fund- t he days were all eit her down or flat - while at t he sam e t im e, t he bonds were cert ainly having som e upt ick days. I n fact , t his price behavior was exhibit ed by virt ually all m unicipal bond funds. = = = = How can you explain t hat ? = = = = I don't know t he answer. Maybe som eone can explain it t o m e som e day. = = = = Of course, you couldn't direct ly profit during t he declining periods, since you obviously can't go short a ft m d. = = = = That 's right , during t hose periods we were in cash. = = = = Given t hat you could be only long or Hat and t he bond m arket was collapsing, were you st ill able t o com e oat ahead? = = = = When I st art ed in March 1980, t he NAV of t he fund was appr oxim at ely $10.50. By t he end of 1981, t he NAV had st eadily eroded t o about $5.65- a drop of nearly 50 percent . Nevert heless, using t he above m et hod, I was able t o achieve gains m excess of 20 percent per year, not count ing int erest incom e, which added anot her 10 percent . The odds appeared t o be so favorable t hat I st art ed t o seriously t hink about how I could get m or e funds t o t r ade. I ended up t aking out four successive second m ort gages over a t hree- year period, which I was able t o do because housing prices in t he Nort heast were rising at a fast clip. = = = = Weren't you at all ret icent about doing t hat ? = = = = No, because t he odds wer e so favorable. Of course, I had t o ov ercom e t he convent ional wisdom . I f you t ell som eone t hat you're t aking out a second m ort gage t o t rade, m e response is hardly support ive. Aft er a while, I j ust st opped m ent ioning t his det ail t o ot hers. I f it t ook only a one- day change in t he direct ion of t he NAV value in order for you t o get a signal, it sounds like you would be swit ching an incredible num ber of t im es during t he year. Act ually, it only worked out t o about t went y or t hirt y t im es per year, because t he t rends were so persist ent . = = = = Wasn't t here any lim it t o t he am oiint of t im es t hat you could swit ch? Even t went y t o t hirt y t im es per year sounds like a high num ber. = = = = Fidelit y's guideline was four swit ches per year, but t hey didn't enforce t hat r ule. m fact , I even discussed m e excess swit ching wit h t hem , and t hey said, " Just don't abuse it t oo m uch." I asked, " What if I m ake t went y or t hirt y t rades per year?" The react ion was, " Well, don't t ell t oo m any people about it ." My im pression w as t hat t he rule was t here as a fallback provision but t hat t hey didn't w orry t oo m uch about it - at least t hey didn't in t he beginning. As t he years went by, I got an occasional let t er from Fidelit y st at ing: " I t has com e t o our at t ent ion t hat you are swit ching m ore t han four t im es a year, and we would appreciat e y our cooperat ing wit h t he guideline." = = = = Did you j ust ignore t hese let t ers? = = = = No. I would use t he m unicipal bond fund for four t rades, t hen t he high- yield m unicipal bond fund for four t rades, and t hen t he lim it ed- t erm m unicipal bond fund for four t rades, and so on. = = = = So, t echnically, you did adhere t o t he four- t rades- per- y ear- rule; you m erely swit ched t o different funds. = = = = That 's right . = = = = I assum e t hat , nowadays, t he NAV m ust change direct ion m uch m ore frequent ly. = = = = That 's right . The next st ep in m y evolut ion as a t rader began when t hat pat t ern st art ed t o go away as m ost of t hese t hings event ually do. = = = = The probabilit ies of a price change in t he sam e direct ion as t he previous day st art ed dropping? = = = = To som e ext ent , but , m ore im port ant ly, t he high volat ilit y st art ed t o disappear. During 1979 t o early 1984, t he volat ilit y in t hese funds aver aged approxim at ely one- quart er t o one- half of a percent per day. The daily volat ilit y event ually dropped t o only about one- t ent h t o t w o- t ent hs of a percent . Also, t he reliabilit y or persist ency of t he prices dropped from 80 percent t o below 70 percent . = = = = What happened when t he reliabilit y of t he t rend persist ence and t he volat ilit y in t he bond funds bot h

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93 st art ed t o decline precipi- t ously? Was t he m et hod st ill profit able? = = = = Yes, but t he pot ent ial annual ret urn in m unicipal bond funds began t o look like about 20 percent . = = = = And t hat was not good enough? = = = = I really want ed t o look for som et hing bet t er. I t hought t hat if I were able t o find profit able inefficiencies in m unicipal bond funds, t hen it was possible t hat sim ilar opport unit ies could be found in equit y funds. From t he fall of 1984 t hrough t he spring of 1985, I pract ically lived at t he local library, ext ract ing years of dat a on perhaps a hundred m ut ual funds off t he m icrofilm m achine. I was looking for anot her needle in a hayst ack. I found t hat t here wer e t radable pat t erns in equit y funds but t hat t he prospect ive ret urns were only around 20 t o 25 percent per year. Ev en wit h higher volat ilit y, t he daily price per sist ency of about 60 percent was j ust not high enough. Through m ost of t his research, I had ignored t he Fidelit y sect or funds, because t hey charged a $50 fee per swit ch. I couldn't see paying t his charge when t here were- eo m any funds t hat had no swit ch fee at all. Two insight s really cont ribut ed t o a breakt hrough. First , I had found early on t hat com m odit y- relat ed funds ( such as t he gold and oil sect ors) seem ed t o work bet t er t han m ore br oadly based funds. Second, I discovered separat ely t hat t he t echnology, oil, and ut ilit y indexes were each significant ly less random t han a broad m ark et index. I went back t o exam ine t he sect or funds and was j ust am azed by what I found. I couldn't believe t hat I had ignored sect ors during m y earlier research. I had alm ost m issed it . = = = = What did you Find? = = = = Generally speaking, I found t hat a price change t hat was larger t han t he average daily price change in a given sect or had anywhere bet ween a 70 t o 82 percent chance of being followed by a m ove in t he sam e direct ion on t he following day. This finding was t rem endously excit ing because of t he volat ilit y in t he sect ors. For exam ple, t he biot ech group m oved an average of 0.8 percent a day and t he gold sect or an average of 1.2 percent a day, com pared wit h t he volat ilit y of t he m unicipal bond funds, which had shrunk t o a m ere 0.1 t o 0.2 percent by t hat t im e. Therefore, I was applying t he sam e bat t ing average t o m arket s t hat offered m ore t han five t im es t he profit pot ent ial. The icing on t he cake was t hat t he sect or funds allowed unlim it ed swit ching per year, inst ead of t he fourswit ch lim it applicable t o m ost of t he ot her funds. You could swit ch a hundred t im es a year if you were willing t o pay t he $50 fee per t ransact ion. = = = = Why do you believe t he sect ors proved so t radable? = = = = That 's m y favorit e quest ion. Not j ust because 1 t hink I m ay have an answer , but also because I have not encount ered t he m at hem at ical explanat ion elsewhere. I n researching t he price behavior of individual st ocks, I have found t hat significant daily price changes ( wit h relat ive st rengt h) have about a 55 percent chance of being followed by a sim ilar direct ional m ove on t he following day. Aft er allow ing for com m issions and bid/ ask spreads, t hat is not a sufficient probabilit y edge t o be t radable. Now, as an analogy, assum e you have a st ack of coins, and each has a 55 percent chance of landing on heads. I f you t oss a single coin, t he odds of get t ing heads are 55 percent . I f y ou t oss nine coins, t he odds of get t ing m ore heads t han t ails go up t o 62 percent . And if you t oss ninet y- nine coins, t he odds of get t ing m ore heads t han t ails go up t o about 75 per cent . I t 's a funct ion of t he binom ial probabilit y dist ribut ion. Sim ilarly, assum e you have ninet y- nine chem ical st ocks, which on average are up 1 or 2 percent t oday, while t he broad m arket is flat . I n t he very short run, t his hom ogeneous group of st ocks t ends t o behave like a school of fish. While t he odds of a single chem ical st ock being up t om orrow m ay he 55 percent , t he odds for t he ent ire chem ical group are m uch closer t o 75 percent . = = = = I assum e t hat t his pat t ern does not ext end t o t he broader st ock m arket That is, once you ext end beyond a given sect or, including m ore st ocks m ay act ually reduce t he probabilit y of an index persist ing in it s t rend on t he following day. = = = = The key ingr edient is t hat t he st ocks m aking up t he index or sect or ar e hom ogeneous. For exam ple, Fidelit y's leisure fund, which was t he least hom ogeneous sect or at t he t im e, including such diverse st ocks as Bud- weiser, Pan Am , and Holiday I nn, was also t he least persist ent of all t he sect ors. Conversely, funds like savings and loans and biot ech, which were m ore hom ogeneous, also t ended t o be t he m ost persist ent . = = = = How did you ant icipat e t he direct ion of t he daily price changes in t he sect or funds in t im e t o ent er a swit ch order, or did you j ust ent er t he order wit h a one- day lag? = = = = I found t hat I could sam ple t en or t went y st ocks in each sect or and get a very good idea where t hat sect or w as going t o close t hat day. This observat ion allow ed m e t o ant icipat e t he signal by one day, which proved t o be crit ically im port ant , as m y research dem onst rat ed t hat t he average holding period for a t rade was only about t wo t o t hree days, wit h approxim at ely 50 percent of t he profit occurring on t he first day. = = = = How did you pick t he st ock sam ple groups? = = = = I nit ially, I used t he Fidelit y holdings for t hat sect or as indicat ed in t heir quart erly report s. = = = = I assum e t hat t he holdings t urned over infrequently enough so t hat t his proved t o be an adequat e est im at e = = = = Act ually, I subsequent ly discovered t hat t his procedure was a lot less im port ant t han I t hought . I found t hat I could t ake a sam ple consist ing of fift een st ocks t hat Fidelit y held in a given sect or , and it would give m e a very good est im at e of t hat sect or. On t he ot her hand, I could also use a sam ple of fift een st ocks in t hat sect or, none of which Fidelit y held, and it would st ill give m e a very good indicat ion. As long as t he num ber of st ocks in m y sam ple was large enough relat ive t o t he st ocks in t hat sect or, it didn't m ake m uch of a

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94 difference. = = = = What percent age of your account were you bet t ing each day? = = = = One hundred percent . = = = = How m any different sect ors m ight you invest in on a given day? = = = = I t raded one sect or at a t im e. = = = = Did you consider diversifying your m oney by t rading different sect ors at t he sam e t im e? = = = = I 'm not a big fan of diversificat ion. My answer t o t hat quest ion is t hat you can diversify very well by j ust m aking enough t rades per year. I f t he odds are 70 percent in your favor and you m ake fift y t rades, it 's very difficult t o have a down year. = = = = How did you select which sect or t o invest in on any given day? = = = = I m agine a board cont aining flashing light s, one for each sect or, wit h red light s indicat ing liquidat e or avoid and green light s indicat ing buy or hold. I would rank each sect or based on a com binat ion of volat ilit y and hist orical reliabilit y, which I call persist ency. Essent ially, I would t ake t he bright est green light , and when t hat green light event ually t urned red, I w ould t ake t he new bright est green light . Very oft en, however, when one light t urned red, t hey would all t urn red. = = = = And if t hey all t urned red, you would t hen go int o cash. = = = = Correct , but I needed only one green light t o t ake a posit ion on any day. = = = = When did you get involved in t aking on client s? = = = = Most of m y client s t oday act ually st art ed wit h m e when I was st ill t rading m unicipal bond funds. I t ook on m y first client in 1982. I t m ade no sense t o be borr owing at 15 percent from Phil Rizzut o at The Money St ore when I could m anage $ 100,000 of client m oney, share 25 percent of t he gains and losses, and effect ively be borrowing $25,000 for not hing. That was t he point at which I decided t o st art t he business. I st ill kept t he second m ort gage, t hough, because I want ed t o t rade t hat m oney as well. I t didn't m ake sense t o m e t o pay off a m ort gage at 15 percent when I was m aking 35 t o 40 percent on t he m oney. = = = = How did you go about solicit ing account s? = = = = All m y account s were eit her friends or neighbors. For exam ple, I would invit e a neighbor over for a beer in t he evening and say, " I 've been doing t his for a couple of years now, and I 'd like you t o t ake a look at it ." Som e people had no int erest at all and ot hers did. I t 's int erest ing how different people are when it com es t o m oney. Som e people don't do any hom ework at all and give you t heir m oney im m ediat ely. Ot hers wouldn't dream of giving you $10, no m at t er what you showed t hem . Finally, t here are t hose t hat do a lot of hom ework and ask t he right quest ions before t hey invest . Everyone falls int o one of t hese t hree cat egor ies. = = = = Which of t hose cat egories do your client s generally fall int o? Obviously, one cat egory is aut om at ically elim inat ed. = = = = Most of m y client s did t he t ype of hom ework m at I like. They asked t he right quest ions. They t old m e about t heir t olerance for risk. = = = = How large were t hese account s? = = = = They ranged from $10,000 t o $100,000. = = = = What kind of fee st ruct ure did you use? = = = = I t ook 25 percent of t he capit al gains. However, I guarant eed t o t ake 25 percent of any losses as well. I also assured each of m y invest ors t hat I would cover 100 percent of losses if t he account were dow n aft er t welve m ont hs. = = = = Heads you win one; t ails you lose t our. You m ust have been awfully confident t o offer t hat t ype of guarant ee. = = = = What I was confident in was t he probabilit y of winning aft er fift y t rades per year. = = = = For how long did you m aint ain t he 100 percent guarant ee against first - year losses? = = = = I st ill m aint ain t hat offer, but I 've accept ed only t wo new client s during t he past five years. = = = = Given your perform ance, I assum e t hat im plies t hat you're no longer accept ing any new account s ==== I st opped accept ing new account s five years ago. I m ade an except ion in t hese t wo cases because t hey were very close friends. = = = = Why did you st op accept ing new account s? Did you feel t here was a lim it t o t he am ount of m oney you could handle wit hout it negat ively im pact ing your perform ance? = = = = I t 's not a lim it t o how m uch m oney I can handle but rat her a lim it t o how m uch m oney m ay be welcom e in t he funds I 'm t rading. I 'm very sensit ive t o any pot ent ial im pact I m ight have on t he fund m anager or on t he ot her shareholders who don't m ove as act ively as I do. I prefer t o rest rict t he am ount of m oney I m ove t o only a couple of m illion dollars in a fund of several hundred m illion dollars, so t hat t he im pact will be m inim al. Also, I have found t hat when I ent er orders, I oft en get a com m ent like, " You're get t ing out ? Most of t he calls we're get t ing t oday are get t ing in." = = = = What does t hat t ell you? = = = = I t t ells m e t hat I 'm m nning count er t o a lot of m oney t hat 's being swit ched in and out ; hence, t he im pact of m y act ivit ies is not great . I 've also been t old by fund em ployees t hat m ost of t he people who do a lot of swit ching in t heir own account s end up doing worse t han if t hey had done no sw it ching at all.

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95 = = = = Did you decide t o lim it your size t o a cert ain dollar am ount in order t o not rock t he boat ? = = = = The m ost im port ant fact or here is m y risk. Sharing 25 percent of bot h profit s and losses is t he exact equivalent of leverage. What I did not fully appreciat e at first was t he psychological im port ance of finding and m aint aining a st able proport ion of client m oney t o m y own capit al. Act ually, I prefer t his proport ion ( or leverage) t o decline over t im e. = = = = Did you ever find yourself m anaging funds beyond your com fort level? = = = = I n 1986 I t ook on new m oney t oo r apidly. I found m yself rat ionalizing t aking 50 percent posit ions. For exam ple, a green light would com e on, and I would t rade only $200,000 of a $400,000 account . I would t hink, " Yes, I 'll feel m uch m ore com fort able t om orrow having only $200,000 in." I soon realized t hat as a result of m y caut ion, I was reducing m y client s' ret urn by one- half. I decided t hat a bet t er approach w as t o have fewer client s, if necessary, and t o t rade all of t hem fully. When I first cut back on t he percent age of an account t hat I was t rading, I wasn't aware of t he m ot ivat ions for m y act ions. I n hindsight , I cam e t o underst and t hat I was really uncom fort able wit h t he size of t he risk. I t wasn't j ust a m at t er of whet her I won or lost t he next day but also how I would feel unt il t he verdict cam e in. I have a rout ine of int ernalizing how I would feel given what m ight happen on t he next day. = = = = That rout ine being what ? = = = = My approach is t o confront losses even before t hey m at erialize. I rehearse t he process of losing. Whenever I t ake a posit ion, I like t o im agine what it would be like under t he worst - case scenario. I n doing so, I m inim ize t he confusion if t hat sit uat ion act ually develops. I n m y view, losses are a very im port ant part of t rading. When a loss happens, I believe in em bracing it . = = = = Why is t hat ? = = = = By em bracing a loss, really feeling it , I t end t o have less fear about a pot ent ial loss t he next t im e around. I f I can't get over t he em ot ions of t aking a loss in t went y- four hours, t hen I 'm t r ading t oo large or doing som et hing else wrong. Also, t he process of rehearsing pot ent ial losses and confront ing act ual losses helps m e adapt t o increasing levels of risk over t im e. The am ount of m oney I 'm m anaging is growing by 15 t o 20 percent a year, which m eans t hat t he dollar risk I 'm t aking is increasing at t he sam e rat e. The best way I can deal wit h t hat realit y is by being willing t o feel t he risk at each level. = = = = How is it t hat t he am ount you're m anaging is growing by only 15 t o 20 percent per year when your rat es of ret urn are m ore t han double t hat am ount ? = = = = Unt il t wo or t hree years ago, growt h probably averaged 50 percent , but recent ly I 've t ried t o lim it t his. I t helps t hat m ore m oney is now wit hdrawn by client s each year for paying m y fees, incom e t axes, and ot her bills. Also, I 've encouraged reduct ions in account s, and I 've asked a few client s wit h m ult iple account s t o close one. = = = = Are t here any client s t hat you've dropped com plet ely? = = = = One of m y client s was som eone I didn't know personally. He opened an account wit h m e in response t o anot her client 's recom m endat ion. The m oney he invest ed repr esent ed an inherit ance his wife had received, and he was very nervous about t he account . I couldn't have st art ed in a w orse sit uat ion. I t was t he fall of 1985, and I had t wo disast rous t rades in healt hcare. I ent ered t he first t rade on t he day m e indust rialized nat ions announced a plan t o weaken t he dollar. The dollar cracked and dm g st ocks t ook off. The next day, everyone was saying t he plan wouldn't work; t he dollar rebounded, dm g st ocks got clobbered, and I w as out wit h a big loss. Only about a week lat er, I went back int o healt hcare. The following day. Hospit al Corporat ion of Am erica report ed sur prisingly bad earnings, and t he sect or got hit ext rem ely hard again. = = = = How big a hit were t hese t rades? = = = = About 2 or 3 percent each. Anyway, t his part icular client was ext rem ely nervous about his invest m ent . The account had gone from $70,000 down t o about $67,000.1 t old him , " Don't worry, I 'll cover 100 percent of your losses." I went down t o t he bank and sent him a cashier's check for $3,000. I t old him , " I f in t wo weeks we're down $3,000, t hen I 'll send you anot her check. Just hold ont o t he check; it 's as good as cash." = = = = Norm ally, you wouldn't m ake up t he difference unt il t he end of t he year- is t hat right ? = = = = That 's right , but t his guy was so nervous t hat I always want ed him t o have t he $70,000. About a m ont h lat er, t he account was back over $70,000.1 have t o adm it t hat I did inquire whet her he cashed t he check, and it t urned out t hat he had. A year or t wo lat er, when I was reducing m y client s, he was t he first t o go, because his act ions were indicat ive of a lack of t rust . = = = = Why do you believe Fidelit y went from a policy of virt ually encouraging swit ching in it s sect or funds t o im posing onerous rest rict ions t hat m ade act ive swit ching all but im possible? = = = = I suppose t hey t hought t hat t he profit s being m ade by som e m arket t im ers were com ing out of shareholders' pocket s. I would subm it , however, t hat t he profit s were com ing m ost ly from unsuccessful m arket t im ersAn exam ple of Fidelit y's at t it ude t oward m arket t im ing was t heir response t o a Wall St reet Journal art icle in early 1989 t hat m ent ioned m y t r ack record and t hat I t raded t he Fidelit y sect or funds. Two days aft er t he art icle appeared, I called t o place an order and was t old, " I 'm sorry, Mr. Blake, but t he hourly invest m ent lim it in energy service has been lowered t o $100,000." ( The previous lim it had been 1 percent of t he fund's asset s, or about $500,000.) I suspect t hey checked and found t hat ener gy service was a sect or t hat I t raded exclusively for a half- dozen client s and t hat I had been doing very well. = = = = Why had you used t his fund m ore act ively? = = = = Because energy service cont ained t he m ost reliable pat t ern t hat I had ever found. A year or so aft er

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96 Fidelit y int roduced hourly pricing of sect or funds in 1986,1 discovered t hat energy service had an ext raordinarily st rong t endency t o t rade near it s daily low at t he beginning of t he day. When I first analyzed t he hourly dat a, I found t here was a 90 t o 95 per cent probabilit y of realizing a gain by sim ply buying t his fund at t en, eleven, and t welve o'clock, for different client s and t hen selling at t he close. Rem arkably, t his ext rem ely high probabilit y cont inued t o hold up in t he year or t wo t hat I t raded t his fund. = = = = I fs am azing t hat such a sim ple pat t ern could exist wit h such consist ency. Does t his pat t ern st ill exist t oday? = = = = I t m ight , but it 's of lit t le value. I n Novem ber 1989, Fidelit y began charging a fee of 0.75 percent on t rades held less t han t hirt y days. = = = = I assum e t hat t he m anagem ent of your funds t akes only a sm all part of your day. = = = = A t iny part . I spend m ost of m y day researching new m et hods. = = = = Do you find new st rat egies t hat are bet t er t han t he ones you're using and shift your approach accordingly? = = = = All t he t im e. = = = = Presum ably, since you can't use everyt hing at t he sam e t im e, you m ust have a lot of viable m et hods on t he shelf t hat you're not even using. = = = = I do. = = = = Do you follow your t rading signals absolut ely? Or do you ever st ray from a st raight m echanical approach? = = = = For m e, it 's im port ant t o be loyal t o m y syst em . When I 'm not , which happens occasionally, t hen, win or lose, I 've m ade a m ist ake. I usually rem em ber t hese for years. I t 's not disloyal, however, t o quest ion a t rade. Som et im es, based on prior ex perience, a t r ade j ust doesn't look right . I f I can com plet e t he necessary research before t he close and t he r esult s so dict at e, t hen I m ake a perm anent am endm ent t o t he rules. = = = = How im port ant is t he perform ance of t he funds you're using t o your overall perform ance? = = = = I t 's not nearly as im port ant as you would t hink. The difference bet ween t rading a fund t hat rises 20 percent in a year versus a fund t hat loses 20 percent in a year is surprisingly sm all. For exam ple, if a fund has an average daily volat ilit y of 1 percent , an annual ret urn of 20 percent would im ply t hat approxim at ely 54 percent of t he days were up and 46 percent were down, and v ice versa for a fund t hat loses 20 percent . [ Assum ing 250 t rading days per year and an average 1 per cent price change per day, a net 20 percent ret urn would im ply 135 up days and 115 down days, and 135 is 54 percent of 250.] For m y st rat egies, t he difference bet ween t rading a fund t hat 's up 54 percent of t he t im e and one t hat 's up 46 per cent of t he t im e is not t hat significant . = = = = Any t rades t hat are part icularly m em orable? = = = = When I was j ust st art ing out , t here was one day when I didn't get t he closing price over t he phone. I knew it had been a pret t y good day, but I didn't know t o what ext ent . I woke up in t he m iddle of t he night and rem em ber ed t hat I hadn't checked t he closing price. I called and found t hat it had been a huge up day- t wice what I had expect ed. I t hink I m ade a few t housand dollars. You have t o rem em ber t his was back when I had j ust st art ed. I was so excit ed t hat I couldn't sleep. I was like a kid at Christ m as. I 'll always rem em ber t hat feeling. = = = = Are t here any ot her t rades t hat st and out for one reason or anot her? = = = = On July 7, 1986, t he st ock m arket fell 62 point s ( a record t hen, I t hink) . I knew t hat m orning t hat I would be out of m y posit ions at t he close. However, since t his was before hourly swit ching was available, t here was not hing I could do in t he int erim . That aft ernoon I had a windsurfing lesson. I t hought t hat I would be able t o get back well before four o'clock t o place a call t o liquidat e m y posit ions. Unfort unat ely, I hadn't m ast ered t he sport well enough and got blown t o t he ot her side of t he lake. 1 knew t im e was running out , and I paddled back as hard as I could t o t ry t o beat t he close. I didn't m ake it , and it cost m e. = = = = Any ot her t rades com e t o m ind? = = = = I n August 1987 I t ook a posit ion in t he gold sect or fund. The day aft er I ent ered t he t rade, t he fund dropped, giving m e a red light , but I st ayed in. = = = = Why did you st ay in? = = = = I honest ly don't rem em ber. Anyway, t he next day, t he gold st ocks were down big, while a bright green light in t echnology was st aring m e in t he face. I rem em ber t hat I found it ext rem ely difficult t o exit all m y client s from t he gold sect or at a big loss- a loss t hat I knew I shouldn't have t aken in t he first place- and im m ediat ely place t hem at risk again in t he t echnology fund, which was already up shar ply. I t hink t he t hing t hat m ade it so difficult was t hat I had violat ed m y rule. As it t urned out , t he subsequent gain in t echnology m ore t han m ade up for t he loss in gold. = = = = So in t he end yon did follow your syst em . = = = = Yes, but I alm ost didn't . Th e lesson for m e was t hat if you break a discipline once, t he next t ransgression becom es m uch easier. Breaking a diet provides an appropriat e analogy- once you do it , it becom es m uch easier t o m ake furt her except ions. = = = = Have t he m arket s changed in t he past decade? = = = = I n a m icro sense- yes; in a m acro sense- no. Opport unit ies change, st rat egies change, but people and psychology do not change. I f t rend- following syst em s don't work as well, som et hing else will. There's always

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97 m oney being lost , so som eone out t her e has t o win. = = = = What do you believe are t he m aj or m yt hs about m arket s? = = = = A prevailing m yt h on Wall St reet is t hat no one can consist ent ly beat t he m arket year in, year out , wit h st eady ret urns of 20 or 30 percent a year. On t he ot her hand, t he sales side would have you believe t hat it can be done by anyone. Neit her is really t he t rut h. = = = = Why do t raders lose? = = = = First of all, m ost t raders don't have a winning st rat egy. Second, even am ong t hose t rader s who do, m any don't follow t heir st rat egy. Trading put s pressure on weaker hum an t rait s and seem s t o seek out each individual's Achilles' heel. = = = = What m akes a good t rader? = = = = A crit ical ingredient is a m averick m ind. I t 's also im port ant t o have a blend bet ween an ar t ist ic side and a scient ific side. You need t he art ist ic side t o im agine, discover, and creat e t r ading st rat egies. You need t he scient ific side t o t ranslat e t hose ideas int o firm t rading rules and t o execut e t hose rules. = = = = Can people be successful using a purchased syst em ? = = = = I believe t hat syst em s t end t o be m or e useful or successful for t he originat or t han for som eone else. I t 's im port ant t hat an approach be personalized; ot herwise, you won't have t he confidence t o follow it . I t 's unlikely t hat som eone else's approach will be consist ent wit h your own personalit y. I t 's also possible t hat individuals who becom e successful t raders are not t he t y pe t o use som eone else's approach and t hat successful t raders don't sell t heir syst em s. = = = = How would you respond t o Burt on Malkiel [ t he aut hor of A Random Walk Down Wall St reet = = = = Well, I 'm m ore in agreem ent t han in disagreem ent wit h him . The m arket s are m ost ly random , and m ost people can't beat or " t im e" t he m ar ket . One hundred m oney m anagers each believe t hat t hey can consist ent ly out perform t he m arket . My feeling is t hat t he num ber is a lot closer t o zero t han one hundred. Trading is probably m ore of an art t han m ost people want t o believe. I guess I 'd also be t em pt ed t o show him m y num bers. = = = = What advice would you give t o a novice t rader? = = = = There ar e five basic st eps t o becom ing a successful t rader. First , focus on t rading vehicles, st rat egies, and t im e horizons t hat suit your personalit y. Second, ident ify nonrandom price behavior, while recognizing t hat m arket s are random m ost of t he t im e. Third, absolut ely convince yourself t hat what you have found is st at ist ically valid. Fourt h, set up t rading rules. Fift h, follow t he rules. I n a nut shell, it all com es down t o: Do your own t hing ( independence) ; and do t he right t hing ( discipline) . At t he core, t he qualit y of open- m indedness is responsible for Blake's success and, for t hat m at t er, his ent ire career. For m any years, Blake sincerely believed t hat t he m arket s wer e random . When confront ed wit h cont radict ory evidence, he didn't dig in his heels and argue his posit ion- t he reflexive response m ost people would have in such a sit uat ion. I nst ead, he researched t he quest ion, and when t he evidence suggest ed t hat his prior views had been wrong, he changed his m ind. The abilit y t o change one's m ind is probably a key charact erist ic of t he successful t rader. Dogm at ic and rigid personalit ies rarely, if ever, succeed in t he m arket s. Anot her at t ribut e t hat has allowed Blake t o excel is his adapt abilit y. The m arket s are a dynam ic process, and sust ained t rading success requires t he abilit y t o m odify and even change st rat egies as m arket s evolve. Blake began by t rading m unicipal bond funds. However, w hen t he reliabilit y and profit abilit y of his approach in t hat sect or st art ed t o dim inish, he didn't j ust blindly keep repeat ing t he sam e st rat egy t hat had worked for him in t he past . I nst ead, he used t he changing m arket condit ions as a spur t o st art an int ensive research proj ect , which event ually yielded an ent irely new and even m or e effect ive approach. When hourly swit ching becam e available in t he Fidelit y sect or funds, he alt ered his m et hods accor dingly. Then, when Fidelit y m ade it virt ually im possible t o use it s funds for swit ching st rat egies ( by im posing prohibit ively high fees) , Blake swit ched t o different fund fam ilies and different st rat egies. Blake's abilit y t o adapt has allowed him t o m aint ain a rem arkable consist ency of perform ance, despit e profound changes in his t rading environm ent . Perhaps Blake's m ost im port ant m essage lies in his am azingly consist ent t rack record, which provides com pelling em pirical evidence t hat t he m arket s ar e indeed nonrandom . Of course, t his nonrandom ness is hardly blat ant . I f it were, we would all be m illionaires. However, Blake's abilit y t o win in an ast ounding t went y- five m ont hs for every m ont h he loses, allows us t o say " Yes, Virginia, t he m arket s can be beat ." How can t he m arket s be beat ? Cert ainly not by buying t he answer. Even if t he answer were for sale, t he odds are t hat it wouldn't fit your personalit y and t hat you wouldn't have t he confidence t o follow it . Essent ially, t here are no short cut s. Each t rader m ust find his or her own solut ion t o t he m arket puzzle. Of course, m ost such research effort s will end in failure. I f, however, you are able t o uncover nonrandom m arket pat t erns and can convincingly dem onst rat e t heir validit y, only t wo st eps rem ain t o achieve t rading success: Devise your t rading rules and t hen follow your t rading rules.

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98 Victor Sperandeo: Markets Grow Old Too Vict or Sperandeo st art ed his career on Wall St reet st raight out of high school. I t was cert ainly an unglam orous beginning, working first as a m inim um - wage quot e boy and t hen swit ching t o a slight ly higher paying j ob as a st at ist ical clerk for St andard & Poor's. Sperandeo found t his work, which basically involved copying and t ransferring colum ns of num bers, " st upifyingly boring." He had a difficult t im e keeping his m ind on his work. To his relief, he was event ually fired for m aking t oo m any errors. Aft er a st int at anot her nont rading j ob in a Wall St reet account ing depart m ent , Sperandeo t alked his way int o an opt ion t rading posit ion. Over t he next t wo years, he was a dealer in t he over- t he- count er ( OTC) opt ions m arket , m at ching up buyers and sellers and " m aking t he m iddle." I n t he m idst of t he 1969 bear m arket , Sperandeo swit ched firm s in a search for gr eat er aut onom y in his t rading decisions. At t his new firm , he was offered a percent age of t he spread he ear ned on each opt ion t ransact ion, as opposed t o t he flat fee com pensat ion st ruct ure at his form er com pany. The new firm , however, would not com m it t o a salary because of a caut ious post ure fost er ed by t he ongoing bear m arket . Sper andeo gladly accept ed t he offer, confident t hat he could subst ant ially increase his incom e by sharing in a percent age of his t ransact ion earnings. Aft er six m ont hs on t he j ob, Sperandeo had earned $50,000 in com m issions. His boss, who earned an annual salary of $50,000, called him hi for a t alk. " Vict or," he said, " you're doing such a good j ob, we decided t o put you on a salary." Som ehow, t he offer of a $20,000 salary and an am biguous com m it m ent t o som e sor t of bonus in lieu of his exist ing com pensat ion arrangem ent j ust didn't sound like good news. Three weeks lat er Sperandeo swit ched j obs. Unfort unat ely, he found t hat his new firm played t he sam e song only in a different key- when he received his m ont hly profit / loss st at em ent s, he discovered t hat his profit s were being eat en away by enorm ous expense allocat ions. Aft er about six m ont hs, Sperandeo finally decided t hat if he were going t o get a fair deal, he would have t o m ake it him self. Aft er finding a part ner t o finance t he operat ion, Sperandeo launched his own firm , Ragnar Opt ions, in 1971. Sperandeo claim s t hat Ragnar was t he first opt ion dealer t o offer guarant eed quot es on opt ions wit hout charging except ionally high prem ium s. I f t hey couldn't find an exist ing opt ion cont ract in t he m arket t o m eet a buyer's request ( which t hey could purchase and resell at a prem ium ) , t hey wrot e t he opt ion t hem selves. ( At t he t im e, opt ions were t ailor- m ade t o t he cust om er's specificat ions, as opposed t o being t raded as uniform inst rum ent s on an exchange.) As a result of t his policy of offering reasonable firm quot es, according t o Sperandeo, wit hin six m ont hs Ragnar was t he largest OTC opt ion dealer in t he world. Ragnar was event ually m erged wit h anot her Wall St reet firm . Sperandeo st ayed on for a while but t hen j oined I nt erst at e Securit ies in 1978. At I nt erst at e, Sperandeo was given a com pany account and a few privat e account s t o m anage at a 50/ 50 split ( expenses as well as profit s) . Sperandeo had finally landed t he perfect j ob: com plet e independence t o t rade any m arket s in any way he desired, capit al backing, and a m eaningful split of profit s ( and losses) . This ideal arrangem ent finally cam e t o an end in 1986 when I nt erst at e went public and decided t o dissolve it s t rading group. Sperandeo t r aded his personal account for a lit t le over a year before deciding t o st art his own m oney m anagem ent firm - Rand Managem ent Corporat ion. Throughout his ent ire career, Sperandeo has placed a great er em phasis on loss avoidance t han on scoring large gains. He was largely successful at t his obj ect ive, st ringing t oget her eight een consecut ive winning years before regist ering his first loss in 1990. Over t his period, his average annual gain was 72 percent , wit h result s ranging from a single loss of 35 percent in 1990 t o five years of t riple- digit gains. Alt hough Sperandeo nev er bot hered t o finish t he credit s for his night t im e college degree, over t he years he has done an enorm ous am ount of reading. I n addit ion t o books about t he m arket , Sperandeo has read widely in t he som ew hat relat ed fields of econom ics, psychology, and philosophy. Overall, he est im at es t hat he has read approxim at ely t went y- five hundred books on t hese subj ect s. The int erview was conduct ed at Sper andeo's " office," which is locat ed in t he basem ent of his house, t he m ain sect ion of which he has convert ed t o a lounge, com plet e wit h a fift een- foot bar, seat ing for sevent y five, and an elaborat e sound syst em . You alm ost expect Bill Murray t o pop up and do his " Sat urday Night Live" lounge singer act . I couldn't help but sm ile at t he im age of a st archy pension fund t rust ee doing an onsit e inspect ion of Sperandeo's operat ions in considering him as a prospect ive m anager for it s funds. I found Sperandeo v ery relaxed and friendly- t he t ype of person who is inst ant aneously likable. = = = = Aft er nearly t wo decades as an independent or quasi- independent t rader, why did you finally decide t o st art a m oney m anagem ent firm ? = = = = I n 1987 I did enorm ously well cat ching t he huge br eak in t he st ock m arket . My success in t his m arket led t o unsolicit ed offers t o m anage som e large sum s of m oney. I realized t hat if I had been m anaging m oney, as opposed t o sim ply t rading m y own account , m y profit pot ent ial would have been enorm ously great er. = = = = How have you done in your t rading since you st art ed your own m anagem ent com pany? = = = = I did well in 1989, which was t he first year of t he firm 's exist ence, but I lost m oney in 1990. Act ually, I found it som ewhat ironic t hat m y first losing year in t he m arket s occurred aft er having gained m ore knowledge t han ever. = = = = How do you explain t hat ? = = = = That 's what you call being a hum an being. [ He laughs loudly and long.] = = = = How did you becom e a t rader? = = = =

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99 I t hink m y first relat ed int erest was an ent husiasm for poker. As a t eenager, I lit erally earned a living by playing poker. When I first st art ed playing, I read every book I could find on t he gam e and quickly learned t hat winning was a m at t er of m anaging t he odds. I n ot her words, if you played only t he hands in which t he odds were in your favor and folded when t hey were not , you would end up winning m ore t im es t han you lost . I m em orized t he odds of every im port ant card com binat ion, and I was v er y successful at t he gam e. Alt hough I did quit e w ell, I realized t hat being a professional card player was not what I want ed t o do wit h m y life. When I was t w ent y years old, I m ade a com plet e survey of t he New York Tim es em ploym ent sect ion and discovered t hat t hree professions offered m ore t han $25,000 per year as a st art ing salary: physicist , biologist , and OTC t r ader . Now, I didn't even know exact ly what an OTC t r ader did, but , since I obv iously didn't have t he educat ional background for being a physicist or biologist and OTC t rading sounded a lit t le bit like playing cards- t hey bot h involved odds- 1 decided t o t ry for a career on Wall St reet . I landed a j ob as a quot e boy for Pershing & Com pany. = = = = How did you learn about t rading and m arket s? Did you have a m ent or? = = = = No. At t he t im e, Milt on Leeds, who w as a legendar y t ape reader and t rader of his day, worked at Pershing. I found observing him inspirat ional, but I didn't work direct ly for him . Basically, I learned about t he m arket s by reading everyt hing on t he subj ect t hat I could get m y hands on. = = = = When did you act ually first becom e a t rader? = = = = Aft er working on Wall St reet for alm ost t hree years, first at Pershing and t hen som e ot her short - lived j obs, I decided m at I want ed t o t ry t rading. I considered t he different areas of t rading t hat I could go int o. There was st ocks- kind of boring. There was bonds- really boring. Then t here was opt ions- very sophist icat ed. I n t he lat e 1960s, probably only about 1 percent of all st ockbrokers even underst ood opt ions. I t hought t hat if I undert ook t he m ost esot eric form of t rading and m ast ered it , t hen I would have t o m ake a lot of m oney. So I applied for a j ob as an opt ions t rader. = = = = What did you know about opt ions t rading at t he t im e? = = = = Not hing, but I knew t hat was what I want ed t o do. I t ried t o m ake an im pression on t he senior part ner who int erviewed m e by t elling him t hat I was a genius. He said, " What do you m ean?" I t old him t hat I had a phot ographic m em ory- which, incident ally, I don't . He said, " Prove it ." I t old him t hat I had m em orized all t he st ock sy m bols- which I had. I had t aken a m em ory course years before. This fellow had been on Wall St reet for t hirt y- five years and didn't know all t he sym bols. He t est ed m e, and I knew t hem all. He offered m e t he j ob. = = = = You said earlier t hat you were drawn t o a t rading career because of t he analogy t o playing cards. Do you t hen see t rading as a form of gam bling? = = = = I 'd say t hat gam bling is t he wrong t erm . Gam bling involves t aking a risk when t he odds are against you. For exam ple, bet t ing on a lot t ery or playing a slot m achine are form s of gam bling. I t hink successful t r ading, or poker playing for t hat m at t er, involves speculat ing rat her t han gam bling. Successful speculat ion im plies t aking risks when t he odds are in your favor. Just like in poker, where you have t o know which hands t o bet on, in t rading you have t o know when t he odds are in your favor. = = = = How do you define t he odds in t rading? = = = = I n 19741 m issed t he huge Oct ober- Nov em ber rally in t he st ock m arket - That error served as a cat alyst for an int ensive t wo- year st udy. I want ed t o know t he answer t o quest ions like: How long do bull and bear m arket s last ? What are t he norm al percent age price m oves a m arket m akes before it form s a t op or a bot t om ? As a result of t hat research proj ect , I found t hat m arket price m ovem ent s are like people- t hey have st at ist ically significant life- expect ancy profiles t hat can be used t o m easure risk exposure. For exam ple, t he m edian ext ent for an int erm ediat e swing in t he Dow during a bull m arket is 20 percent . This doesn't m ean t hat when t he m arket is up 20 per cent , it 's going t o t op; som et im es it will t op earlier, som et im es lat er. However, what it does m ean is t hat when t he m arket is up m ore t han 20 percent , t he odds for furt her appreciat ion begin t o decline significant ly. Thus, if t he m arket has been up m ore t han 20 percent and you begin t o see ot her evidence of a possible t op, it 's im port ant t o pay close at t ent ion t o t hat inform at ion. As an analogy, consider life insurance, w hich deals wit h t he life expect ancy of people inst ead of price m oves. I f you're writ ing life insurance policies, it 's going t o m ake a great deal of difference whet her t he applicant is t went y years old or eight y years old. I f you're appr oached by an out - of- condit ion t went y- yearold, you m ight j udge t hat t he odds of his survival are pret t y good. However, you'd be a lot less anxious t o writ e a policy on an eight y- year- old. I f t he eight y- year- old is t he Jack LaLanne of eight y- year- olds- he can do t wo hundred push- ups; he can swim t he English Channel- m en fine, you can writ e him a policy. But let 's say t he sam e eight y- year- old sm okes t hree packs of Cam els a day, drinks a quart of scot ch a day, and has pneum onia- t hen you probably wouldn't want t o writ e him a policy. The older t he individual, t he m ore significant t he sym pt om s becom e. Sim ilarly, in a m arket t hat is in a st age of old age, it is part icularly im port ant t o be at t uned t o sym pt om s of a pot ent ial end t o t he current t rend. To use t he life insurance analogy, m ost people who becom e involved in t he st ock m arket don't know t he difference bet ween a t went y- year- old and an eight y- year- old. I n m y opinion, one reason why m any t ypes of t echnical analysis don't work t oo well is because such m et hods ar e oft en applied indiscrim inat ely. For exam ple, if you see a head- and- shoulders pat t ern form in

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100 what is t he m arket equivalent of a t went y- year- old, t he odds are t hat t he m arket is not likely t o die so quickly. However, if you see t he sam e chart form at ion in t he m arket equivalent of an eight y- year- old, t here's a m uch bet t er chance of t hat pat t ern being an accurat e indicat or of a price t op. Trading t he m arket wit hout knowing what st age it is in is like selling life insurance t o t went y- year- olds and eight y- year- olds at t he sam e pr em ium . = = = = When you say t hat t he hist orical m edian lengt h of a hull m ove has been 20 percent , how are you defining a bull m ove? = = = = I 'm t alking about int erm ediat e upm oves in a long- t erm bull m arket . Wit h very rare except ions, I define " int erm ediat e" as a price m ove last ing a m inim um of t hree weeks t o a m axim um of six m ont hs. Of course, t here are analogous figures for all ot her t ypes of m arket m ovem ent s cat egorized by t ype of m arket ( bull or bear) , lengt h of m ove ( short t erm , int erm ediat e t erm , or long t erm ) , and locat ion wit hin m arket cycle ( first swing, second swing, and so on) . I ncident ally, t here's rem arkable consist ency in t he 20 percent m edian upm ove figure, which I based on a st udy of all years since 1896. When I looked only at m arket s up t hrough 1945,1 found t hat t he corresponding figure was virt ually ident ical at 19 percent . I t hink t here are t wo reasons t hat help explain t he st abilit y of t his approxim at e 20 percent figure. The first fact or is relat ed t o value. Roger I bbot son did a st udy spanning sixt y years of dat a in which he com pared t he ret urns of different form s of invest m ent . He found t hat , over t he survey period, t he st ock m arket ret urned an average of 9.2 per cent annually, including dividends. Therefore, if t he m arket rises 20 percent in, say, 107 days- which happens t o be t he m edian t im e durat ion of an int erm ediat e upm ove- t hen you've squeezed out a lot of value in a very short am ount of t im e. The m arket as a whole has becom e m uch less of a value. The second fact or is psychological. Let 's say you go t o t he superm arket t o buy ingredient s for a salad. A head of let t uce is selling for $1.00, and a pound of t om at oes is selling for $1.00. You go back t wo w eeks lat er and let t uce is st ill selling for $1.00, but t om at oes ar e now $1.50. I n t hat sit uat ion, a lot of people w ill look for a subst it ut e for t om at oes. They'r e going t o say, " I 'm j ust not paying t hat m uch for t om at oes." Does t he fift y cent s really m at t er? I 've done t he sam e t hing when m y incom e was in t he seven figures. I t really doesn't m at t er, but you don't want t o pay up beyond a cert ain num ber. = = = = And you're saying t hat 20 percent is t hat t ype of num ber? = = = = That 's m y hypot hesis. Obviously, I can't really prove it . = = = = Do you use your st at ist ical st udies of t he norm al durat ion and m agnit ude of price m oves t o set t arget s eit her in t erm s of price or t im e? = = = = Absolut ely not . To use ext ent and durat ion profiles t o predict exact m arket t urning point s would be like an insurance com pany t elling you when and how you will die on t he day you buy your policy. They don't have t o do t hat t o m ake a profit . All t hey need t o do t o m ake a profit is t o know what t he odds are. = = = = How t hen do you analyze a sit uat ion in which a m arket has reached t he m edian age of hist orical upm oves? = = = = Once a price m ove exceeds it s m edian hist orical age, any m et hod you use t o analyze t he m arket , whet her it be fundam ent al or t echnical, is likely t o be far m ore accurat e. For exam ple, if a chart ist int erpret s a part icular pat t er n as a t op form at ion, but t he m arket is only up 10 percent from t he last relat ive low, t he odds are high t hat t he proj ect ion will be incorrect . However, if t he m arket is up 25 t o 30 percent , t hen t he sam e t ype of form at ion should be given a great deal m ore weight . = = = = When you m iss a m aj or t urning point , such as t he Oct ober 1974 low you m ent ioned before ( w hich was t he low point of t he m arket since t hat t im e) , how do you event ually get back int o t he m arket ? = = = = Market s go up in st epwise fashion. I wait unt il a sit uat ion arises t hat looks like t here's anot her m aj or relat ive low. I n t he case of 1974,1 w ent long t he world on Decem ber 6. That day proved t o be t he exact bot t om of t he m arket . I ronically, I act ually ended up losing m oney on t he t rade. = = = = Before I ask you t o explain t hat apparent paradox, first t ell m e what m ade you so sure t hat it was t he bot t om of t he m arket . = = = = To begin, t here was a Dow Theory buy signal- t he Dow Jones I ndust rial index had m ade a new low, but t he Transport at ion index and t he S&P 500 had not . I n addit ion, t he volum e on t he break t o new lows was relat ively light . Also, we had been in a bear m arket for a long t im e, and bearish sent im ent was pervasive. Finally, bad news was st art ing t o lose it s im pact on t he m arket - bear ish news st ories would com e out , and st ocks would essent ially lie flat . = = = = Now t ell m e how you m anaged t o lose m oney buying t he Decem ber 1974 low. = = = = I had an incredibly profit able year up t o t hat point . I t ook one- t hird of m y profit s for t he year and bought out - of- t he- m oney calls expiring in January. As one exam ple, at t he t im e, Kodak was t rading at 64, and I bought t he January 70 calls, which were t rading near 1. On January 27, which was t he expirat ion day of t he January opt ion series, Kodak had rebounded t o 69. The calls obviously went out wort hless. One week lat er, Kodak was t rading at 80. The sam e t y pe of experience was repeat ed in a dozen ot her posit ions. = = = = So your m ist ake was buying opt ions t hat were t oo far out of t he m oney and t oo short in durat ion? ==== They weren't t oo far out of t he m oney. My m ist ake was t hat I didn't allow enough t im e unt il expirat ion. This episode preceded m y st udy on t he durat ion and m agnit ude of hist orical price m oves, which we discussed earlier. Aft er I com plet ed m y st udy in 1976,1 realized t hat t he second legs of bull m arket s t end t o be relat ively ext ended. I 'm cert ain t hat if I encount er ed a sim ilar sit uat ion aft er 1976,1 would have bought t he

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101 April opt ions inst ead of t he January opt ions. But at t he t im e, I sim ply didn't have enough knowledge about t he pr obabilit ies of various m arket m oves. = = = = How did you event ually get back int o t he m arket ? = = = = I got long in February 1975 and did ver y well. By t he way, t hat was very hard t o do because I was get t ing back int o t he m arket at a point at which st ock prices were t rading m uch higher t han when m y opt ions expired wort hless in January. = = = = I don't com plet ely underst and y our st at ist ical st udy of t he longevit y of price m oves. I t appears t hat we've been in an ext ended bull m arket since 1982, which at t he t im e of t his int erview [ April 1991] would m ake t he current bull m arket nine years old. Doesn't t hat place t he age of t his bull m arket off t he chart s in t erm s of your hist orical st udies? Wouldn't you have been inclined t o look for a m aj or t op far t oo prem at urely? ==== I look at it from a com plet ely different perspect ive. By m y definit ions, t he bull m arket t hat began in 1982 ended in Novem ber 1983. = = = = How do you obj ect ively m ake t hose kinds of classificat ions? = = = = What defines an upt rend? One essent ial crit erion is t hat you do not t ake out a prior m aj or relat ive low . The bear phase t hat last ed from June 1983 t o July 1984 consist ed of t wo m aj or downswings- t hat is, you t ook out a prior m aj or relat ive low. Also, by m y definit ions, t o qualify as a bear m arket , t he price m ove m ust last a m inim um of six m ont hs and be equal t o at least 15 percent . Bot h of t hese condit ions were m et by t he price decline from t he June 1983 high t o t he July 1984 low. Thus, in t erm s of all m y crit eria, t he price upm ove t hat began in July 1984 m arked t he beginning of a new bull m arket . = = = = By your classificat ion, when did t he bull m arket t hat began in July 1984 end? = = = = I n m y view, t hat bull m arket ended in Oct ober 1989, m aking it t he second longest bull m arket since 1896 ( t he st art of m y st at ist ical survey) . The bull m arket didn't end in August 1987 because t he subsequent price break last ed only t hree m ont hs. Therefore, alt hough t hat price decline was ext raordinarily sharp, it did not m eet t he m inim um t im e durat ion definit ion for a bear m arket , nam ely, six m ont hs from t op t o bot t om . = = = = I s t here anyt hing you consider unique about your m oney m anagem ent approach? = = = = Yes, I analyze risk by m easuring t he ext ent and durat ion of price swings. For exam ple, if t he m arket has risen 20 percent in roughly 107 days, even if I 'm st ill ext rem ely bullish I 'll have a m axim um posit ion size of 50 percent , because st at ist ically we've reached t he m edian hist orical m agnit ude and durat ion of an upm ove. = = = = I n ot her words, you vary t he size of t he bet relat ive t o your percept ion of t he m arket risk. Do you do anyt hing different ly in t erm s of cut t ing loses? = = = = Losses ar e always predet erm ined so t hat I can m easure m y risk. = = = = By predet erm ined" you m ean t hat you decide where you're get t ing out before you get in? = = = = Exact ly. Let m e give you an exam ple t o illust rat e why t his principle is so im port ant . Take t he t ypical t rader who get s a call from his broker. " List en," his broker says, " I have som e inform at ion from a reliable source t hat st ock XYZ is going t o be a t akeover play. I t 's only t rading at $20; it could go up t o $60! " The t rader buys t he st ock, and t wo weeks lat er it 's t rading at $18. The act ion j ust doesn't seem right , so he prom ises him self t o get out w hen he's even. The next week t he st ock is down t o $17. Now he's beginning t o feel a lit t le bit concerned. " I 'll get out on t he first rally," he vows t o him self. One week lat er t he st ock is down t o $15, and t he t rader, who has bought t he st ock on m argin, suddenly realizes he's lost half his m oney. Two days lat er t he st ock is at $14, and he calls up his broker in a st at e of desperat ion and exclaim s, " Get m e out ! " He get s filled at $13, and t hat 's t he bot t om of t he m arket . Sound fam iliar? Think about t he psychological process involved. At t he beginning, t he t rader fell for t he lure of m aking easy m oney. When t he st ock declined t o $18, he felt a lit t le anxious. When it fell t o $17, he felt t he onset of panic. When t he st ock slid t o $15, it was pure panic. When he finally got out , he felt a sense of relief- which is som ewhat ironic since he had j ust lost 70 percent of his m oney. There's not hing logical about t his process. I t 's all an em ot ional pit fall. Planning w here t o get out befor e put t ing on t he t rade is a m eans of enforcing em ot ional discipline. = = = = I s predet erm ining an exit point som et hing t hat you've done for t he last few years? = = = = No, t hat 's som et hing t hat I 've done since m y first day in t he business. I 've always had a point where I knew t hat I was get t ing out . = = = = Does t aking a loss have an em ot ional im pact on you? = = = = None. Taking a loss never affect s m e, but I don't t ake big losses. = = = = Never? Wasn't t here ever any inst ance in which you deviat ed from your risk cont rol guidelines? ==== Well, act ually, t here was one inst ance in Novem ber 1984. That sit uat ion was dram at ic because it ended up cost ing m e over $1 m illion. At t he t im e, t he Fed was easing, and I was convinced t hat we were in a bull m arket . The m arket had st art ed t o sell off because Congress was considering a change in t he t ax code. However, when t he newspaper s repor t ed t hat ( he proposed change in t he t ax code would be " revenue neut ral," I decided t o go long. 1 put on a huge posit ion because I t rade at m y biggest when I 'm m aking m oney, and I had experienced a great year up t o t hat point . I was long t he world- t wo legal- size pages of posit ions. My sm allest posit ion was one hundred opt ions and m y biggest posit ion- I 'm not exaggerat ing- was t wo t housand opt ions. What I failed t o realize was t hat , even t hough t he proposed change in t he t ax code was r evenue neut r al, t he plan called for t aking m oney from corporat ions and giving it t o individuals. When you're long st ocks, you

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102 don't want any plan t hat t akes m oney away from corporat ions [ he laughs] . When t he m arket went down four days in a row, I knew I was wr ong. I want ed t o be out . The m arket j ust kept on falling. On t he sixt h st raight down day, I got out . I f I had sold aft er t he fourt h down day, m y loss would have been only half as large. = = = = I t hought you had a rule about get t ing out ? = = = = I did. My rule would have had m e out on t he fourt h day. = = = = So you violat ed your rule? = = = = Yes, but it wasn't a m at t er of m y hoping t hat t he m arket would go up. The reason t hat I didn't get out was t hat t he decline seem ed ext rem ely overdone. My plan was st ill t o liquidat e, but t o wait for t he first day t he m arket rallied. = = = = Did you end up get t ing out at t he bot t om ? = = = = No, t he m arket act ually declined for nine consecut ive days. = = = = What lesson did you learn from t hat experience? = = = = Whenever t here's a t ax proposal, or som e ot her m aj or legislat ive uncer t aint y, I now get flat im m ediat ely. The m arket will always run t o t he sidelines unt il it knows what will happen. = = = = I s t here any m ore general lesson t hat would apply? = = = = Yes, when you're t rading at your biggest , you should be m aking m oney inst ant aneously. = = = = I n ot her words, when you have a large posit ion, you should cut your bet size quickly unless t hat posit ion st art s m aking m oney right at t he st art ? = = = = Exact ly. When you're t rading large, you need t o have an especially short fuse in regard t o cut t ing losses. My goal on Wall St reet was never t o get rich but t o st ay in business. There's a big difference. I f you're out of t he business, you can nev er get rich. That 's why y ou have t o be especially caut ious when you're t rading a larger posit ion size. = = = = Any ot her t rades t hat st and out as being part icularly dram at ic? = = = = On one of t he expirat ion days in t he S&P in 1985 or 1986- 1 forget t he exact dat e- t he spr ead act ion bet ween t he S&P and OEX convinced m e t hat a m aj or buy program was going t o hit t he m arket . The Maj or Mar ket I ndex [ MMI ] was t rading at about 349. I bought four t housand of t he 355 opt ions at 1/ 8 and five hundred of t he 350s at 1 3/ 4. The m arket m oved higher, and at 3: 30- one half- hour before t he close- t he 355& were t rading at 2 and t he 350s wer e t r ading at 5 1/ 2.1 sold t he five hundred 350 opt ions, giving m e a free ride on t he rest of t he posit ion. At t hat point , one of t he m aj or Wall St reet firm s hit t he m arket wit h an ext rem ely large sell program , and prices collapsed. Wit h less t han a half- hour rem aining unt il expirat ion and t he opt ions out of t he m oney, t here was no way t o get out of anyt hing. The m arket finished down sharply for t he day. Aft er t he close, I rem em ber going t o Michael's One and t elling t he bart ender, " I need a drink. I j ust m ade $100,000 t oday- t he only problem is t hat an hour ago I was ahead $800,000." = = = = Your t rack record shows t hat you m ade subst ant ial wit hdrawals from your account during t he 1980s. You don't seem t o be t he t ype of person who's an ext ravagant spender. Ther efore, I assum e t hat t his m oney was reinvest ed in som e form . What alt ernat ive invest m ent s did you choose? Why didn't you sim ply let t he m oney com pound in your account , since you were doing so well? = = = = One of m y m aj or invest m ent s was st art ing a t rading com pany. I hired ot her t raders, t aught t hem what I did, and gave t hem m y capit al t o t rade. = = = = Why did you do t hat ? = = = = Because I want ed t o be t he McDonald's of t rading rat her t han an egot ist ical, solit ary t rader . This vent ure, of course, didn't work out as well as McDonald's [ he laughs loudly] . = = = = What was t he out com e? = = = = Over a five- year period, I t rained t hirt y- eight people. Each of t hese people spent sever al m ont hs by m y side while I t aught t hem virt ually everyt hing I knew about t he m arket . Out of t hese t hirt y- eight people, five m ade m oney. = = = = How did you choose t he people you select ed for t raining? = = = = 1 wasn't ver y scient ific about it . Basically, I went wit h m y inst inct s and whim s about who m ight be a good t rader. The people I select ed were a very diverse group. = = = = Was t here any correlat ion bet ween int elligence and success at t rading? = = = = Absolut ely, but not in t he way you t hink. For exam ple, one of t he people I picked w as a high school dropout , who I 'm sure didn't even know t he alphabet . He was one of t he five who m ade m e a great deal of m oney. = = = = Why did you pick him ? = = = = He was m y phone clerk on t he Am erican St ock Exchange, and he was very aggressive and alert . Also, he had been in Viet nam and had a hand grenade explode near him , leaving shrapnel in his pancreas. As a result of t his experience, he was always afraid of everyt hing. When it cam e t o t rading, he was m ore worried about losing t han winning. He t ook losses very quickly. On t he ot her ext rem e of t he int elligence spect rum , one of t he people I t rained was a genius. He had a 188 I Q, and he was on " Jeopardy" once and answered every quest ion correct ly. That sam e person never m ade a dim e in t rading during five years. I discovered t hat you can't t rain people how t o t rade by j ust im part ing knowledge. The key t o t r ading

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103 success is em ot ional discipline. Making m oney has not hing t o do wit h int elligence. Think of all t he bright people t hat choose careers on Wall St reet . I f int elligence were t he key, t here would be a lot m ore people m aking m oney t rading. = = = = You alm ost seem t o be im plying t hat int elligence is an im pedim ent t o successful t rading. How would you explain t hat ? = = = = Assum e t hat you're a brilliant st udent who graduat es Harvard sum m a cum laude. You get a j ob wit h a t op invest m ent house, and wit hin one year, t hey hand you a $5 m illion port folio t o m anage. What would you believe about yourself? Most likely, you would assum e t hat you're very bright and do everyt hing right . Now, assum e you find yourself in a sit uat ion where t he m arket is going against your posit ion. What is your react ion likely t o be? " I 'm right ." Why? Because everyt hing you've done in life is right . You'll t end t o place your I Q above t he m arket act ion. To be a successful t rader, you have t o be able t o adm it m ist akes. People who are very br ight don't m ake very m any m ist akes. I n a sense, t hey generally are correct . I n t rading, however, m e person who can easily adm it t o being wrong is t he one who walks away a winner. Besides t rading, t here is probably no ot her profession where you have t o adm it when you're wrong. Think about it . For exam ple, consider a lawyer who, right before a big case, goes out wit h his girlfriend and st ays up half t he night . The next day, he's drowsy and inadequat ely prepared. He ends up losing t he case. Do you t hink he's going t o t ell t he client , " I 'm sorry, I went out last night and st ayed up t oo long. I f I were sharper, I would have won t he case. Here's your m oney back." I t will never happen. He can always find som e excuse. He would probably say som et hing like, " I did t he best I could, but t he j ury was biased." He will never have t o adm it he was wrong. No one will ever know t he t rut h except him . I n fact , he'll probably push t he t rut h so far int o his subconscious t hat he'll never adm it t o him self t hat his own act ions caused t he loss of m e case. I n t rading, you can't hide your failures. Your equit y provides a daily reflect ion of your perform ance. The t rader who t ries t o blam e his losses on ext ernal event s will never learn from his m ist akes. For a t rader, rat ionalizat ion is a guarant eed road t o ult im at e failure. = = = = Typically, how m uch m oney did you give t hese t rainees t o t rade, and what was t heir cut out point ? ==== I n m ost cases, I st art ed people out wit h $25,000 t o $50,000. I n a few cases, I st art ed t rainees out wit h account s as large as $250,000. Their cut out point was when t hey lost it all [ he laughs] . I never had t o fire anyone, t hey j ust self- dest ruct ed. = = = = On balance, did you lose m oney on t his t rainee t rading program ? = = = = No, because t he five of t he t hirt y- eight t rainees who were successful m ade m ore m oney t han all t he ot hers com bined lost . The only unfort unat e t hing w as t hat t hese five people m ade so m uch m oney t hat t hey quit . That was one out com e I didn't consider at t he onset . = = = = I n t he end, t hough, you st ill ended up wit h net profit s on t he deal. = = = = Yes, but not very m uch considering t he effort t hat went int o t his vent ure. I cert ainly wouldn't do it again. = = = = Why do you t hink t he m aj orit y of people you t rained lost m oney? = = = = They lacked what I call em ot ional discipline- t he abilit y t o keep t heir em ot ions rem oved from t rading decisions. Diet ing provides an apt analogy for t rading. Most people have t he necessary knowledge t o lose weight - t hat is, t hey know t hat in order t o lose weight you have t o exercise and cut your int ake of fat s. However, despit e t his widespr ead knowledge, t he vast m aj orit y of people who at t em pt t o lose weight are unsuccessful. Why? Because t hey lack t he em ot ional discipline. = = = = I f you were going t o repeat t his experim ent again- which obviously you are not - do you t hink t hat you'd be able t o pick a higher percent age of winning t raders? = = = = Yes, because t his t im e around I would pick people on t he basis of psychological t rait s. = = = = Specifically, what t rait s would you look for? = = = = Essent ially, I w ould look for people w it h t he abilit y t o adm it m ist akes and t ake losses quickly. Most people view losing as a hit against t heir self- est eem . As a result , t hey post pone losing. They t hink of all sort s of reasons for not t aking losses. They select a m ent al st op point and t hen fail t o execut e it . They abandon t heir gam e plan. = = = = What do you t hink are t he great est m isconcept ions people have about t he m arket ? = = = = I n m y opinion, t he gr eat est m isconcept ion is t he idea t hat if you buy and hold st ocks for long periods of t im e, you'll always m ake m oney. Let m e give you som e specific exam ples. Anyone who bought t he st ock m arket at any t im e bet ween t he 1896 low and t he 1932 low would have lost m oney. I n ot her words, t here's a t hirt y- six- year period in which a buy- and- hold st rat egy would have lost m oney- and t hat doesn't even include t he oppor t unit y loss on t he funds. As a m ore m odem exam ple, anyone who bought t he m arket at any t im e bet ween t he 1962 low and t he 1974 low would have lost m oney. I f som et hing happens once, I t hink logic t ells you t hat it can happen again. Act ually, I believe t hat anyt hing can happen, but cert ainly if it has happened before, it can happen again. From 1929 t o 1932, t he m arket dropped an average of 94 percent . I n fact , it has even happened in m ore m odem t im es- during 197374, t he " nift y fift y" st ocks lost over 75 percent of t heir value. = = = = I s your point t hat we could get a bear m arket t hat would be far worse t han m ost people could im agine? = = = = Exact ly, and people who have t he not ion t hat buying and holding for t he long t erm is t he way t o go can

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104 easily go bankrupt . = = = = Wouldn't your own durat ion and m agnit ude rules lead you ast ray if we get a m arket t hat goes down 80 or 90 percent ? = = = = Not at all. Rem em ber t hat I use t hese st at ist ical st udies as only one am ong m any t ools. = = = = How do you handle losing st reaks? = = = = We all go t hr ough periods when we're out of sync w it h t he m arket . When I 'm doing t hings correct ly, I t end t o expand m y rat e of involvem ent in t he m arket . Conversely, when I st art losing, I cut back m y posit ion size. The idea is t o lose as lit t le as possible while you're in a losing st reak. Once you t ake a big hit , you're always on t he defensive. I n all t he m ont hs I lost m oney, I always ended up t rading sm all- som et im es t rading as lit t le as 1 percent of t he account . When I get int o a losing st reak, I like t o read a nonfict ion book t o learn som et hing new. That act ion accom plishes t wo t hings. First , it t akes m y m ind off of t rading; second, by enhancing m y knowledge, I help im prove m y self- est eem . The key is t o do som et hing posit ive. = = = = Do you som et im es pull yourself away from t he m arket s t ot ally? = = = = Yes. = = = = For how long? = = = = Som et im es for as long as a m ont h or t wo. = = = = Do you t hink t hat t aking such ext ended wit hdrawals from t he m arket is a good pract ice? = = = = Wit hout a doubt . You don't want t o keep losing if you're in a m t , because t hat will only dest roy your selfconfidence even m ore. = = = = How do you get back int o t rading? = = = = Ty Cobb once was asked why he never had slum ps. He said t hat whenever he felt him self get t ing int o a slum p, he wouldn't t ry t o get a hit , but he would sim ply t ry t o m ake cont act wit h t he ball. To relat e t hat concept t o t r ading, when you're in a slum p, t ry t o be pat ient and wait for a t rade t hat you feel very confident about and k eep t he bet size sm all. Your goal should not be t o m ake lot s of m oney but rat her t o get your confidence back by m aking correct decisions. = = = = Why do m ost people lose m oney in t he m arket ? = = = = I know t his will sound like a cliche, but t he single m ost im port ant reason t hat people lose m oney in t he financial m arket s is t hat t hey don't cut t heir losses short . I t is a curiosit y of hum an nat ure t hat no m at t er how m any books t alk about t his rule, and no m at t er how m any expert s offer t his advice, people st ill keep m aking t he sam e m ist ake. = = = = What ot her m ist akes do people m ake? = = = = They don't approach t rading as a business. I 've always viewed t rading as a business. = = = = Can you elaborat e on your business plan for t rading? = = = = I view t he obj ect ives in t rading as a t hree- t iered hierarchy. First and forem ost is t he preservat ion of capit al. When I first look at a t rade, I don't ask, " What is t he pot ent ial profit I can realize?" but rat her, "What is t he pot ent ial loss I could suffer?" Second, I st rive for consist ent profit abilit y by balancing m y risk relat ive t o t he accum ulat ed profit s or losses. Consist ency is far m ore im port ant t han m aking lot s of m oney. Third, insofar as I 'm successful in t he first t wo goals, I at t em pt t o achieve superior ret urns. I do t his by increasing m y bet size aft er, and only aft er, periods of high profit abilit y. I n ot her words, if I have had a part icularly profit able recent period, I m ay t ry t o pyram id m y gains by placing a larger bet size assum ing, of course, t he right sit uat ion present s it self. The key t o building wealt h is t o preserve capit al and wait pat ient ly for t he right opport unit y t o m ake t he ext raordinary gains. = = = = What is your opinion about chart analysis? = = = = I 've m ade t oo m uch m oney t rading on t echnical observat ions t o dism iss t echnical analysis as m any pure fundam ent alist s do. However, I do believe t hat t echnical analysis is insufficient as a sole m et hod of analyzing and t rading t he m arket . Back in 1974,1 was approached by a t echnical analyst who t alked a convincing gam e about how he could help im prove m y t rading. I hired him as an advisor on a t rial basis for S125 a week. I also offered t o pay him a percent age 6T t he profit s on his recom m endat ions. Well, t his fellow was very indust rious. He worked sixt een- hour days and analyzed his chart s in ways t hat I st ill don't underst and. However, whenever I asked him for a specific recom m endat ion, he would show m e t he chart and say t hings like, " This st ock m ight be form ing a t op." He could never give m e a st r aight answer when I asked him if I should buy or sell. My m ost dist inct m em ory about him is t hat his shirt sleeves were frayed and he at e hom em ade t una fish sandwiches for lunch. = = = = Do you use chart analysis? = = = = Yes, but I like t o keep it sim ple. My prim ary m et hodology is a t hree- st ep process t o define im port ant t rend changes. Let m e t ake t he exam ple of t rying t o ident ify a t op in a rising m arket . The first st ep is wait ing for t he upt rend line t o be brok en. = = = = I n m y experience, I have not found t rend lines t o be part icularly reliable. = = = = I t is essent ial t hat you draw t he t rend line correct ly. Most people draw t rend lines incorrect ly. = = = = What is t he correct way of drawing a t rend line? = = = = I n t he case of an upt rend line, you draw t he line from t he lowest low t o t he highest low im m ediat ely preceding t he highest high, m aking sure t hat t he connect ing point you select does not result in t he t rend line

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105 passing t hrough any prices bet ween t he t wo point s. = = = = I int errupt ed you. You said you used a t hree- st ep process of chart analysis. What are t he rem aining t wo st eps? = = = = Once t he t rend line is broken, I t hen look for an unsuccessful t est of t he recent high. This failure m ay t ake t he form of prices reversing below t he previous high or, in som e inst ances, prices m ight act ually penet rat e t he previous high by a m odest am ount and t hen break. I n t he case where prices penet rat e t he previous high, a pullback below t hat high would serve as confirm at ion of a failed t est of t he high. The t hird and final confirm at ion of a t rend change would be t he downside penet rat ion of t he m ost recent relat ive low. = = = = I n t he second crit erion you m ent ioned- t he failed t est of t he previous high- you indicat ed t hat som et im es t he rebound will fall short of t he high and som et im es it will penet rat e t he high before prices break. I s t he pat t ern m ore reliable if t he previous high is penet rat ed before prices pull back? = = = = As a m at t er of fact , yes. I n fact , t his one pat t ern alone can som et im es cat ch t he virt ual exact high or low. I n m y view, t hese t ypes of price failures are probably t he m ost reliable and im port ant chart pat t erns. The reason t hese t ypes of failures oft en m ark m aj or t urning point s is relat ed t o t he m echanics of t he t rading floor. Many t rader s t end t o set t heir st ops at or near t he previous high or low. This behavioral pat t ern holds t m e for bot h m aj or and m inor price m oves. When t here is a heavy concent rat ion of such st ops, you can be r easonably sure t hat t he locals on t he floor are aware of t his inform at ion. There will be a t endency for t he locals t o buy as prices approach a concent rat ion of buy st ops above t he m arket ( or t o sell if t he m arket approaches heavy sell st ops below t he m arket ) . The locals t ry t o profit by ant icipat ing t hat t he act ivat ion of a large pocket of st ops will cause a m inor ext ension of t he price m ove. They will t hen use such a price ext ension as an opport unit y t o liquidat e t heir posit ions for a quick profit . Thus, it 's in t he int erest of t he locals t o t ry t o t rigger heavy concent rat ions of st op orders. I n cases where t here ar e valid fundam ent al reasons for t he cont inuat ion of a price m ove beyond t he previous high ( or low) , t he m ove will t end t o ext end. However, if t he m ove t o a new high ( or low) was largely caused by local t rading act ivit y, once t he st op orders are filled, prices w ill t end t o reverse, falling back below t he prior high ( or rebounding above t he prior low) . I n effect , t he t riggering of t he st ops repr esent s t he m arket 's last gasp. The process I have j ust described applies t o an open out cry t ype of m arket , such as fut ures. However, a sim ilar process also operat es in specialist - t ype m arket s, such as t he st ock exchange. The specialist t rades one st ock or several st ocks. I t 's t he specialist 's j ob t o m ake a m arket in t hese st ocks. For providing t his service, t he specialist is paid a flat fee per hundred shares t raded. Obviously, it 's in his int erest t o have prices m ove t o t he levels t hat will result in t he execut ion of t he largest am ount of orders. These point s will norm ally be prices j ust above t he prior high or j ust below t he prior low. Also, keep in m ind t hat t he specialist has t he advant age of knowing ahead of t im e t he locat ion of all t he orders for his st ock. I n addit ion, t he locals on t he st ock exchange floor will have a sim ilar t ype of int erest in t riggering st ops as do t he locals on, say, t he fut ures m arket exchanges. The prim ary point I 'm t rying t o m ake is t hat key chart pat t erns are oft en based on t he act ivit y of t he professionals on t he floors. = = = = Do you use any t echnical indicat ors? = = = = I use t hem as a secondar y t ype of input . I n t he st ock m arket , t he one indicat or I give t he great est weight is t he t wo- hundred- day m oving average. I wouldn't recom m end t his indicat or as a sole input for m aking t rading decisions, but it does add a bit of usefiil inform at ion t o sup plem ent ot her m et hods and form s of analysis. I n fact , one st udy I saw dem onst rat ed t hat by sim ply using t he t wo- hundred- day m oving average on t he Dow Jones st ock s, an invest or could have earned an average annual ret urn of 18 per cent over t he fift y- year survey period- approxim at ely double t he ret urn t hat would have been realized by a st raight buy- and- hold m et hod. = = = = I know t hat you're a self- t aught st udent in econom ics, having read scores or possibly even hundreds of books on t he subj ect . Has t his st udy been a purely int ellect ual endeavor, or does it yield som e pract ical benefit s in t erm s of t rading? = = = = There have been a num ber of incident s in which I believe m y knowledge of econom ics and econom ic hist ory helped m e profit from t he m arket s. A classic exam ple occurred when Francois Mit t errand, a selfproclaim ed socialist , won a surprise vict ory in t he 1981 Fr ench president ial elect ion. I n his cam paign, Mit t errand had prom ised t o nat ionalize segm ent s of indust ry and t o int roduce m assive social welfare program s. I underst ood t hat t he econom ic im plicat ions of Mit t er rand's program s would spell disast er for t he French franc. I im m ediat ely sold t he franc, which was t hen t rading at approxim at ely a four- t o- one exchange rat e t o t he dollar. I covered t hat posit ion a m ere t hree weeks lat er when t he franc was t rading at six t o one t o t he dollar. I n m y view, t hat t rade was about as close as you can get t o a sure t hing. I ncident ally, t he franc event ually sank t o a t en- t o- one rat e against t he dollar. = = = = Probably your best - publicized m arket call was a predict ion for a m aj or t op in t he st ock m arket , which you m ade in Barron` s in Sept em ber 1987- one m ont h before t he crash. What m ade you so confident about an im pending collapse in st ock prices? = = = = At m e August 1987 high, t he st ock m arket had gained nearly 23 percent in ninet y- six days. These figures were alm ost exact ly in line wit h t he hist orical m edians for t he m agnit ude and durat ion of int erm ediat e bull m arket m oves. This considerat ion was only a caut ionary not e. I f all t he ot her fact ors were posit ive, t hen fine. However, t o recall an analogy I used earlier, t his m arket was no Jack LaLanne. I n August , t he Dow Jones I ndust rial index m ade a new high, but t he advance/ decline rat io

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106 did not - a bearish divergence. The price/ earnings rat io at t he t im e was at it s highest level in t went yfive years. Governm ent , corporat e, and consum er debt were at record levels. Virt ually any indicat or you looked at was scream ing caut ion against t he possibilit y of an im pending collapse. = = = = Were you short going int o t he Oct ober 19 crash? I f so, what considerat ions did you use t o act ually t im e your ent ry int o t he m arket ? = = = = The first m aj or t im ing signal cam e on Oct ober 5, when I read Fed Chairm an Greenspan's com m ent in t he Wall St reet Journal, in which he was quot ed as saying t hat int erest rat es could becom e " dangerously high" if inflat ion fears were t o " m ushroom " in t he financial m arket s. Alt hough Greenspan indicat ed t hat he felt such concerns wer e unwarrant ed, he also hint ed t hat t he discount rat e m ight have t o be raised t o alleviat e such worries. On Oct ober 15, Dow Theory gave a sell signal, and I init iat ed m y short posit ion. The st r aw t hat broke t he cam el's back was Secret ary of St at e Jam es Baker's disput e wit h Germ any, in which he urged Germ any t o st im ulat e it s econom y. When Germ any refused t o cooperat e, Baker m ade a weekend announcem ent t hat t he Unit ed St at es was prepar ed t o " let t he dollar slide." I n m y opinion, t here's no doubt t hat t his st at em ent was t he t rigger for t he Oct ober 19 st ock m arket collapse. An unknown devaluat ion of a currency is not som et hing t hat any foreign invest or want s t o live wit h. What does " slide" m ean? Five percent ? Ten percent ? Tw ent y per cent ? How m uch are you going t o let it slide? I nvest ors who hold dollar- denom inat ed securit ies are going t o sell unt il t hey know what " slide" m eans. At t hat point , I was absolut ely convinced t hat t he st ock m ark et was going t o collapse because of t his unknown dollar devaluat ion. On Monday m orning, I im m ediat ely added t o m y short posit ion, even t hough t he Dow Jones index opened over 200 point s lower. = = = = I know t hat you also caught t he Oct ober 1989 m inicrash. Was t he analysis process sim ilar t o t hat in Oct ober 1987? = = = = Very m uch so. I n Oct ober 1989, t he m arket had been up for 200 days wit hout an int erm ediat e downt rend [ by Sperandeo's definit ion, a decline of fift een days or longer] , versus a hist orical m edian of 107 days. Moreover, t he m arket was up over 24 percent , and m y hist orical st udies had shown t hat seven out of eight t im es when t he m arket was up by t hat am ount , a correct ion event ually occurred t hat carried prices back below t hat point . I n ot her words, t he odds for t he m arket cont inuing t o m ove higher were very low. Consequent ly, I was out of longs and very at t uned t o signs t hat t he m arket was ready t o die. St at ist ically, t his m arket was like an eight y- seven- year- old. = = = = Any final words? = = = = Being involved in t his business requires t rem endous dedicat ion and desire. However, you shouldn't m ake t rading your whole life. You have t o t ake t im e off. You need t o spend t im e wit h loved ones. You need t o balance your life. When I did m y exhaust ive st udy on hist orical st ock t rends, m y daught er, Jennifer, was in her pr eschool years. That 's a crit ical age for t he child in t erm s of developm ent and a wonderful age for parent s t o enj oy t heir children. Unfort unat ely, I was so involved wit h m y proj ect t hat when I cam e hom e from work, I would eat and im m ediat ely head for m y st udy. When m y daught er wandered int o m y office, I had no t im e t o share wit h her. I t was a m ist ake t hat I regret t o t his day. Som e t raders m ake t his business t heir ent ire life and, as a r esult , t hey m ay m ake m ore m oney, but at t he expense of living a m ore rounded, balanced, and sat isfying life. One way or anot her, it all com es down t o odds. Unless you can find som e way t o get t he odds in your favor, t rading, like any ot her 50/ 50 gam e wit h a cost t o play ( com m issions and execut ion slippage in t his case) , w ill event ually be a losing proposit ion. Sperandeo has t aken t he definit ion of odds t o an act uarial- like ext rem e. Just as insurance com panies guarant ee t hat t he odds are in t heir favor by classifying policyholders according t o risk, Sperandeo cat egorizes t he st ock m arket by risk. When it com es t o t he st ock m arket , he can t ell t he difference bet w een a t went y- year- old and an eight y- year- old. Anot her som ewhat relat ed elem ent behind Sperandeo's success is t hat he var ies his bet size considerably. When he im plem ent s a posit ion in a m arket t hat he per ceives t o be in t he beginning st ages of a new t rend and various indicat ors confirm t he t rade, he will t end t o t rade m uch larger t han in sit uat ions where t hese condit ions are lacking. I n t his way, Sperandeo places his largest bet when he est im at es t hat t he odds are m ost favorable. ( I ncident ally, t his st rat egy is essent ially t he key t o success in gam es such as blackj ack; see t he Hull int erview.) Sperandeo em phasizes, however, t hat when t rading large, it is essent ial t hat t he m arket go im m ediat ely in your favor; ot herwise, t he posit ion should be pared down quickly. This m easure is essent ial t o ensure financial survival when you are wrong in a sit uat ion t hat you t hought was highly favorable. While his view is hardly universal, Sperandeo dow nplays t he significance of int elligence t o t rading success. Based on his experience in t raining t hirt y- eight t raders, Sperandeo concluded t hat int elligence was virt ually irrelevant in predict ing success. A far m ore im port ant t rait t o winning as a t rader, he says, is t he abilit y t o adm it m ist akes. He point s out t hat people who t ie t heir self- est eem t o being right in t he m arket s will find it very difficult t o t ake losses when t he m arket act ion indicat es t hat t hey are wrong. One sacred cow t hat Sperandeo believes is really a bum st eer is t he st andard advice t o use a buy- andnold st rat egy in t he st ock m arket . Sperandeo provides som e exam ples of very ext ended periods in which such a st rat egy would have been disast rous.

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107 PART V Multiple-Market Players

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108 Tom Basso: Mr. Serenity To be frank, Tom Basso w as not on m y list of int erview subj ect s for t his book. Alt hough his t rack record is solid, it is by no m eans st riking. As a st ock account m anager , he has av eraged 16 per cent annually since 1980, approx im at ely 5 percent above t he S&P 500 r et urn. Quit e respect able, considering t hat t he m aj orit y of m anagers underper- form t he index, but st ill not t he st uff of legends. As a fut ures fund m anager, Basso has averaged 20 percent annually since 1987 wit h only m oderat e volat ilit y. Here, t oo, t he result s are significant ly bet t er t han t he indust ry average, but hardly ext raordinary. And yet , in an im port ant sense, Basso is perhaps t he m ost successful t rader I have int erviewed. To paraphrase a r ecent com m ercial, how do you spell success? I f your answer is M- O- S- T B- U- C- K- S, t hen Basso doesn't m ake t he grade. I f, however, your answer is G- OO- D B- U- C- K- S, G- R- E- A- T L- I - F- E, t hen Basso has few peers. When I first m et Basso, I was im m ediat ely st ruck by his incredible ease about t rading. He has learned t o accept losses in t rading not only in an int ellect ual sense but on an em ot ional level as well. Moreover, his feelings of exuberance about t rading ( or, for t hat m at t er, about life) bubble right out of him . Basso has m anaged t o be a pr ofit able t rader while apparent ly m aint aining com plet e peace of m ind and experiencing great j oy. I n t his sense, I can't t hink of a m ore wort hy role m odel for a t rader. I knew wit hin m inut es of m eet ing Basso t hat he was som eone I want ed t o include in t his book. I also realized t hat m y m et hod of select ing int erview subj ect s st rict ly on t he basis of num bers was a som ewhat m yopic approach. Basso st art ed out as an engineer for Monsant o Com pany. He found t hat t his j ob didn't fully absorb his energies, and he began dabbling in t he invest m ent field. His first foray int o t he financial m arket s was a com m odit y ( fut ures) account , which proved t o be an im m ediat e disast er. Alt hough it t ook m any years before Basso was able t o t rade fut ures profit ably, he persist ed unt il he finally succeeded. I n 1980, he began m anaging equit y account s as an out growt h of an involvem ent in an invest m ent club. I n 1984 he expanded his m anagem ent scope t o include fut ures account s as well. The sm all size of m ost of t hese fut ures account s ( m any as sm all as $25,000) result ed in excessive volat ilit y. Basso realized t hat in order t o reduce volat ilit y t o a reasonable level while st ill m aint aining adequat e diversificat ion, he w ould have t o drast ically raise his m inim um account size. I n 1987, he raised his m inim um t o $1 m illion and ret urned t he funds of all client s wit h sm aller account s. Today, he cont inues t o m anage bot h st ock and fut ures account s. Basso and I m et at a psy chology invest m ent sem inar m n by Dr. Van Tharp and Adrienne Toghiaie. The sem inar was held in t he som ewhat unlikely locale of Newark, New Jersey. The int erview was conduct ed over lunch at a local diner. = = = = One of t he t hings t hat im m ediat ely st ruck m e about you is t hat you have t his aura of incredible relaxat ion- alm ost bliss- about your t rading. I t 's t he ant it hesis of t he m ent al st at e people t ypically associat e wit h t raders. Have you always had t his at t it ude about t rading? = = = = Not at all. I st ill rem em ber m y first t rade. I n 1975,1 opened a com m odit y account for $2,000. I bought t wo corn cont ract s and im m ediat ely lost $600. My st om ach was t urning. I couldn't concent rat e on m y work. ( I was an engineer in t hose days.) I called m y broker every hour. = = = = Do you rem em ber your m ot ivat ion for t hat t rade? = = = = I put on t he t rade because of a rat her naive st udy I did in which I found t hat a cert ain very infrequent chart pat t ern had been followed by a price advance 100 percent of t he t im e. Several years ago I hear d you give a speech in which you t alked about " t he well- chosen exam ple." 1 laughed t o m yself when I heard you use t hat phrase because it rem inded m e of m y first t rade, which was t he epit om e of t he well- chosen exam ple. [ The well- chosen exam ple Basso is referring t o represent s one of m y pet peeves. The basic cont ent ion is t hat virt ually any syst em ever invent ed can be m ade t o look great if one sim ply illust rat es t he approach by select ing t he hist orical m arket t hat pr oved m ost favorable for t he part icular m et hod. I first becam e aware of t his concept in t he m id- 1980s, when I read an art icle on a sim ple, fully disclosed t rading syst em . At t hat t im e I was working on a rat her com plex syst em of m y own. To m y shock and dism ay, t his very sim ple syst em seem ed t o have out perfor m ed t he far m ore com plicat ed syst em I had spent so m uch t im e developing- at least for t he one illust rat ion provided. 1 reread t he art icle wit h great er scm t iny. The proposed syst em consist ed of only t wo condit ions. I and Norm an St rahm , m y part ner in syst em developm ent at t he t im e who did all our program m ing, had t est ed one of t he condit ions before. We knew it t o be a net winning, albeit only m oderat ely perform ing, t rading rule. The ot her condit ion was a rule t hat we considered t o have such a poor prospect of success t hat we never even bot hered t est ing it . However, if t he syst em described in t he art icle were really t hat good, it s superiorit y had t o com e from including t his second condit ion- a t rading rule we had dism issed out of hand. Nat urally, we t est ed t his second condit ion. I t s perform ance for t he m arket illust rat ed in t he art icle was exact ly as indicat ed. However, t he t im e period select ed for t he exam ple j ust happened t o be t he single best year in a t en- year t est period for t hat m arket . I n fact , it was t he single best year for any of t he t went y- five m arket s we t est ed for t hat t en- year period. No wonder t he sy st em had appeared t o be t hat good- w e were looking at t he single best case out of t he 250 possible m arket and year com binat ions we t est ed. What a coincidence! I 'm sure hindsight had not hing t o do wit h it . But t hat 's not t he end of t he st ory. The syst em did dism ally in t he rem ainder of t he t est sam ple. I n fact , for t he t en- year period t est ed, sev ent een out of t went y- five m arket s act ually lost m oney once t ransact ion cost s were t aken int o account . Ever since t hat t im e, I have had an ingrained sense of skept icism regarding t he illust rat ions used in t rading syst em art icles and advert isem ent s.]

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109 = = = = Do you believe t hat m ost of t he people who sell t rading syst em s using t hese well- chosen exam ples know bet t er? Or are t hey really fooling t hem selves- as you adm it t edly did in your first t rade? = = = = I t hink it 's probably a bit of bot h. Som e people are j ust selling garbage and t hey know it , while ot hers are kidding t hem selves- t hey believe t hey have som et hing t hat 's wort hwhile, but t hey really don't . This t ype of self- delusion occurs frequent ly, because it 's psychologically com fort ing t o const ruct a syst em t hat looks very good in it s past perfor m ance. I n t heir desire t o achieve superior past perfor m ance, syst em developers oft en define syst em condit ions t hat are unr ealisncally rest rict ive.The problem is t hat t he fut ure never looks exact ly like t he past . As a result , t hese well- chosen m odels fall apart when t hey're t r aded in t he fut ure. Aft er m y years of experience in t he m arket s, I now t ry t o keep m y m odels as flexible as I possibly can. I t ry t o im agine scenarios t hat would alm ost m ake good m ovie plot s. As an exam ple, t he U.S. governm ent falls, causing t he Treasury t o default on it s T- bill obligat ions and t he U.S. dollar t o drop by 50 percent overnight . = = = = How can you possibly design syst em s t hat can cope wit h t hose t ypes of ext rem e sit uat ions? = = = = I don't necessarily design syst em s t hat will cope wit h t hose sit uat ions, but I m ent ally live t hrough w hat will happen t o m y posit ions, given one of t hese scenarios. = = = = How does t hat help? = = = = I t helps prepare m e for all t he different m arket condit ions t hat can arise. Therefore, I know what I 'll do in any given sit uat ion. = = = = I n your descript ion of your first t rade, you com e across as being filled wit h t ension and anxiet y. How did you go from t hat m ind- set t o your current ext raordinarily relaxed at t it ude? = = = = I realized t hat every t im e I had a loss, I needed t o learn som et hing from t he experience and view t he loss as t uit ion at t he College of Trading. As long as you leam som et hing from a loss, it 's not really a loss. = = = = When did yon adopt t hat m ent al at t it ude? = = = = Very early; probably right aft er t he corn t rade. = = = = Did it help? = = = = Definit ely. By adopt ing t hat perspect ive, I st opped looking at t he losses as problem s and st art ed viewing t hem as opport unit ies t o elevat e m yself t o t he next plat eau. Over t he next five years, I gradually im proved and lost less each year. = = = = Aft er losing m oney for five consecut ive years from your st art in t rading, didn't you ever t hink t hat you m ight not be cut out for t his endeavor? = = = = No, never. = = = = What gave you t he confidence? You obviously weren't get t ing any reinforcem ent from t he m arket ==== My reinforcem ent cam e when m y losses gradually becam e sm aller and sm aller. I was get t ing very close t o t he breakev en point . I also kept m y losses at a m anageable level. I always t raded a v ery sm all account - an am ount t hat I could afford t o lose wit hout affect ing m y life- st yle. = = = = Did you st op t rading when you lost what ever am ount of m oney you had set aside t o risk in a given year? = = = = That never happened. I had developed t he concept of never t aking a t rade t hat would j eopardize m y abilit y t o cont inue t rading. I always lim it ed t he risk on any t rade t o a level t hat I knew would perm it m e t o com e in and play t he gam e again if I were wrong. = = = = What lessons st and out m ost vividly from t he period during which you at t ended your so- called College of Trading? = = = = An absolut ely pivot al experience occurred in 1979, about four years aft er I had st art ed t rading. My parent s, who lived in Syracuse, New York, cam e in for a week- long visit . I was busy playing t our guide and fell behind in m y work. Unbeknownst t o m e, t hat sam e week, silver broke out violent ly on t he upside. The next week, I updat ed m y work and discovered I had m issed a buy signal in silver. = = = = Were you t rading a syst em at t he t im e? = = = = Yes. I was following a specific syst em and had t aken every t rade for nine m ont hs st raight . I n ot her words, t here's no quest ion t hat I would have t aken t he t r ade had I updat ed m y work. Over t he next few m ont hs, silver skyrocket ed. The end of t he st ory is t hat m issing t hat single t rade m eant an opport unit y loss of $30,000 profit per cont ract . = = = = What was your t rading account size at t he t im e? = = = = I t was very sm all- about $5,000. So t hat t rade would have m eant an approxim at e sixfold increase in t he account size. From t hat point on, no m at t er what syst em I was using, I always m ade cert ain t hat I would t ake all t he t rading signals. = = = = Were any ot her t rades pivot al in shaping your overall t rading approach? = = = = I n 1987 m y wife and I had an account t hat , at t he t im e, had an equit y level of about $130,000. We w ere long several cont ract s of silver when t he m arket exploded. We wat ched t he account go up by about $500,000 in one m ont h and t hen surrender 80 percent of t hat profit in only a week. That t rade t aught m e a lot about m y own st om ach lining. When your account has t hese m assive swings up and down, t here's a t endency t o feel a rush when t he m arket is going your way and devast at ion when it 's going against you. These em ot ions do absolut ely not hing t o m ake you a good t rader. I t 's far bet t er t o keep t he equit y swings m anageable and st rive for a sense of balance each day, no m at t er what happens. That

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110 t rade was t he cat alyst for m y adopt ing a form ula t hat lim it ed bot h m y profit s and drawdowns by not ching back t he num ber of cont ract s t raded in each m arket t o a t olerable level. The key is t hat t he num ber of cont ract s t raded fluct uat es in accordance wit h each m arket 's volat ilit y. = = = = Get t ing back t o m y first quest ion; can you explain how you m anage such a com posed at t it ude in t rading t he m arket s? = = = = When I com e t o work each day, I know t hat t he risk and volat ilit y in m y port folio is exact ly t he sam e as it was yest erday, last week, and last m ont h. So why should I let m y em ot ions go up and down if I 'm in exact ly t he sam e exposure all t he t im e? = = = = I assum e t hat being able t o have t hat at t it ude requires great confidence in your syst em . = = = = I t 's a m at t er of bot h having confidence and being com fort able in t he approach you're using. For exam ple, if I gave you m y exact syst em , I 'm sure t hat wit hin a m ont h you would be m aking changes t o fit your own ideas. For one reason or anot her, you probably wouldn't be com fort able wit h what I gave you. I t would be even worse if I gave you t he syst em as a black box [ a com put er program t hat generat es buy and sell signals based on undisclosed rules] . That would drive you crazy. Since you wouldn't have any idea what went int o t he program , t he first t im e t he syst em had a losing st reak, you would probably abandon it alt oget her. You would say, " Tom m ay be a nice guy, but how do I know he j ust didn't develop t his syst em off of som e wellchosen exam ples?" = = = = That is precisely t he reason why I believe people alm ost invariably fail t o m ake m oney on t rading syst em s t hey buy. Even if t hey are lucky enough t o purchase a syst em t hat worksy t hey alm ost never have t he confidence t o st ay wit h t he syst em when it hit s it s first m aj or drawdown period- and every syst em in t he world will have a drawdown. = = = = I couldn't agree m ore. = = = = What would you say t o t he t rader who says, " I 'm m aking m oney overall, and I 'm using st ops t o lim it m y losses, but I st ill have a lot of anxiet y about t rading. I st ill can` t st and t o lose." ? = = = = I would t ell t hat t rader t o t hink of each t rade as one of t he next one t housand t rades he's going t o m ake. I f you st art t hinking in t erm s of t he next one t housand t rades, all of a sudden you've m ade any single t rade seem very inconsequent ial. Who cares if a part icular t rade is a winner or a loser? I t 's j ust anot her t rade. = = = = Do yon do any m ent al exercises t o relax, or is t hat not necessary now t hat you're fully com put erized? ==== I probably do m ore m ent al exercises now t han I ever did. Each m orning while I 'm driving t o work, I m ake a conscious effort t o relax. I m ent ally rehearse any conflict t hat m ight happen t hat day. The process of m ent ally organizing and relaxing before I get t o work helps m e st art m y day iri a very posit ive fram e of m ind. = = = = I n effect , are you visualizing all possible crises or t ensions t hat m ight occur and how you would respond t o t hem , so t hat if t hey do arise, t hey're not st ressful? = = = = Exact ly. = = = = Can you give m e an exam ple in which t hat m ent al at t it ude was put t o t he t est of fire? = = = = A good exam ple is t he recent Gulf War. On t he evening of January 16, 1991 [ t he night t he Unit ed St at es launched t he air war against I raq] , I had com e int o t he office t o do som e com put er work . While I was t here, t he news of t he war broke, and crude oil prices shot up t o $40. I happened t o have a subst ant ial long posit ion at t he t im e. My first t hought was ... = = = = " We're going t o have a great day t om orrow." = = = = Act ually, I t hink m y m ost im m ediat e t hought was, "We're going t o have a lot of volat ilit y and risk cont rol alarm s going off t om orrow, and we bet t er be pr epared." I called our m anaging direct or, George, at hom e t o m ake sure he was aware of t he sit uat ion. He said, " I know, it 's on all t hree net works. I 'll be in early." The next m orning, I was drying m y hair aft er com ing out of t he shower, while m y wife was wat ching t he news in t he next room . I t hought I heard t he newscast er say t hat crude oil prices were at $22. Of course, I couldn't believe t he num ber. I t hought t o m yself, " Was t hat $42? Or m aybe $32?" I walked int o t he bedroom and asked m y wife, " Did he say $22?" " I 'm sorry," she said, " I didn't hear it ." I wait ed for t he st ory t o com e back on and found t hat t he price was indeed $22.1 called up George and asked him , " Did you see t he news? We're really going t o have our work cut out for us t his m orning." We bot h got in early, ran all t he program s, w orked out all our risk alarm s, and called in all t he orders before t he openings. We did everyt hing we had planned t o do. By 9: 30, everyt hing was done- all our order s had been placed, we had received our execut ion prices, and we had our new posit ion balances figured out . I sat back, let out a sigh of relief, and asked Geor ge, " What do you t hink we lost on t his t oday?" " I would guess about 15 per cent ," he answered. " Yeah, I would guess about t he sam e am ount ," 1 said. I sat t here for a m om ent and t hought about all t he event s and act ions of t he pr evious evening and t hat m orning. I realized t hat t here was not a single t hing I would have done different ly. Despit e having j ust lost 15 percent in our port folios overnight , I felt phenom onally good at t hat point . = = = = Because you had done everyt hing t hat you were supposed t o do? = = = = Exact ly. = = = = When you went t o sleep t he night before, was t he m arket st ill t rading above $40? Did yon assum e it was st ill going t o be up t he next m orning? = = = = Sure.

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111 = = = = I t m ust have been a great shock t hen t o discover t hat crude oil prices had gone from being up $8 t he night before t o being down $10 t he next m orning. What were your gut em ot ions when you realized t hat your profit s of t he previous evening had suddenly been t ransform ed int o a gargant uan one- day loss? ==== I wondered how m y progr am s were going t o deal wit h t he volat ilit y ill cm de oil going from $1,000 per day [ per cont ract ] t o $18,000 per day. I was bot h excit ed and horrified at t he t hought of how m y program s would handle t he sit uat ion. I hoped t hat I had done a good j ob in preparing for a cat ast rophic event . = = = = But on t he inside, didn't yon have any hurt or depressed feelings? = = = = No, I was m ore curious. = = = = That is exact ly t he at t it ude I find so fascinat ing. Your port folios went from being up sharply t he night before t o a 15 percent loss t he next m orning. Most people would have som e very negat ive em ot ions in t hat t ype of sit uat ion. How were yon able t o respond wit h such em ot ional aloofness? = = = = You have t o put it int o perspect ive. I 'm fond of t hinking of t rading in t erm s of scores of years. I f I live long enough, I 'll t rade for fift y or sixt y years. I figure t hat , over t hat t im e span, I 'll see dev ast at ing declines, spect acular advances t hat I virt ually can't believe, and everyt hing in bet ween. I f you have done m ent al rehearsals t o see how you would react in different cat ast rophic sit uat ions, t hen when such an event occurs, you becom e curious. = = = = Curious t o see if you're going t o follow your m ent al rehearsal? = = = = Exact ly. You feel like you've already seen t his m ovie once before, and you wonder whet her it 's going t o com e out t he sam e way. = = = = How do you handle such sit uat ions in your m ent al rehearsal? = = = = My m ent al rehearsal for a cat ast rophic event is t o pict ure a doct or in a t riage sit uat ion. He's in a bat t lefield em ergency operat ing room . hi com e fift y bodies. Som e are going t o live; som e are going t o die. The doct or has been t rained t o handle t he sit uat ion. He's going t o m ake all t he necessary decisions. " This pat ient goes t o operat ing room num ber one." " This pat ient get s pushed aside." He's calm and collect ed, not nervous. He knows t hat he has t he best chance of saving t he m axim um num ber of lives. He knows t hat he can't save t hem all, but he's going t o do t he best he can wit h what he has. = = = = You j ust st ay focused on what you have t o do. = = = = Exact ly. = = = = Does t hat focus act ually shut out any negat ive em ot ions t hat m ight arise? = = = = Who knows? You don't really t hink about it at t hat point . You don't get t hrilled at t he gains eit her. = = = = Act ually, being t hrilled about t he gains isn't so desirable. One t rader described t he em ot ional flux t o m e as follows: " When I 'm losing m oney, I 'm upset because I 'm losing. When I 'm m aking m oney, I 'm anxious because I worry t hat I won't be able t o keep it up." = = = = I liken em ot ions in t rading t o a spring, wit h em ot ions being st ret ched up and down, up and down. While it 's going up and down, it 's kind of t hrilling, but event ually t he spring wears out . Burnout set s in, and you realize t hat m aybe it isn't so m uch fun t o be on t his em ot ional roller coast er. You find t hat if you can j ust keep your em ot ions in balance in t he m iddle, it 's act ually a whole lot m ore fun. = = = = How do you achieve t hat balance? = = = = I focus m y t ot al at t ent ion on t rading well, and let t he result s t ake care of t hem selves. = = = = I t sounds ahnost as if you're viewing yourself from t he out side, com plet ely det ached. = = = = When I was in high school I had an ext rem e fear of get t ing up in front of t he class and t alking. My knees would lit erally t rem ble. I event ually learned t o deal wit h t he sit uat ion by disassociat ing and observing m yself. I was able t o have t his observer show up in t im es of st ress. When I found m yself shaking, m y observer would say, " Why are you shaking, Tom ? Just relax. You're t alking t oo fast . Slow down a lit t le bit ." Event ually, I found t hat t he observ er was t here all t he t im e. I f you're wat ching yourself doing everyt hing, you get pret t y close t o wat ching a m ovie. The observer is wat ching you play a role in t his m ovie called Life. = = = = I s t his advice t hat you give t o people in general- t ry t o be an observer of yourself? = = = = Absolut ely. I couldn't recom m end it m ore. I f inst ead of saying, " I 'm going t o do t his t rade," you say, " I 'm going t o wat ch m yself do t his t rade," all of a sudden you find t hat t he process is a lot easier. = = = = How does having t his observer help your t rading? = = = = The observ er is able t o say, " You're get t ing greedy on t his t rade, wat ch out ." You m ight be st raining and st ruggling because som e of your indicat ors are bullish and som e are bearish, and you don't know what t o do. The observer m ight say, " How about doing not hing? You don't have t o t rade." This concept is som et hing I would recom m end not only for t rading but for life in general. There's no reason why you have t o st ruggle and st rain and claw your way t hrough life. = = = = But if you are observing your life, you're not living it . I t sounds so det ached. = = = = That 's what a lot of people t hink, but it 's not like t hat at all. Think of life as a m ovie in which you'll see what you're seeing right now only one t im e. You'll never see it exact ly t he sam e way again. Absorb it ; be aware of it ; enj oy it . = = = = What advice would you have for people who feel st ressed out ? = = = = First , keep t hings in perspect ive. The universe is overwhelm ing. I t was here before you were born, and it will be her e aft er you die. I n t he general schem e of t hings, your problem s are not t hat im port ant . Also, it helps if you view your life as a m ovie. I f you go t o a video st ore and rent a horror m ovie, you're volunt arily

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112 let t ing yourself be horrified, and it 's not st ressful because deep down you know it 's j ust a m ovie. What if you had t he sam e at t it ude about life? = = = = Earlier you m ent ioned t hat you envisioned yourself t rading for about fift y or sixt y years. Do you really expect t o cont inue t rading all t he way t hrough old age? Have you ever considered an earner ret irem ent once you reach som e specified m onet ary goal? = = = = Act ually, I briefly t oyed wit h t he idea of ret irem ent several years ago. My wife asked, " What would you do if you ret ired?" " Well, I would set up m y com put ers and quot e scr een at t he house," I answered. " I would do som e t r ading and spend m ost of t he t im e on research developing new syst em s. I would t ake som e t im e each m orning t o read t he Wall St reet Journal and ot her financial periodicals." My wife list ened pat ient ly and said, " That sounds exact ly like what you're doing right now. The only difference is t hat now you have a st aff t o back you up when you want t o go on vacat ion." Of course, she was right . I realized t hat I was really doing what I loved t o do and would be doing it anyway if I were ret ired. = = = = Your t rading approach is obviously heavily com put erized. I s it ent irely m echanical or do you st ill m ake som e discret ionary decisions when ent ering t rades? = = = = My int uit ive feelings about t he m ark et s are probably right m ore oft en t han t hey are wrong. However, having observed m yself as I do, I not ice t hat som et im es t he t rading signals t hat I 'm int uit ively m ost nervous about t urn out t o be t he best t r ades. Therefore, ov er t he long r un, I t hink m y perform ance is best ser ved by following m y syst em s unquest ion- ingly. There's anot her aspect t o why I prefer a purely syst em at ized approach. I find t hat using syst em s get s t he m onkey off your back. I f you lose m oney t oday, it 's not your fault ; it 's t he syst em t hat had t he pr oblem . There is an elem ent of disa- ssociat ion involved. Even t hough you designed t he syst em , you st art t aking losses less personally. At least t hat 's what happened t o m e. Once I was fully com put erized, I found t hat I was less and less em ot ionally involved in each t rade. I now have m uch m ore t im e available t o pursue a variet y of work proj ect s and personal int erest s because I 'm not t ied t o a quot e m achine wat ching every t ick go up and down. I n t he process, life has becom e m uch m ore fun. = = = = I f you were st art ing out as a t rader t oday, knowing what you know now, what would you do different ly t han t he first t im e around? = = = = I st art ed out by worrying about t he syst em I was going t o- use t o t rade. The second fact or I worked on was risk m anagem ent and volat ilit y cont rol. The t hird area I focused on was t he psychology of t rading. I f I had it t o do over again, I would reverse t he process com plet ely. I t hink invest m ent psychology is by far t he m ost im port ant elem ent , followed by risk cont rol, wit h t he least im port ant considerat ion being t he quest ion of where you buy and sell. I f t here is a single t hem e t hat keeps recurring in t his volum e, as it did in Market Wizards, it is t hat psychology is crit ical t o success at t r ading. Cert ainly t his idea is repeat ed st rongly in t he Basso int erview . However, t here is a m ore im port ant lesson here: I n order t o achieve success in life, you m ust have t he right m ent al at t it ude, wit hout which success in t rading is a Pyrrhic vict ory. I f t rading ( or any ot her j ob or endeavor) is a source of anxiet y, fear, frust rat ion, depression, or anger, som et hing is wrong- even if you are successful in a convent ional sense, and especially if you are not . You have t o enj oy t rading, because if t rading is a source of negat ive em ot ions, you have probably already lost t he gam e, even if you m ake m oney. Basso is far from being t he m ost successful t rader I have int erviewed in t erm s of perform ance st at ist ics, but he is probably one of t he first I would choose as a role m odel. Essent ially, adopt ing such a m odel im plies t he following prescript ion: Com bine your ent husiasm , energy, focus, devot ion, and discipline t o becom ing t he best t rader you can be, but once you have done t hat , t here is no point in agonizing over t he det ails. Maint ain t he perspect ive of viewing unfolding m arket event s as you would view a m ovie. Don't worry about t he adverse m ar ket m oves if you've got it right in a long- t erm sense. And if you haven't yet developed a fully sound approach, t hen leam from your losses and view t hem as t uit ion for t rading lessons ( alw ays m aking sure you never risk m ore t han you can afford t o lose) . Basso's advice t o view your life as a m ovie m ay sound passive on t he print ed page, but t hat is not t he feeling t hat com es across on a personal level. Basso is suggest ing t hat you enj oy and experience your life wit h t he sam e involvem ent and int ensit y you would an engrossing m ovie, but at t he sam e t im e, m aint ain t he sense of perspect ive you would have if you were wat ching a m ovie. Don't t ake your problem s t oo personally. The universe will st ill be t here t om orrow.

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113 Linda Bradford Raschke: Reading the Music

of the Markets

Linda Bradford Raschke is so serious about t rading t hat she t raded right t hrough t he last day of her pregnancy. " You didn't t rade while you were in labor?" I asked her half- j okingly. " Well, no," she said, " but t hen again, it was four A. M. and t he m arket s weren't open. I did, however, put on a t rade about t hree hours aft er I gave birt h t o m y daught er. I was short som e currency cont ract s t hat were ex piring t hat day. I t seem ed like such a good t rade t hat I couldn't bring m yself t o give up t he opport unit y of rolling t he posit ion over int o t he next cont ract m ont h." As I said, Linda Raschke is very serious about her t rading. Raschke knew t hat she want ed t o be involved in t he m arket s from an early age. When she was unable t o land a j ob as a st ockbroker aft er graduat ing from college, she got int o t he rout ine of hanging out on t he floor of t he Pacific Coast St ock Exchange ev ery m orning before work. Alt hough t he driving m ot ivat ion for her daily visit s t o t he exchange floor was her fascinat ion wit h t he m arket s, t his rout ine event ually led t o an opport unit y t o becom e a t rader. One of t he exchange locals befriended Raschke and t aught her t he basics of opt ions. I m pressed by Raschke's ent husiasm and quick abilit y t o grasp m ar ket concept s, he provided her wit h a t rading st ake. Raschke spent six years as a floor t rader, init ially at t he Pacific Coast St ock Exchange and t hen at t he Philadelphia St ock Exchange. Wit h t he except ion of one cat ast rophic event early in her t rading career, Raschke m ade m oney st eadily as a floor t rader. I n lat e 1986, when inj uries suffered in an accident forced Raschke t o t rade from an office, she discover ed t hat she m uch preferred off- t he- floor t rading. Thereaft er, she set up her t rading office at hom e. Alt hough m any floor t raders who t ry t o m ake t he t ransit ion t o office t rading encount er m aj or difficult ies in t he first year of t he changeover, Raschke's first year off t he floor was act ually her best ever. She cont inued t o be a consist ent ly profit able t rader in subsequent years. When I first m et Linda Raschke, I was im pressed by her ebullient dem eanor. I was shocked when she t old m e t hat she was suffering from Epst ein- Barr Syndrom e- a m alady whose hallm ark sym pt om is chronic loss of energy. " What you don't know," she said, " is t hat I have spent t he bet t er par t of t he past four days rest ing t o build up enough ener gy t o m ake t his t rip." ( Alt hough I had offered t o t ravel t o her hom e t o do t he int erview , Raschke want ed an excuse t o m ake a day t rip t o New York.) Even so, I could hardly im agine what she m ust be Uke when she is fully healt hy. Raschke believes t hat she cont ract ed her ailm ent because she had j ust pushed herself t oo farsim ult aneously t rading full- t im e, t aking care of an infant , dealing wit h hordes of workers as her hom e was being rem odeled, and act ively pursuing her hobby of t raining and riding horses. Raschke even m anages t o be upbeat about her illness. " I feel a t rem endous am ount of good has com e out of t his," she explains. " I nst ead of t rying t o cram in everyt hing before I t urn t hirt y- five, I now realize t hat at t hirt y- t hree I 'm st ill really young and t hat I have m any years of great opport unit ies ahead of m e." The first few hours of t he int erview were conduct ed at m y office. We t hen cont inued our conversat ion at a local Wall St reet area rest aurant . I kept eyeing m y wat ch and hast ening our conversat ion along t hroughout dinner, because I was aware t hat m issing her next scheduled bus hom e would m ean a four- hour wait . Alt hough Raschke seem ed relaxed and unconcerned, I didn't want t o be responsible for her being st randed at Port Aut horit y Bus Term inal for t hat lengt h of t im e. There are far bet t er places t o spend four hours ( a Turkish prison, t o nam e only one) . = = = = When did you first get involved wit h t he m arket s? = = = = My fat her loved t o t rade t he m arket s, alt hough he never m ade any m oney at it . Being t he oldest of four children, I was enlist ed t o help him leaf t hrough hundreds of st ock chart s, looking for som e specific t ypes of pat t erns. My first real involvem ent in t he m arket s cam e when I at t ended Occident al College. The school had a program wherein t en st udent s were select ed each year t o m anage a t rust set up by an anonym ous donor. = = = = What did you know about t he m arket s at t hat t im e? = = = = Not m uch. We m ade decisions based alm ost st rict ly on fundam ent als. Anyone m t he group could com e up wit h an idea, and it would be im plem ent ed if approved by t he m aj orit y. = = = = What did you leam from t hat experience? = = = = I j ust learned t hat it was an awful lot of fun. = = = = Did you get a m arket - relat ed j ob aft er finishing college? = = = = Aft er graduat ing college, I went up t o San Francisco t o t ry t o find a j ob as a st ockbrok er. I m ust have applied t o every brokerage firm in t he cit y, and I was t urned down by all of t hem . They didn't t ake m e seriously. To t hem , I was j ust a young kid who had graduat ed college. I was repeat edly t old t o com e back in four or five years. I finally ended up t aking a j ob as a financial analyst wit h Crown Zeilerbach, a paper com pany. As fat e would have it , m y office was only t wo blocks away from t he Pacific Coast St ock Exchange. Since I didn't have t o be at work unt il 8: 30 and t he exchange opened at 7: 30,1 st ar t ed spending t he first hour of m y day at t he exchange. = = = = What did you do t here? = = = = I j ust wat ched what was going on. Aft er a while, people not iced I was t here, and som e of t hem went out of t heir way t o explain t hings. One t rader ex plained t he pricing of opt ions t o m e, and I t hought , " Gee, I can do t hat ." I t didn't sound like such a big deal. The t rut h is t hat once you get down on t he t rading floor, you find t hat t he t raders com e from all walks of life. You don't have t o be a rocket scient ist t o be a t rader. I n fact , som e of t he best t raders whom I knew down on t he floor were surf bum s. Form al educat ion didn't really seem t o have m uch t o do wit h a person's skill as a t rader.

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114 = = = = How did your t ransit ion from observer t o part icipant com e about ? = = = = The person who had explained t he basics of t he opt ions m arket t o m e t hought t hat I would m ake a good t rader and offered t o back m e. At t he t im e, I was applying t o graduat e schools t o get an M.B.A. I t hought t o m yself, " I can eit her go t o business school t o get m y M.B.A., or I can t rade on t he floor of t he st ock exchange- hm m , which do I want t o do?" I t wasn't a hard decision. = = = = On what basis was he willing t o back you as a t rader? = = = = What has im pressed m e about ot her people whom I have ended up t raining or backing is t heir level of int erest . I f som eone has a st rong enough int erest or desire, it usually overcom es ot her obst acles. I t hink he was im pressed wit h m y int erest in t he m arket s. = = = = How big a st ake did he give you? = = = = As was st andard procedur e for t raders backing ot her t raders, we set up a part nership, in which I was t he general part ner and he was t he lim it ed part ner. He put up $25,000, wit h t he agreem ent calling for a 50/ 50 split of t he profit s. = = = = How were you m aking your t rading decisions? = = = = I would j ust buy opt ions t hat were underpriced or sell opt ions t hat wer e overpriced and hedge t he posit ions wit h ot her opt ions or st ock. = = = = Wasn't it difficult for you as a novice t o be com pet ing wit h m ore experienced brokers t rying t o do t he sam e lypes of t rades? = = = = No, t he opt ions m arket w as j ust incredibly inefficient in t he early 1980s. You didn't really need an I Q over 100 t o m ake m oney. Aft er m y first t hree m ont hs, I had m ade about $25,000. Around t hat t im e, I got involved in selling calls on Cit ies Service, because t he opt ions were overpriced. And why were t hey overpr iced? Because t he st ock was a t akeover candidat e. = = = = Did you know t hat at t he t im e? = = = = Oh sure. = = = = But did you know how t o fact or t hat sit uat ion int o t he price? = = = = I t hought t hat I did. At t he t im e, t he st ock was t rading at $32. At t he prices at which I was able t o sell t he opt ions, I knew I would be okay as long as t he st ock price didn't go above $55. Unfort unat ely, t he t akeover was announced t he aft er noon before t he opt ions expired, and t he st ock j um ped from about $34 t o $65. Suddenly, I discovered t hat you could lose $80,000 overnight . = = = = So overnight you lost all your profit s and your init ial st ake, and you were st ill in t he hole for $30,000. Who was responsible t o m ake up t hat deficit ? = = = = I was, since I was t he general part ner. = = = = Do you rem em ber your em ot ional response at t he t im e? = = = = I t wasn't so bad em ot ionally, because I had seen ot her t raders around m e lose m uch gr eat er am ount s in sudden t akeover sit uat ions. They were able t o survive aft er t aking hit s of several m illion dollars. I n com parison, m y sit uat ion didn't seem t hat ext rem e. Also, I felt t hat in any business where you could lose m oney t hat quickly, you had t o be able t o m ake it back. I t alm ost sounds as if you were able t o shrug it off. I don't want t o m ake light of t his experience, because it was int im idat ing being faced wit h a m ount ain of debt at t he age of t went y- t wo. I n fact , I st ill had $10,000 in debt left over from college st udent loans. Fort unat ely, 1 was able t o find anot her backer, and everyt hing worked out . Overcom ing t hat experience gave m e t he confidence t hat I could overcom e anyt hing t hat m ight happen in t he fut ure. = = = = How did you do aft er t hat point ? = = = = I m ade m oney st eadily. = = = = What m ade you decide t o abandon floor t rading for t rading from an office? = = = = I n lat e 1986, I had a bad horse riding accident . I fract ured m y ribs, punct ured m y lung, and dislocat ed m y shoulder. I found it physically very uncom fort able t o st and on t he floor. That was t he first rim e I st art ed sit t ing upst airs and t rading off a quot e m achine. I t hought it was great ! Ther e were all t hese indicat ors and different m arket s I could wat ch at t he sam e t im e. Over t im e, I evolved m y own t rading st yle in t he S&P fut ures. = = = = What is your t rading st yle? = = = = My niche is short - t erm t rading, which is how I m ake m y bread and but t er. The occasional long- t erm t rades are frost ing on t he cake. I believe t hat only short - t erm price swings can be predict ed wit h any precision. The accuracy of a predict ion drops off dram at ically, t he m ore dist ant t he forecast t im e. I 'm a st rong believer in chaos t heory. [ A basic concept of chaos t heory is t hat for aperiodic syst em s- i.e., syst em s t hat never exact ly repeat t hem selves and hence nev er find a st eady st at e, such as weat her or t he m arket s- slight differences in variable values or m easurem ent s can be m agnified t o have huge effect s over increasing., periods of t im e. The t echnical nam e for t his phenom enon- sensit ive dependence on init ial condit ions- has becom e bet t er known as t he But t erfly Effect . As Jam es Gleick described it in his excellent book, Chaos: Making a New Science, " I n weat her, for exam ple, t his t ranslat es int o what is only half- j okingly known as t he But t erfly Effect - t he not ion t hat a but t erfly st irring t he air t oday in Peking can t r ansform st orm syst em s next m ont h in New York." ] There are t oo m any unpredict able t hings t hat can happen wit hin t wo m ont hs. To m e, t he ideal t rade last s t en days, but I approach every t rade as if I 'm only going t o hold it t wo or t hree days.

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115 I 'm also a firm believer in predict ing price direct ion, but not m agnit ude. I don't set price t arget s. I get out when t he m arket act ion t ells m e it 's t im e t o get out , rat her t han based on any considerat ion of how far t he price has gone. You have t o be willing t o t ake what t he m arket gives you. I f it doesn't give you very m uch, you can't hesit at e t o get out wit h a sm all profit . I put a great deal of effort int o get t ing t he best ent ry price possible. 1 feel t his is probably one of m y st rongest skills. I n day t rading, a good ent ry price is crit ical because it buys you t im e t o see how t he m arket will react . I f you buy because you t hink t he m arket should bounce, but it only goes sideways, you'd bet t er get out . Part of t he t rading process is a m at t er of t est ing t he wat er. I f your ent ry t im ing is good enough, you won't lose m uch even when you're wrong. Som e of t he best t r ades com e when ev eryone get s very panicky. The crow d can oft en act very st upidly in t he m arket s. You can pict ure price fluct uat ions around an equilibrium level as a rubber band being st ret chedif it get s pulled t oo far, event ually it will snap back. As a short - t erm t rader, I t ry t o wait unt il t he rubber band is st ret ched t o it s ext rem e point . = = = = How do you det erm ine when t he m arket is near such an ext rem e? = = = = One of m y favorit e pat t erns is t he t endency for t he m arket s t o m ove from relat ive lows t o relat ive highs and vice versa every t wo t o four days. This pat t ern is a funct ion of hum an behavior. I t t akes several days of a m arket rallying before it looks really good. That 's when everyone want s t o buy it , and t hat 's t he t im e when t he professionals, like m yself, are selling. Conversely, when t he m arket has been down for a few days, and everyone is bearish, t hat 's t he t im e I like t o be buying. I also t rack different indicat ors. I don't t hink t he specific choice of indicat ors is t hat crit ical, as long as you have a good feel for int erpret ing t he indicat ors t hat you use. Personally, I pay close at t ent ion t o t he t ick [ t he difference bet ween t he num ber of issues whose m ost recent t ick was up and t hose whose m ost recent t ick was down] , TRI N [ a m easure t hat relat es t he price and volum e of advancing issues t o t he corresponding figures for declining issues] , and prem ium [ t he prem ium , or discount , of st ock index fut ures t o t he t heoret ically equivalent cash index price] . For exam ple, if t he t ick is at an ext rem e level and falling- - 480, 485, - 490, - 495- and t hen j ust pauses- - 495, - 495, - 495- and t he ot her indicat ors I wat ch are also oversold, I 'll oft en go in and buy at t he m arket . Som et im es, I 've act ually bought t he low t ick of t he day using t his m et hod. I really have no fear of buying int o breaks or selling int o rallies. Sure, once in a while t he m arket will keep on going, and I 'll im m ediat ely be dow n a full point or m ore on t he S&P. However, by wait ing for a sufficient ext rem e, even in such sit uat ions, t he m arket will oft en snap back enough t o let m e out near even. Perhaps m y num ber one rule is: Don't t ry t o m ake a profit on a bad t rade, j ust t ry t o find t he best place t o get out . = = = = So when you have a bad t rade, you don't dum p it im m ediat ely. = = = = That 's right . I find t hat I can usually get out at a bet t er price if I have a lit t le pat ience, since t he r eason I got int o t he t rade in t he first place was because t he m arket was so overdone t hat a react ion seem ed ov erdue. Once I 'm out , it 's easy for m e t o get back in. I f I buy back at a higher price, I j ust look at it as a fresh t rade. = = = = When did you set up your hom e t rading office? = = = = About t hree m ont hs aft er leaving t he floor. = = = = Aft er spending years surrounded by people on t he floor,, did you find it difficult t o adj ust t o t he isolat ion of t rading from hom e? = = = = For t he first four years, being off t he floor was great - no dist ract ions, no out side opinions. Last year, however, t he isolat ion st art ed t o really bot her m e. I got lonely. I t ried t alking t o ot her t r aders on t he phone during. t he day, but I found t hat it was dist ract ing and lowered m y product ivit y. I also t ried est ablishing a t rading office wit h anot her t rader, which worked great for a w hile unt il he left t o est ablish a t rading operat ion in New York. And I t ried hiring an assist ant , but it didn't add t o m y bot t om line. Now I t ry t o deal wit h t he isolat ion by scheduling proj ect s out side of t he t rading day in order t o keep m e involved wit h t he out side world. F m a m em ber of t he Market Technicians Associat ion and I t ry t o at t end every m eet ing. I have also worked wit h a program m er t o develop neural net work t rading indicat ors, which I 'm now using as a m arket t ool. [ A key charact erist ic of neural net work program s is t hat t hey are not st at ic; rat her, t hey evolve as t hey " leam " from t he dat a.] This proj ect has also led t o lot s of calls t o ot her people across t he count ry w ho are working on applying neural net works t o t rading. I recognize t hat isolat ion has becom e a problem , and I keep on t rying t o find different solut ions. I t hink t hat event ually I m ight like t o have one or t wo t raders sharing m y office again. = = = = Since you're prim arily a t rader of st ock index fut ures, I 'm curious about what your experiences were during t he incredible crash of Oct ober 1987. = = = = I ronically, I st opped t rading about a m ont h before t he crash. I had a phenom enal year up t o t hat point , m aking m ore t han half a m illion dollars, which was nearly t wice as m uch as I had m ade t he year before. I couldn't believe how well I was doing. I had caught all t he m aj or m arket swings. I had a feeling t hat I had j ust been t oo hot and shouldn't press m y luck anym ore. At t he sam e t im e, I had t he opport unit y t o apprent ice wit h a horse t r ainer whom I had been working wit h. I decided t hat it would be a good t im e t o t ake a t rading hiat us. = = = = So you weren't involved in t he m arket at t he t im e of t he Oct ober 1987 crash? = = = = Not exact ly. I had no posit ions at t he st art of t hat week. However, during t he period in which I had st opped t rading, I called m y husband ( he's a m arket m aker on t he Philadelphia St ock Exchange) each m orning t o find out what was happening in t he m arket s. When I called him from t he st ables t hat m orning, he

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116 said, " You'd bet t er get hom e and wat ch t his day! All t he world m arket s have crashed, and it looks like t he Dow Jones is going t o open 200 point s lower! " When I hear d t hat , I t hought t o m yself, " Boy, t his is great . This is t he buying opport unit y I 've been wait ing for." I rushed hom e and t urned on t he news. Everyone was t alking panic, panic, panic. Silly old cont rarian m e is t hinking, " This is t errific. Let 's see how low we can open t he m arket ." As you recall, t he m arket kept plum m et ing all t hrough t he day. I had t o force m yself t o hold back from buying. Finally, in t he early aft er noon, I couldn't wait any longer. I bought one S&P fut ures cont r act . I n t he final hour of t rading, I kept on buying, as t he m arket m oved lower. By t he end of t he day, I was long t en cont ract s. = = = = When t he m arket closed, were you down for t he day? = = = = Oh sure. The m arket closed near it s lows. I was down about a $100,000. = = = = Did t hat bot her you? = = = = No, not really. Of course, I was a lit t le annoyed wit h m yself for not being m ore pat ient , because I could have got t en a bet t er av er age price if I had wait ed. However, I really wasn't concerned about t he init ial loss on t he posit ion. The fut ures m arket was at such a large discount relat ive t o t he cash st ock index t hat I was sure it would open higher t he next day, which it did. = = = = Did you get out on t he higher opening? = = = = I t ook profit s on only part of t he posit ion. My plan was t o st ay long. I t hought t hat we had seen such a level of st upidit y in t he m arket , wit h people virt ually t hrowing away st ocks t hat had value, t hat I felt it j ust had t o be a selling exhaust ion point . As one exam ple, I rem em ber when I first went dow n t o t he floor of t he Philadelphia St ock Exchange, Salom on Brot hers st ock was t rading at $32. I t event ually ran up t o over $60. Here it was on t he day of t he crash down t o $22. To m e, it seem ed ridiculous t hat people were pricing st ocks t hat way. = = = = You m ake it sound like you com plet ely shrugged off t he panic t hat engulfed t he m arket s t hat week. ==== I don't t hink I underest im at ed t he risk of t he t rade when I bought t en S&P fut ures on t he day of t he cr ash. However, in ret rospect , I cert ainly was naive in having fait h t hat t he m ar ket s, clearing firm s, and bank s would cont inue t o funct ion. The subsequent realizat ion t hat if t he Fed had been less aggr essive, m y clearing firm , along wit h m any ot hers, could have gone bank rupt , oblit erat ing m y account equit y in t he process, really shook m e up. = = = = Does it ever bot her you when you lose? = = = = Not at all. I t never bot her ed m e t o lose, because I always knew t hat I would m ake it right back. I always knew t hat no m at t er what happened, I could go int o any m arket place, wit h any am ount of m oney, and m ake a living. = = = = Could you describe t he m ist akes you've m ade in your t rading career t hat served as learning experiences? = = = = My own part icular weakness has always been being a bit prem at ure on ent er ing posit ions. As t he saying goes, " The pioneers are t he ones wit h t he arrows in t heir backs." I 've learned t o t hink t o m yself, " Pat ience, pat ience, pat ience." I t ry t o wait unt il t hings set up j ust right before I t ake a t rade. Then, when I 'm ready t o t ake t he t rade, I slowly count t o t en before I pick up t he phone. I t 's bet t er t o have t he wrong idea and good t im ing t han t he right idea and bad t im ing. Anot her m ist ake I 've frequent ly m ade is part icipat ing in t oo m any m arket s at one t im e, which leads t o sloppy t rading. I 've also found t hat it 's m y sm allest posit ions t hat cause m y biggest losses, because t hey t end t o be neglect ed. I t 's nat ural t o be caut ious and at t ent ive t o big posit ions. Wit h t he sm all posit ions, it 's easy t o fall int o t he t rap of being com placent . My awareness of t his pit fall has m ade m e m ore careful wit h such posit ions. I realize t hat I 'm only hum an, and t hat I 'll always m ake m ist akes. I j ust t ry t o m ake t hem less frequent ly, recognize t hem fast er, and correct t hem im m ediat ely! = = = = What percent age of your t rades are profit able? = = = = About 70 per cent . = = = = I s your average winner also larger t han your average loser? = = = = On m y short - t erm t rades, on a per cont ract basis, m y average win is about $450 ( t he figure would be higher if I included longer- t erm t rades) , and m y average loss is j ust over $200. = = = = Wit h bot h t he percent age and average m agnit ude of your winning t rades out dist ancing t he losers by a bet t er t han t wo- t o- one rat io, it sounds like you would be profit able in every m ont h. = = = = Every m ont h! My philosophy is t o t ry t o be profit able every day! Of course, I don't quit e achieve t hat consist ency, but t hat 's m y goal. I 'm probably profit able nearly every week. Rem em ber, I do t his for a living, and I use m y own m oney. I really value t he fact t hat I 've learned t o t rade as a craft . Like any craft , such as piano playing, perfect ion m ay be elusive- I 'll never play a piece perfect ly, and I 'll never buy t he low and sell t he high- but consist ency is achievable if you pract ice day in and day out . = = = = I assum e t hat , in part , your consist ency can be at t ribut ed t o t he int ensit y wit h which you follow t he m arket s. When you described your t rading earlier, it sounded like you virt ually followed a m arket t ick by t ick* I assum e t his t ype of approach m ust lim it t he num ber of m arket s you can t rade. How m any m arket s do you follow at one t im e? = = = = I t varies. I analyze t went y m arket s. But at any given t im e, I t rade no m ore t han about six m arket s.

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117 I deally, I would like t o t rade every m arket , every day, but I know t hat 's physically im possible. = = = = Couldn't you t rain assist ant s t o apply your m et hodologies t o t he m arket s you can` t wat ch? = = = = I 've t ried t hat . I hired and t rained som eone for a year. He was t he nicest per son you could hope t o m eet . Any organizat ion would have been proud t o have him as an em ployee. He was ext rem ely hardworking and loyal. He was in perfect physical shape- he at e well and pract iced karat e ev ery day. Em ot ionally, he was on such an ev en keel t hat I never once saw him get angry at anyone. I put a lot of t im e and effort int o t raining him . I even gave him his own account , because I t hought t hat t he only way he could learn t o t rade was by doing it . Unfort unat ely, it didn't work out . = = = = What went wrong? = = = = He didn't seem t o have any passion for t rading. He couldn't pull t he t rigger. I t hink he didn't like t he idea of t aking risks. [ Linda describes a t ypical conversat ion wit h her assist ant : ] " OK, St eve, what 's your gam e plan for t oday?" " I t hink I 'm going t o buy wheat t oday," he says, explaining his reasons for t he t rade. 'That 's gr eat ! " I say, t rying t o encourage him . At t he end of t he day, I ask him , " Did you buy t he wheat ?" " No," he answers. " Well, what did you do?" " I wat ched it go up." [ She laughs wholeheart edly at t he recollect ion.] = = = = Why do you believe you have excelled as a t rader? = = = = I believe m y m ost im port ant skill is an abilit y t o perceive pat t erns in t he m arket . I t hink t his apt it ude for pat t ern recognit ion is probably relat ed t o m y heavy involvem ent wit h m usic. Bet ween t he ages of five and t went y- one, I pract iced piano for sever al hours every single day. I n college, I had a dual m aj or of econom ics and m usical com posit ion. Musical scores are j ust sym bols and pat t erns. Sit t ing t here for hours every day, analyzing scores, probably helped t hat part of m y brain relat ed t o pat t ern recognit ion. Also, pract icing an inst rum ent for several hours every day helps develop discipline and concent rat ion- t wo skills t hat are very useful as a t rader. = = = = Could you elaborat e som e m ore on t he parallels bet ween m usic and t he m arket s? = = = = A m usical piece has a definit e st ruct ure: t here are repeat ing pat t erns wit h variat ions. Analogously, t he m arket s hav e pat t erns, which repeat wit h variat ions. Musical pieces have quiet int erludes, t hem e developm ent , and a gradual crescendo t o a clim ax. The m arket count erpart s are price consolidat ions, m aj or t rends, and runaway price m oves t o m aj or t ops or bot t om s. You m ust have pat ience as a m usical piece unfolds and pat ience unt il a t rade set s up. You can pract ice, pract ice, pract ice, but you're never going t o play a m usical piece per fect ly, j ust as you're nev er going t o buy t he low and sell t he high on a t rade. All you can hope t o do is t o play a piece ( or t rade) bet t er t han before. I n bot h m usic and t rading, you do best when you're relaxed, and in bot h you have t o go wit h t he flow. A fm al analogy m ay explain t he t ype of t rading I 've gravit at ed t oward. You m ust be able t o read individual not es and learn a piece of m usic m easure by m easure before you can play t he whole piece t hrough. Perhaps t hat 's why I spend m ost of m y energy on short - t erm t rades rat her t han analyzing t he long- t erm pict ure. = = = = There are so few full- t im e wom en t raders. Do you believe t here are any obst acles t o wom en t rying t o get int o t he field? = = = = I have som et im es felt t hat I had t o work t wice as hard t o gain respect or t o be t aken seriously. But , quit e honest ly, t hat percept ion was probably based on m y own beliefs rat her t han grounded in realit y. I n ret rospect , I don't t hink t hat being a wom an has ever really hindered m e. I n fact , if anyt hing, it som et im es seem ed t hat people m ade an ext ra effort t o be helpful t o m e, perhaps because t here are so few wom en t raders. Of course, t here m ay be pocket s in t he indust ry in which wom en do encount er barriers- for exam ple, t he large New York inst it ut ional firm s and banks. I have known wom en who felt t hat sexism int erfered wit h t heir abilit y t o land a j ob on a t rading desk. But , again, I have never personally encount ered such difficult ies. I would st rongly encourage wom en who have t he confidence t o becom e t raders t o m ake t he effort . There is no reason for wom en t o feel any fear s of int im idat ion. Trading, m ore t han any ot her field, is a bot t om - line business. People look at your perform ance num ber s. They don't care if you're a m an or a wom an. I f you perform well, you'll get financial backing. Conversely, if you're incom pet ent as a t rader, j ust being a m an is cert ainly not going t o help. Wom en m ay also have int rinsic advant ages over m en as t r aders. For exam ple, wom en are less likely t o use t rading as an ego t rip. They aren't prone t o m aking t he m acho- t ype t rades [ put t ing on a large posit ion wit h t he int ent of feeling a sense of power in m oving t he m arket ] , which I have seen lead t o t he financial ruin of a num ber of m ale t raders. Even t he largest wom en t raders I know t end t o be very low- key, alm ost reserved, as t raders. = = = = Are t here any ot her differences bet ween w om en and m en as t raders? = = = = Wom en m ay be m or e int uit ive. I cert ainly feel t hat I can see pat t erns t hat ot her people can't , but I don't know if t hat 's because I 'm a fem ale. 1 t hink it 's oft en m ore accept able for a wom an t o rely on int uit ion t han it is for a m an t o do so, and int uit ion cert ainly com es int o play in t rading. For exam ple, when I 'm wat ching t he price quot es, I never say som et hing like, " Oh, t he m arket is down exact ly 62 percent , I have t o buy right here." Rat her, I m ight t hink, " Gee, it looks like we've cor rect ed enough and t he price has st opped going

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118 down, so I 'd bet t er buy." = = = = I n our init ial phone conversat ion, you m ent ioned t hat you've shared y our t rading m et hods wit h ot her t raders. Aren't you concerned t hat revealing your approach could dest roy it s effect iveness as ot her people st art t o use it ? = = = = I t ruly feel t hat I could give away all m y secret s and it wouldn't m ake any difference. Most people can't cont rol t heir em ot ions or follow a syst em . Also, m ost t raders wouldn't follow m y syst em , even if I gave t hem st ep- by- st ep inst ruct ions, because m y approach w ouldn't feel right t o t hem . They wouldn't have t he sam e confidence or com fort in t he t rading m et hod as I do. But for argum ent 's sake, let 's say t hat showing m y m et hods t o ot her t raders did event ually cause som e of t he pat t erns t hat I follow t o change. I f t hese pat t erns changed, new ones would be creat ed, and I 'm confident t hat I would find t hem . = = = = What advice would you give novice t raders? = = = = Underst and t hat learning t he m arket s can t ake years. I m m erse yourself in t he world of t rading and give up everyt hing else. Get as close t o ot her successful t raders as you can. Consider working for one for free. St art by finding a niche and specializing. Pick one m arket or pat t er n and leam it inside out before expanding your focus. My favorit e exer cise for novice t raders is pick one m arket only. Wit hout looking at an int raday chart , j ot down t he price every five m inut es from t he opening t o t he close. Do t his for an ent ire week. Be in t une t o t he pat t erns. Where ar e t he support and resist ance levels? How does price act when it hit s t hese levels? What happens dur ing t he last half- hour? How long does each int raday price m ove last ? You won't believe how m uch you can leam from t his exercise. Never fear t he m arket s. Never fear m aking a m ist ake. I f you do m ake a m ist ake, don't com plicat e t he posit ion by t rying t o hedge it - j ust get out . St ay act ively involved wit h t he m arket . Don't j ust sit passively in front of a m onit or, or sim ply st are at chart s. Not ice how m any old- t im ers who have been successful for years st ill const ruct t heir own point - andfigure chart s by hand int raday. They keep t he sam e rout ine day aft er day. Develop your own rout ine for t aking periodic m arket readings. Never be gr eedy. I t 's OK t o leave m oney on t he t able. I f you can't get in at a favorable price, let t he t rade go and st art looking for t he next t rade. Finally, rem em ber t hat a t rader is som eone who does his own work, has his own gam e plan, and m akes his own decisions. Only by act ing and t hinking independent ly can a t rader hope t o know when a t r ade isn't working out . I f you ever find yourself t em pt ed t o seek out som eone else's opinion on a t rade, m at 's usually a sure sign t hat you should get out of your posit ion. = = = = What are your goals? = = = = There's no bet t er sat isfact ion t han playing a piece well, whet her t he inst rum ent is a piano or t he m arket s. I m easure m y progress not in dollars but in m y skill in predict ing m arket pat t erns- t hat is, in how close I can com e t o pinpoint ing m y ent ries and exit s t o t he m arket t urns. I believe t hat I can go int o any m arket wit h j ust a quot e m achine and out - t rade 98 percent of t he ot her t raders. Over t he next t en years, I would like t o significant ly st ep up m y t rading size. I really believe t hat I can becom e one of t he best t raders around. Cert ainly one of t he prim ary com m on charact erist ics I have found am ong t he great t raders is an alm ost com pelling sense of confidence in t heir abilit y t o succeed. Linda Raschke per sonifies t his t ype of confidence as well as any t rader I have int erviewed. There is not t he slight est doubt in m y m ind t hat she could st art over in any m arket wit h m inim al funds and excel. She t ruly believes t hat she will becom e one of t he best t rader s ever, and I for one cert ainly wouldn't t ake t he ot her side of t hat bet . Are t raders like Raschke confident because t hey succeed, or do t hey succeed because t hey are confident ? Probably a lit t le bit of bot h. However, t he key point is t hat exuberant confidence appears t o be one of t he essent ial elem ent s in except ional achievem ent as a t rader, and I assum e in m any ot her endeavors as well. Occasionally, an int erview provokes m e t o reassess m y view of realit y. I have long assum ed t hat m arket s m ight be predict able over t he long t erm but t hat short - t erm price m ovem ent s are largely random . Raschke holds exact ly t he opposit e point of view. She believes t hat in t he m arket s, m uch as in weat her forecast ing, short - t erm predict ions can be quit e accurat e but long- t erm forecast ing is a virt ual im possibilit y. Wit h her abilit y t o see pat t erns t hat ot hers don't , she has been able t o t rade short - t er m price swings wit h a consist ency t hat would defy die laws of probabilit y, if indeed t here were no pat t erns in t hese m ovem ent s. Raschke has m ade m e a believer. Clearly, t here are predict able m ovem ent s in price even over periods as short as a few days or a single day. Raschke rem inds us t hat t rader s are people who do t heir own work, m ake t heir own decisions. One part icularly insight ful observat ion m ade by Raschke is t hat t he t em pt at ion t o seek out ot her peoples' opinions on a t rade is a sure sign t hat t he t rade should be liquidat ed. Am ong t he charact erist ics t hat Linda Bradford Raschke cit es as essent ial t o being a good t rader ar e a passion for t rading, self- reliance in developing t rading ideas and m aking t rading decisions, t he w illingness t o t ake risk, t he abilit y t o correct m ist akes im m ediat ely ( because t hey are inevit able) , and pat ience, pat ience, pat ience.

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119 PART VI The Money Machines

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120 CRT: The Trading Machine You guys m ake m oney every day," said t he floor broker t o Mark Rit chie in a reference t o CRT ( Chicago Research and Trading) . His voice was a m ixt ure of envy, disgust , and adm irat ion. He was holding a long posit ion, and t he m arket had m oved locked lim it - down against him , in one of t he periodic painful set backs t hat are a bane t o even successful t rader s. The am azing t hing is t hat t he exasperat ed broker was exagger at ing only slighdy. CRT m ay not m ake m oney every day, but it is profit able virt ually every m ont h, if not every week. Think about t hat ! The st ory of CRT is one of t he m ost incredible in t he invest m ent world. A m ere fift een years ago, Joe Rit chie ( Mark's brot her) , t he firm 's founder and leading force, was so br oke t hat he had t o borr ow his brot her's wholesale suit t o visit t he Chicago Board of Trade. Today, Joe is t he helm sm an of a t rading com pany of eight hundred em ployees, including a prim ary dealer of governm ent securit ies, t hat has been est im at ed t o have garnered close t o $1 billion in t rading profit s. To gener at e t hat profit , Joe Rit chie est im at es t hat t he firm has done ov er $10 t rillion in t ransact ions. ( That 's t rillion like t he figures used t o describe t he t ot al U.S. debt - we're t alking big num bers here.) CRT doesn't go for hom e m ns. I t is in t he business of ext ract ing t he m any m odest profit opport unit ies t hat are cont inually creat ed by t he sm all inefficiencies in t he m arket place. Are opt ions on one exchange slight ly higher priced t han equivalent opt ions on anot her ex change? I f so, CRT uses it s st at e- of- t he- art inform at ion and execut ion capabilit ies t o buy t he opt ion t hat is low and sell t he one t hat is dear. Do opt ions in a given m arket provide a bet t er risk/ reward pr ofile t han t he underlying m arket ? Or vice versa? I f such a discrepancy exist s, CRT t rades one posit ion against t he ot her. There are lit erally hundreds, if not t housands, of variat ions on t his t hem e. CRT is const ant ly t racking approxim at ely sevent y- five different m arket s, t raded on ninet een worldwide exchanges, w it h sophist icat ed t rading m odels inst ant aneously signaling w hich financial inst rum ent s ar e relat ively underpriced and which are overpriced. Ot her m odels cont inuously evaluat e t he net risk of all t he firm 's posit ions, wit h t he goal being t o reduce net exposure as close t o zer o as possible. I n t aking advant age of t hese sm all profit opport unit ies and keeping net risk t o a m inim um , CRT has com e as close as any firm t o creat ing a successful t rading m achine. How does CRT operat e? Floor brokers have sheet s generat ed by t he firm 's propriet ary com put er m odels, t elling " t hem what price t hey can bid or offer for each opt ion at any given m arket price level. The calculat ed figures t ake int o account not only t he m at t er of det erm ining t he opt ion's value but also how t hat opt ion int errelat es wit h t he firm 's overall posit ion. For exam ple, if a given opt ion posit ion helps bring t he firm 's net risk exposure closer t o zero, t he indicat ed bid price for t hat opt ion m ight be skewed upwar d. The floor t raders are support ed by t eam s of upst airs t raders, who use t he firm 's com put er m odels t o m onit or t he im pact of fluct uat ing prices and t he firm 's const ant ly changing port folio on opt ion values. The upst airs t raders feed t he floor t raders a const ant st ream of updat ed inform at ion. On very volat ile t rading sessions, runners m ay bring t he floor t raders r evised com put er valuat ion sheet s as oft en as t went y t im es in one day. When t he floor t rader im plem ent s an opt ion t rade, he or she im m ediat ely offset s t he posit ions wit h an equivalent opposit e t rade in t he out right m arket . For exam ple, if a t rader sells T- bond 98 calls, he will buy t he equivalent am ount of T- bond fut ures t o count erbalance t he posit ion. This hedge is im plem ent ed inst ant aneously. As soon as t he floor t rader post s t he opt ion t rade, he hand signals an arbit rage clerk st anding on t he t op st ep of t he bond fut ures pit fift y feet away. Wit hin a second or t wo, a fut ures t rader has placed t he offset t ing order , and t he t ransact ion is com plet e. The init ial hedge placed m t he out right m arket virt ually elim inat es any significant near- t erm risk on t he posit ion. However, as t he m arket m oves, t he posit ion will becom e unbalanced. Once t he init ial t rade and offset t ing hedge are book ed, t he r esponsibilit y for m anaging t he posit ion is t ransferred t o an upst airs posit ion m anager. The j ob of t his m anager is t o keep t he risk exposure of t he firm 's const ant ly changing port folio as close t o zero as possible. CRT is so rigid about risk cont rol t hat it even has a backup risk cont rol group. The backup group assures t hat t he firm is always ready t o handle even t he m ost ext raordinary t rading event s ( e.g., t he Oct ober 1987 st ock m arket crash and huge price m ov es t riggered by t he out br eak of t he Persian Gulf War) . The com plexit y of m onit oring t he posit ions placed by hundreds of t rader s, reevaluat ing t housands of int errelat ionships bet ween different m arket inst rum ent s t raded worldwide, and t racking t he firm 's port folio risk balance cont inuously, all while prices and posit ions are changing every second, requires enorm ous com put er support . CRT has nearly an ent ire floor in it s office building devot ed t o com put ers. There are depart m ent s for developing new propriet ary soft ware, and t he firm even has it s own on- sit e hardware r epair unit . CRT's com put er soft ware program s are highly sophist icat ed. Bvery effort has been m ade t o t ranslat e dat a int o graphic displays, reflect ing t he belief t hat t he hum an m ind can draw inform at ion m uch m ore readily if it is in visual form . A new generat ion of CRT soft ware, which was in an advanced st age of developm ent when I visit ed t he com pany, provides t hree- dim ensional displays. These com put er im ages will allow t he t raders t o view t he firm 's real- t im e posit ion for an opt ion m arket across bot h a range of st rike prices and a range of expirat ion dat es in one pict ure, wit h different colors used t o represent different concent rat ions of posit ions. All t he high t ech aside, ask anyone at CRT about t he firm 's success, and t hey will t ell you t hat t eam wor k is t he key. I t m ay sound corny, but it is obviously an absolut ely essent ial elem ent of CRT's philosophy. You eit her buy int o t hat philosophy or you are in t he wrong place. Self- cent ered m averick t raders, no m at t er how t alent ed, need not apply.

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121 Here is how one form er CRT floor t rader ( who now handles a variet y of ot her roles) describes t he advant ages of CRT's t eam work approach versus t he sit uat ion at m ost ot her firm s: I f you have t he confidence t hat t he person upst airs is not going t o blam e you, it m akes life so m uch easier. When I worked on t he floor, I oft en saw scr eam ing m at ches bet ween people t rying t o m ake sur e t he blam e didn't get laid on t hem . The broker would blam e t he clerk; t he clerk would blam e t he person on t he ot her side of t he phone: and t he per son on t he phone would blam e t he cust om er. That never happened t o m e. When a five- hundred- lot order cam e int o t he pit , I knew I could use discret ion t o act on it right away, whereas m any of t he ot her t raders at com pet ing firm s would have t o first call upst airs t o get per m ission t o do anyt hing m ore t han a fift y- lot . Anot her CRT t rader echoed a sim ilar t hem e: Our com pet it ion has t raders in t he pit who on expirat ion day will hand t he clerk a $100 bill t o give t hem special at t ent ion. I don't have t o hand m y clerk a $100 bill. I let him know t hat I believe in him and t he . com pany values him . I get bet t er ser vice from m y clerk by m aking him feel t hat way t han t hat ot her broker does by handing his clerk a $100 bill. The t eam work philosophy also ext ends t o com pensat ion. As one em ployee describes it : " Joe is absolut ely com m it t ed t o sharing t he wealt h. I nst ead of t hinking about how lit t le he can pay people and get away wit h it , he seem s t o be m ore concerned about how he can split up t he profit s fairly." Mark Rit chie gave m e m y first perfunct ory t our of CRT, walking m e t hrough t he m ain t r ading floor. The workspaces appear ed very at t ract ive and com fort able. However, som et hing seem ed out of place. I t hought of t hose childhood puzzles wit h t he capt ion " What 's wrong wit h t his pict ure?" When we walked past t he recept ionist area, Mark was t old t hat he had a phone call holding. While he was on t he phone, t he nat ure of t he oddit y finally st ruck m e. The t rading floor was quiet ! I m ean, you m ight have t hought we had t oured t he offices of a universit y or law firm . The shout ing, t urm oil, act ivit y, anxiet y, st ress, cheering, swearing, and ot her assort ed noises and em ot ions t hat norm ally perm eat e a t rading floor were all m issing. CRT is a laid- back firm in m any ways t hat go beyond t he ext raordinary calm in which t rades are planned, m onit ored, and execut ed. No suit s and t ies here, unless of course t hat 's y our preference. Jeans and sport shirt s are t he com m on at t ire. There is a cafet eria in t he cent er of t he t rading floor, w hich is available t o all em ployees- and t he food is hom e- cook ed, not t he t ypical cafet eria variet y. There is even a lounge area on t he floor. Again, not your t ypical t rading operat ion. The following t wo chapt ers cont ain int erview s w it h t wo of CRT's init ial four founding m em ber s: Mark Rit chie and Joe Rit chie. Mark act ually drift ed aw ay from CRT years ago, preferring t o t rade on his own, unencum ber ed by addit ional m anagerial obligat ions. Joe's involvem ent wit h CRT, however, rem ains st rong. He is st ill t he firm 's prim ary visionary and guiding force, albeit t he responsibilit ies for t he day- t o- day operat ion of t he firm have been t ransferred t o a senior m anagem ent t eam . Alt hough Mark is no longer act ively involved wit h CRT, his int erview is placed first , m aint aining t he or der in which t he conver sat ions act ually Transpired.

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122 Mark Ritchie: God in the Pits The subt it le of t his chapt er is t aken from Mark Rit chie's aut obiographical book- a highly unusual blend of spirit ual revelat ions, exot ic experiences, and t rading st ories. I t cert ainly does not m ean t o im ply, however, t hat Rit chie believes he has deit y- like t rading prowess. On t he cont rary, t he t it le refers t o Rit chie's convict ions about t he presence of God t hat he perceives in his life. I t is hard t o im agine an educat ional background furt her rem oved from t rading- Mark Rit chie at t ended divinit y school. ( No, it doesn't help in praying for posit ions.) While at t ending school, he barely scraped by, working a variet y of part - t im e j obs such as correct ional officer ( night - t im e shift ) and t ruck driver. I n t hose days, he was so poor t hat when he dr ove a t ruck, he som et im es could not even afford t o fill t he t ank. Mar k init ially got hooked on t rading when he accom panied his bot her, Joe, on a visit t o t he Chicago Board of Trade. Mark spent m ost of his t rading career on t he floor of t he Chicago Board of Trade, specializing in t rading t he soybean crush ( explained in t he int erview) . Alt hough he was consist ent ly successful as a floor t rader , about five years ago he decided t o t ry t rading from an office. Realizing t hat t his t ype of t rading w as com plet ely different from t he t rading he had been accust om ed t o. Mark Rit chie devot ed him self t o researching various possible t rading approaches. The first year was fairly t ough because his inexperience led him down m any blind alleys. Despit e t hese early difficult ies, his off- t hefloor t rading proved r em arkably successful. His t rading account , which st art ed wit h $1 m illion in 1987, regist ered an average annual ret urn of 50 percent over t he next four years. Rit chie's int erest s have ranged far bey ond t he world of t rading. I n recent years, he has becom e int ensely involved in philant hrophic effort s aim ed at helping a prim it ive Am azonian t ribe. His involvem ent has not been confined t o m onet ary cont ribut ions, but has included num erous ext ended st ays living am ong t he t ribespeople. Rit chie has com piled a series of narrat ives t old from t he perspect ives of t he I ndians int o a recent ly com plet ed m anuscript , Vict im of Delusion. My first cont act wit h Mark Rit chie occurred when he sent m e his book, God in t he Pit s [ MacMillan, 1989] , inscribed wit h a beaut iful com plim ent of m y own first book. I responded wit h a let t er, and furt her correspondence ensued. This book of int erviews, however, provided t he cat alyst for our first m eet ing. I found Mark Rit chie t o be very personable, low- key, and sincere. The int erviews were conduct ed over several sessions in CRT's offices. = = = = I t hink you're an ideal person t o whom t o address t his quest ion, since you've m ade a life of blending t he t rading business ( m uch of it on t he floor) wit h an obvious deep sense of et hics. There has been a lot of publicit y about t he et hics of floor brokers, as part icularly highlight ed in t he relat ively recent FBI st ing operat ion on t he Chicago fut ures exchange floors. Are we t alking about a sm all fringe elem ent , like in any ot her indust ry, or does t he t em pt at ion of large dollar am ount s act ually lead t o a m ore serious problem of dishonest y? Wit hout m ent ioning any nam es, of course. = = = = I f I m ent ioned any nam es, I know you wouldn't print t hem . How could you [ he laughs] You're st ar t ing off wit h t he heavy st uff here. I t varies drast ically from pit t o pit . Each pit is alm ost a cult ure in it self. A pit has it s own personalit y. I used t o spend 90 percent of m y t im e in t he soybean m eal pit , and t he t raders t her e are som e of t he nicest and m ost honest people I 've known in m y life. I n one sense, you have t o be awfully honest t o be in t his business, where huge t ransact ions t ake place wit h a nod of t he head. Having said t hat , t hough, t here's t rem endous opport unit y t o cheat . However, I don't believe t here are any m ore cheat s in t his business dian, say, am ong plum bers or lawyers. = = = = Now t here is a raving endorsem ent . I t rem inds m e of a sign I saw for sale in a count ry st ore saying sim ply, "Honest Lawyer." = = = = [ Laughing] That 's probably t he only one t hey m ade, and t hey're st ill w ait ing t o sell it ! There's no indust ry t hat has a com er on crooks. Think of t he j okes we can m ake about dishonest polit icians. Essent ially, I t hink t here's probably t he sam e percent age of dishonest people in our business as in any ot her. The difference is in t he payoff for a dishonest act . There are people on t he exchanges who would fill orders for not hing, sim ply for t he oppor t unit y t o bucket t rades. I n fact , I have been t old t here are brokers who would even pay t o fill orders- if t hey could do it wit h a st raight face. The broker who t old m e t his said t hat t he conflict of int erest bet ween t r ading his own account and filling cust om er orders was so great t hat t he only way he could sleep at night was t o refuse t o ever do any cust om er orders. = = = = What is your own opinion of t he FBI 's st ing operat ion? Do you t hink it uncovered a real problem , or was it overblown? = = = = I t hink t hat all t he honest people in t his business were t hankful t hat som et hing was finally done. For years, I 've been saying t hat if we didn't clean up our own business, som eone else would do it for us, and we wouldn't like t he result . I nst ead of a scalpel, t hey'd likely use a dull chainsaw. = = = = Let 's swit ch t he subj ect . I n your est im at e, what percent age of t he people who com e t o t he t rading floor t o m ake t heir fort une act ually succeed? = = = = Well, I really don't know, but I 'll give you m y best guess. I 'd say roughly 10 percent do well, and m aybe 1 percent do ext rem ely well. But t hat 's only a wild guess. I 'd be willing t o accept anybody else's percent ages. = = = = That 's a relat ively low success rat e. What would you say is t he prim ary reason so m any apparent ly fail? = = = = Lot s of people in t his business who pass t hem selves off as successes are really failures. I know one person in part icular w ho t o t his day w rit es art icles in indust ry publicat ions and is oft en quot ed by t he press, yet he

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123 hardly knows t he first t hing about successful t rading. One t im e, I was holding a posit ion in a volat ile int erest rat e spread. The t rade was going against m e, and I was nervous about t he posit ion. This part icular t rader was holding t he sam e posit ion and seem ed quit e worried. " Do you t hink I 'm overt rading?" he asked m e. I quest ioned him about his account size and t he num ber of cont ract s he held. " I have $25,000 in t he account ," he said, " but I can't afford t o lose it , and I have a fift y- cont ract posit ion." My m out h fell open. I had about $1,000,000 in m y account for a posit ion t hat was only t wice as large, and I was even worried about t hat . " Overt rading, wouldn't even begin t o com m unicat e it ," I said. So he t akes off half t he posit ion and says, " I 'm OK now, right ?" " You're not OK," I said. " You haven't even begun." Ther e's no way you can com m unicat e wit h a per son like t hat . I rem em ber saying t o t he people who were clearing his orders t hat he was a walking t im e bom b. = = = = Did he event ually self- dest ruct ? = = = = Absolut ely, and he left t he clearing Him wit h a huge debit , which he had t o work off. = = = = How do you decide when a posit ion is t oo large? = = = = I have a rule t hat whenev er I 'm st ill t hinking about m y posit ion when I lay m y head on m y pillow at night , I begin liquidat ion t he next m om - ing. I 'm hesit ant t o say t his because it could be m isconst rued. You know t hat I 'm a pr aying person. I f I find m yself praying about a posit ion at any t im e, I liquidat e it im m ediat ely. That 's a sure sign of disast er. God is not a m arket m anipulat or. I knew a t rader once who t hought he was. He went broke- t he t rader, I m ean. = = = = I assum e t his sensit ivit y t o t rading t oo large or let t ing losses get out of line is one of t he ingredient s t hat has m ade you successful. = = = = Absolut ely. Magnit ude of losses and profit s is purely a m at t er of posit ion size. Cont rolling posit ion size is indispensable t o success. Of all t he t rait s necessary t o t rade successfully, t his fact or is t he m ost under valued. As soon as you m ent ion posit ion size, you also bring up t he t opic of greed. Why did t he t rader I j ust m ent ioned hold a huge posit ion backed up by only $25,000 he couldn't afford t o lose? I will not presum e t o be j udgm ent al. A person m ust look inside for t hese answers. But it would be foolish t o overlook t he hum an vice of greed. The successful t rader m ust be able t o recognize and cont rol his greed. I f you get a buzz from profit s and depressed by losses, you belong in Las Vegas, not t he m arket s. = = = = What ot her t rait s do you t hink are im port ant t o be successful as a t rader? = = = = You have t o be able t o t hink clearly and act decisively in a panic m arket . The m arket s t hat go wild are t he ones wit h t he best oppor t unit y. Tradit ionally, what happens in a m arket t hat goes ber serk is t hat even vet eran t raders will t end t o st and aside. That 's your opport unit y t o m ake t he m oney. As t he saying goes, " I f you can keep your head about you while ot hers are losing t heirs, you can m ake a fort une." = = = = Act ually, I t hought t hat line ended wit h, ". . . t hen you haven't heard t he news." = = = = [ Laughing] That 's right . That 's t he risk. Maybe you haven't heard t he news. But , on t he ot her hand, it 's also oft en an opport unit y. I f it looks t oo good t o be t rue, t he rest of t he m arket m ay know som et hing t hat you don't . But usually t he way we m iss opport unit ies in t his business is by saying, " I t looks t oo good t o be t rue," and t hen not doing anyt hing. Too oft en we t hink t hat everybody else m ust know som et hing t hat we don't , and I t hink t hat 's a crit ical m ist ake, How m any t im es have you heard som eone put down an idea you're excit ed about by saying, " I f it 's such a good idea, why isn't everyone doing it ?" This is t he bat t le cry of m ediocrit y. Think about it for a m inut e. Any invest m ent opport unit y t hat everyone else is doing is by definit ion a bad idea. I would always recom m end doing t he opposit e. The reason m arket s get out of line is because everyone is doing t he wrong t hing. The good t rader always st icks wit h his own ideas and closes his ears t o t he why- isn't - e very one- doing- it cry of t he crowd. He'll m ake a t rade against t he crowd at a conservat ive level t hat he can afford, and t hen get out if he's wrong. That 's what a st op is for. You need t o have t he courage t o st and up against t he crowd, decide your posit ion, and execut e it . One experience t hat really brought t his hom e t o m e was when I was t aking flying lessons. I had t he t heory down, but not very m uch experience. I was com ing in for what was m y second or t hird landing. When I was only about t went y or t hirt y feet above t he m nway, several gusts of wind blew t he plane all over t he place. I fought t he plane down for what was probably t he worst landing ever in hist ory. When I finally brought t he plane t o a st op, I was act ually chuckling at how t errible a landing it was, wondering what t he inst ruct or would say. " Well, t hat was really im pressive," he said. I laughed a lit t le m ore and asked, " What was im pressive about t hat ? I t hought it was t errible." He replied,. "I have never seen any ot her beginner do t hat . Any ot her beginner would have t aken his hand off t he st ick, given up, and expect ed m e t o land t he t hing. You hung in t her e and im plem ent ed t he program all t he way unt il t he landing w as com plet e." He paused for a m om ent and added, " You're right , t hough, it was t errible. Just t errible." I t hought about t hat lat er and realized t hat t hat is t he t rait you have t o have t o t rade. = = = = That t rait being what ? = = = = The abilit y t o im plem ent your ideas despit e adverse condit ions. There is no opport unit y in t he m arket t hat is not an adverse condit ion sit uat ion. = = = = So t he abilit y t o t hink dearly and have courage when ot hers are in a panic is an elem ent of a successful t rader? = = = = I ndispensable. = = = = I s t hat an innat e abilit y? I assum e you eit her have it or you don't . You can't quit e t rain yourself t o act

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124 t hat way, can you? = = = = I 'm not sure, but I don't t hink it 's innat e. You can prepare for it by having a gam e plan- Once I had a coach who when I st epped up t o t he plat e would yell, " Have an idea?! What are you going t o do?" I nvest ing is t he sam e. You have t o know what you're going t o do when t he m arket get s out of line. Generally speaking, it 's hum an nat ure t o hesit at e. = = = = What do you do t o prepare? = = = = I go t hrough a m ent al pr ocess. I decide what I 'm going t o do when X, Y, or Z happens. I fX, Y, or Z is a surprise, t hen you're part of t he crowd. = = = = Your book God in t he Pit s was ext raordinarily personal. Didn't you have any ret icence about being so open in print ? = = = = I rem em ber one reviewer called t he book " em barrassingly personal." Sure t here was som e reluct ance t o be t hat vulnerable. I n t he first few m ont hs aft er t he book was released, I could hardly look anybody in t he eye who said t hey had read it , because I felt t hey knew m ore about m e t han was necessary . = = = = Does t hat im ply t hat you had second t hought s? Would you do t he sam e t hing all over again? = = = = Yes, I would. My hope was t hat t he book would m ake people t ake a long, honest look at t hem selves- at t heir relat ionship t o ot hers and t heir relat ionship t o God. How could I expect people t o honest ly confront t hese quest ions unless I was willing t o do t he sam e. I 'm sure t hat aft er having read t he book, m ost people are probably disappoint ed when t hey m eet m e, because I can't be as honest in person as I t ried t o be in print . = = = = How did you first get involved in t his business? = = = = I n t he early 1970s, m y brot her, Joe, was working for a silver coin dealer in Los Angeles. He had com e t o Chicago t o explore t he possibilit y of set t ing up a silver arbit rage operat ion bet ween t he Chicago and New York m arket s. [ Silver is t raded in bot h New York and Chicago. Theoret ically, t he price should be t he sam e in bot h locat ions. However, occasionally, large influxes of eit her buy or sell orders in one m arket or t he ot her m ay result in a t em porar y price disparit y. Arbit rageurs t end t o profit from t his aberrat ion by buying silver in t he lower- priced m arket and sim ult aneously selling an equivalent am ount in t he higher- priced m arket . Since m any arbit rageurs are com pet ing t o profit from t hese t ransit ory dist ort ions, t he price in t he t wo m ark et s will never get t oo far out of line. I n essence, arbit rageurs t ry t o lock in sm all, virt ually risk- free profit s by act ing ver y quickly t o exploit inefficiencies in t he m arket place.] Joe asked m e t o j oin him in visit ing t he Chicago Board of Trade. He also needed t o borrow a suit . At t he t im e, I had only t wo suit s t o m y nam e. One was ragged and t he ot her I had picked up wholesale for $60. Since Joe would do t he t alking, I gave him m y good suit . When we arr ived at t he exchange, we inquired at t he president 's office about m em berships and t rading privileges. Upon seeing us, one of t he exchange officials slowly eyed us from head t o t oe and back again and said, " You boys have got t o be in t he wrong place! " = = = = Was t hat t he end of t he conversat ion? = = = = No, but t he whole conversat ion was about as st rained as you m ight expect aft er an opening com m ent like t hat . Joe asked him about t he possibilit y of get t ing a m em bership, but t he ex change official j ust couldn't get t he sm irk off his face. " Do you know t he financial requirem ent s t o becom e a clearing m em ber?" he asked disdainfully. = = = = Did you? = = = = No, of course not [ laughing] . We had no idea! We couldn't have guessed wit hin t wo decim al places. The whole conversat ion was alm ost a Joke. I was glad I wasn't t he one doing t he t alking. Aft er t hat inauspicious st art , we m ade our way t o t he visit ors' gallery. I had heard rum or s about t he floor of t he exchange being a wild place. We st ood t her e wat ching for a bit . Alt hough everyone was running around and t here was a lot of noise, it didn't seem as wild or excit ing as we had ex pect ed. Suddenly, we heard t his ear- shat t ering dong and t he floor erupt ed int o sheer pandem onium . Obviously, we had been wat ching t he m arket before t he opening. And t his was a part icularly hect ic t rading session. The crowd in t he pit s flowed from t he bot t om up and back again in waves. Our m out hs dropped open in ast onishm ent . At t hat m om ent , bot h Joe and I decided t hat t his was t he place for us. I t j ust looked like a barrel of fun. = = = = Did you have anot her j ob at t his t im e? = = = = Act ually, I was going t o sem inary school, m aj oring in philosophy of religion. I had a j ob as a correct ional officer working t he m idnight - t o" eight shift . I t alm ost covered t he rent and t uit ion. = = = = Did you ever finish divinit y school? = = = = Yes, aft er I got int o t he business. I t t ook m e seven years t o com plet e t he degree. = = = = Were you planning t o use your religious t raining? = = = = I wasn't headed t o be a m em ber of t he clot h, alt hough t hat w as an opt ion. I was m ainly in sem inary t o answer som e personal spirit ual quest ions t hat were nagging m e. I had no specific plans. = = = = You had no real plans about how you were going t o earn a living? = = = = No, T was t oo idealist ic for t hat . This was t he lat e 1960s and early 1970s. We had t he feeling t hat if you j ust did right , everyt hing else would t ake care of it self. You rem em ber, t his was t he at t it ude t hat societ y t hought was so naive. = = = = How did you first get on t he ex change floor? = = = =

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125 About six m ont hs aft er our visit t o t he exchange, Joe's com pany sponsored him t o st art a silver arbit rage floor operat ion. Several m ont hs lat er, I got a j ob wit h t he com pany as a phone clerk on t he floor. That Job last ed for over a year. Then t he volat ilit y in t he silver m arket declined sharply from t he hect ic levels of t he 1973- 74 period, and t he arbit rage opport unit ies dried up. Or, perhaps m ore accurat ely, t he opport unit ies were st ill t here, but t oo sm all t o j ust ify an operat ion t hat was paying nonm em ber clearing rat es. I n any case, t he com pany let m e go. = = = = Did you t ry t o st ay in t he business? = = = = I found a j ob for a com pany t hat was m arket ing com m odit y opt ions t o t he public. Now correct m e if I 'm wrong, but as I r em em ber it , t his was well before exchange- t raded opt ions, and t he com panies t hat were selling opt ions at t he t im e were char ging t he public exorbit ant prem ium s. [ The " prem ium " is t he price of an opt ion.] Unconscionable prices. Rip- off levels- Their m arkup was approxim at ely 100 percent . They would buy an opt ion for $2,000 and sell it for $4,000. = = = = When you went t o t he int erview, did you t urn down t he j ob because you were aware of what was involved? = = = = I had no idea what was going on. = = = = Were you offered t he j ob? = = = = Yes. = = = = Then what happened? = = = = I worked t here for about a day and realized ( hat t he ent ire operat ion w as basically involved in cold calling. They had list s of possible invest ors and t hey called t hese people t o convince t hem t o buy opt ions. = = = = I n ot her words, you found yourself in a boiler room operat ion? = = = = Exact ly [ laughing] . I was int roduced t o what t he ot her side of t he business was all about . Aft er I was hired, I went t o t heir t raining program , which was aim ed at t eaching us how t o sell opt ions. Since, at t he t im e, U.S.- t raded opt ions did not yet exist , t hey were buying t he opt ions in London and selling t hem t o t he public at a high m arkup. They had writ t en script s on how t o sell. You'd call up som ebody and say, " Hello Mr. so- and- so. We underst and t hat you are a wealt hy invest or, and t hat is how we got your nam e. You are obviously t he t ype of int elligent person who can appreciat e t his kind of opport unit y." You'd but t er him up. I 'm sit t ing t here wit h a t rader's m ent alit y, and I 'm t hinking t o m yself t hat if I 'm going t o sell som et hing t o som ebody, I want t o know t he t rack record. = = = = Did yon ask t he inst ruct or? = = = = Cert ainly. He answered, " We m ake m oney for our client s." So I asked him , " How m uch? Exact ly what am I going t o t ell t he people whom I 'm calling? What kind of percent age r et urn can t hey expect ?" He st ared at m e as if I were asking frivolous quest ions, and wit h a suspicious look said, " Why would you want t o know about all t hat st uff?" = = = = I n ot her words, was his at t it ude: What difference does it m ake? = = = = Of course, t hat was exact ly his at t it ude. " The point is t o sign t he guy up," he said. = = = = Well, what were you supposed t o t ell people when t hey asked yon how m uch t hey could m ake on t he invest m ent ? = = = = Oooooh," You're going t o m ake big bucks! Sugar is going t o double! " Or you m ight hype a special sale. Som et im es t hey would com e up wit h t hese specials where a $4,000 opt ion was being sold for $3,000. My guess is t hat it was probably an opt ion t hey had bought at $2,000, which was running out of t im e and about t o expire wort hless, and t hey j ust want ed t o dum p it . So t hey would call up all t heir people and t ell t hem t hey had a special on t his opt ion. = = = = How were you supposed t o handle t he quest ion from t he pot ent ial invest or- and I use t he t erm loosely- who asked t o see a t rack record? = = = = I asked a quest ion exact ly like t hat . The inst m ct or said, " Our records show t hat 62 percent of our client s m ake m oney." = = = = Was he lying out right ? = = = = Well, I t hink he had som e figures, but it w as difficult t o say what t hey m eant . Maybe 62 percent of t he client s had m ade a profit on a t r ade at one t im e or anot her. However, for all I know, m ost of t hem wer e wiped out . So I kept pressing t he quest ion. = = = = Was his at t it ude: St op bot hering m e kid? = = = = Was it ever' Anyway, I kept on pr essing t he issue. I asked him , " Look, I 'm selling an opt ion for $4,000. At what price can t he buyer sell it back?" You can always t ell very quickly whet her a m arket is legit im at e by sim ply asking for a quot e on t he ot her side. He gave m e t his funny look and asked, " Why would he want t o sell it ? He's buying it from you. He's going t o hold it unt il he m akes a lot of m oney." So I said, "Hypot het ically, if he want ed t o sell it t he next day, what price could he sell it at ? I 'm used t o a m arket . A m arket m eans t hat t here ar e buyers and sellers." He kept on evading t he issue, and t his went back and fort h for a while. Finally I said, " Just t ell m e what you paid for t he $4,000 opt ion." He gave a deep sigh, leaned on his desk and said, " Now look. I f you go int o a furnit ure st ore and refuse t o

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126 buy t he furnit ure unt il t he salesm an t ells you what he paid for it , he's not going t o t ell you. You can ask t hat quest ion all day, but event ually he's going t o t ell you t o rock off. And t hat 's exact ly what I 'm t elling you." There was a long silence in t he classroom . = = = = How was t he rest of t he class react ing t o t his whole I nt erchange? = = = = They were beginners t o t he business and didn't have a clue t o what was going on. One of t he t rainees had seen a com pany salesm an drive up in a Corvet t e, and t hat was all he needed; he was signed up right t hen and t here. = = = = Were you asked t o leave? = = = = No. But I was kind of em barrassed by t he whole sit uat ion. I event ually m um bled som et hing along t he line t hat if m ost people were m aking m oney t hen it was probably all right . = = = = But you didn't really believe t hat , did you? = = = = No, of course not . I n fact , at one point , t he phone rang and t he inst ruct or answered saying, " He's on t he t rading floor, let m e get him ." I t hought t o m yself, " I didn't know t here w as a t rading floor in t his building." He opens t he door t o t his big room , packed wit h people at desks- t he so- called t rading floor, w hich you have apt ly described as a boiler room - and yells at t he t op of his voice: " Hey Bob, pick up t he phone! " They loved t hat t rading- floor- pandem onium am bience. I said t o m yself, " Trading floor? This t hm g is not hing but a con operat ion. These people are conning t hem selves." I n fact , a lot of dishonest y in t his business begins when people are dishonest wit h t hem selves. = = = = Do you really believe t hat t hey had glossed over t he fact s so m uch in t heir own m inds t hat t hey didn't realize t hey were com plet ely ripping off t he public? = = = = I t hink so. I believe t he m aj orit y of crooks have t old t hem selves enough lies t hat t hey begin t o believe t hem . For exam ple, t he floor brokers who were indict ed in t he FBI st ing operat ion t hat w e t alked about earlier generally said, " Hey, I wasn't doing anyt hing anybody else wasn't doing." I t 's not t rue, but I t hink t hey believe it . = = = = Did you quit at t hat point ? = = = = I m ade a few half- heart ed calls on t he first day following t he t raining session, but it had a feel of scam writ t en all over it . I left aft er t hat and never cam e back. = = = = Are t here any t rades t hat you would consider part icularly m em orable? = = = = One t hat com es t o m ind occurred on t he day t he Falklands war broke out . People off t he floor have t he idea t hat t he t raders on t he floor are t he first t o know what 's going on. Not hing could be furt her from t he t rut h. The m arket erupt s long before we ever get t he news. We're t he last t o hear what 's driving t he m arket . On t hat day, I had t aken a large posit ion in soybean m eal at what looked like s great price. By t he rim e I got out of t he posit ion, in what was probably only one m inut e, I had lost $100,000. = = = = Any ot her m em orable t rades? = = = = I 've always lost m oney fast er t han I 'v e m ade it . One part icularly st riking inst ance concer ned t he roaring gold m arket during t he period from 1979 t o early 1980. Gold was sit t ing at around $400 when I ran t ook t he host ages. I t hought t hat t he height ened t ensions aroused by t his sit uat ion would push gold prices m uch higher. But t he m arket responded sluggishly, so I hesit at ed. The m arket event ually did go higher; it went t o alm ost $500 over t he next m ont h. This was a classic exam ple of not doing what you know should be done. = = = = I n ot her words, you failed t o act decisively, a t rait you cit ed earlier as one of t he key ingredient s t o being a successful t rader. = = = = Exact ly. I ev ent ually ended up buying gold at j ust under $500 an ounce. And as you m ight guess, it went down t he lim it t he day I bought it . Locked lim it - down, in fact . = = = = Did you t hink of get t ing out ? = = = = No. The host age sit uat ion was st ill com plet ely unresolved. Also, around t he sam e t im e, t he Soviet Union had invaded Afghanist an. I st ill felt t he m arket would event ually cont inue t o go higher. So I st uck wit h it . Of course, as you know, t he m arket did go sharply higher. = = = = Did you have a plan for get t ing out ? = = = = Yes, m y plan was t o get out whenever t he m arket dropped 10 percent from it s high. = = = = Basically, your plan was t o let t he m arket run unt il t here was som e sign of m eaningful weakness. ==== Right . Unfort unat ely, when t he m arket dropped, it lost 25 percent of it s value in one day. Needless t o say, t hat was a part icularly painful loss. But t he point is t hat I st ill ended up wit h a large profit on t he t rade. I n fact , t his t rade raises t he whole quest ion of how you view drawdowns. Most people don't dist inguish bet ween drawdowns in open equit y and drawdow ns in closed equit y. [ The dist inct ion is t hat open equit y refers t o unrealized profit s on an exist ing posit ion. I n effect , what Rit chie is im plying is t hat he views a given loss different ly if it is a part ial surrender erf profit s on a winning t rade as opposed t o if it is a drawdow n in a'losing t rade.] I f I prot ect ed open equit y [ i.e., open profit s] wit h t he sam e care I prot ect ed closed equit y, I would never be able t o part icipat e for a long- t erm m ove. Any sensible overall risk cont rol m easure could not wit hst and t he norm al volat ilit y in such a m ove. = = = = I n ot her words, in order t o scor e t he really large gains, you have t o be willing t o see t hose gains erode significant ly before get t ing out of t he m arket . = = = = I can't see any ot her way. I f you get t oo careful about not risking your gains, you're not going t o be able t o ext ract a large profit ,

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127 = = = = How m uch do you risk on any single t rade or idea ( m easured from t rade init iat ion, not peak equit y) ? = = = = About one- half of 1 percent . I t hink it 's generally a good idea t hat when you put on a t rade, it should be so sm all t hat it seem s alm ost a wast e of your t im e. Always t rade at a level t hat seem s t oo sm all. = = = = You spent approxim at ely t he first t en years of your t rading career on t he floor and t hen m ade a t ransit ion t o t rading from an office. Since you were very successful as a floor t rader, I 'd like t o underst and your m ot ivat ion for m aking t he swit ch. First , t ell m e, would I be safe in assum ing t hat while you were a floor t rader, virt ually every m ont h was profit able? Let 's t ake it one st ep furt her. What percent age of your weeks would you est im at e were profit able during t hat period? = = = = Ninet y percent . = = = = Most people would say, * * My God, 90 percent of t he weeks t his guy m akes a profit ! " Why would you ever leave t hat t ype of an edge? = = = = First I 'll give you m y short answer: old age. Also, t he soybean m arket had lost m uch of it s volat ilit y, which reduced t rading opport unit ies. I t seem ed like t he right t im e t o t ry t rading off t he floor. = = = = Did you have a plan on how you would approach t rading from upst airs? = = = = I had no idea. I checked out lot s of t hings. I t ried a num ber of advisory services but found t hat t hey were oft en not wort h t he t im e it t ook t o list en t o t he phone t ape. I event ually gravit at ed t oward t rying t o develop m y own syst em s. One of t he t hings t hat am azed m e was t he unreliabilit y of inform at ion by t he so- called pros of t he indust ry. For exam ple, when I st art ed working on t est ing and developing syst em s, I purchased price dat a from a com pany t hat m arket ed what t hey called a " perpet ual" cont ract . [ The per pet ual price is derived by int erpolat ing bet ween t he nearest t wo act ual fut ures cont ract s t o obt ain a hypot het ical price series t hat is always a const ant am ount of t im e forward from t he current dat e ( e.g., ninet y days) . The result ing price is a t heoret ical concept t hat will be a hybrid of t wo different cont ract s and cannot be replicat ed by any real- world t rading inst rum ent s) .] I used t his dat a for over six m ont hs before I realized t hat it was not a reflect ion of t he real m arket . For exam ple, t he perpet ual series could show a large price m ove t hat im plied a profit t hat you could not have realized in t he real m arket . When I discovered m is, I alm ost fell off m y chair. I couldn't underst and how anyone who had ever t raded anyt hing could have const ruct ed t his t ype of series. I asked m yself, " How can all t hese professionals who obviously know what t hey're doing be following dat a t hat 's fundam ent ally foolish?" The quest ion was easy enough t o answer. Aft er all, I had used it m yself for six m ont hs. I had t o go back t o square one and st art over. I never again t rust ed anyone else's work. = = = = Did you buy any com m ercial t rading syst em s at t he t im e? = = = = Yes, I did buy a couple. One of t hem - 1 don't w ant t o m ent ion t he nam e- was essent ially a sim ulat ion package. I had assum ed t hat if I could get a t ool t hat would allow m e t o develop opt im ized t rading sy st em s, it would be a t housand t im es m ore effect ive t han t rying t o approach t he m arket by using chart s. [ Opt im izat ion refers t o t he process of t est ing a part icular syst em , using m any different values for t he key input s, and t hen choosing t he single com binat ion of values t hat worked best for past hist ory. Alt hough t his procedur e can yield wonderful perform ance for t he past , it usually wildly overinflat es t he im plied perform ance for t he fut ure.] I nst ead, I found t he soft ware was wort hless. There again, I was am azed at t he m agnit ude of ignorance of t he people who had developed t his syst em . = = = = I n what way was it wort hless? = = = = The soft ware was a syst em t hat allowed you t o opt im ize t he m arket t o deat h. I n fact , t his organizat ion even recom m ended r eopt im izing t he syst em every week. I n ot her words, curve- fit t he program t o last week so t he t rades t his week will m at ch what should have been done t he previous week. I j ust got t he overwhelm ing im pression t hat whoever had developed t he ideas for t his syst em had never t raded him self. = = = = Did you ever find out if t hat was t rue? = = = = [ A long sigh] I asked t hat quest ion, but t hey j ust dodged it . I n fact , I rem em ber t he com pany salesm an showing m e how t o ent er t he dat a m anually. Personally, I prefer t o get t he dat a by com put er, because m anual ent ry j ust seem s like t oo m uch work. Anyway, t his fellow, who was him self a t rader, said, " I don't even pay for t he price of t he Wall St reet Journal I have a friend phot ocopy t he price page for m e." I t hought t o m yself, " Here's a guy w ho's m arket ing a program t hat 's being represent ed as t he pr em iere t rading syst em soft ware on t he m arket , and he doesn't even have enough m oney t o buy t he Wall St reet Journal." = = = = Did you act ually t ry t rading t he syst em ? = = = = Yes, but t he result s wer e j ust spasm odic. Moreover, I was ext rem ely uncom fort able wit h t he idea of t rading a black box [ t rading syst em com put er soft ware t hat generat es buy and sell signals wit hout revealing t he rules of how t he signals are generat ed] . I swore t o m yself t hat I would never purchase a black box syst em again. = = = = I s your advice t o people t hen: Forget what ` s out t here and do your own work? = = = = My advice t o people has always been: St ay out of t he business; st ay com plet ely away from t he m ark et . For novices t o com e in and t ry t o generat e profit in t his incredibly com plex indust ry is like m e t rying t o do brain surgery on t he weekends t o pick up a lit t le ext ra cash. I have a friend who knows t hree doct ors who got t oget her t o invest in a st ud race horse. When t hey t ook delivery of t he horse, t hey found t hat it w as a gelding. My friend w as t easing t hem about t his and asked if t hey had ever t hought of inspect ing t he horse. You won't believe t his, but it t urns out t hat t hey had t hought of it , but t hey didn't go any furt her. So he said, " Well, you guys are all doct ors; did you ever bend over and

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128 t ake a look under t here t o m ake sure he had t he necessary t ools?" I f you asked t hose t hree doct ors t oday what t heir m ist ake was, I 'm sure t hey would t ell you t hat t hey should have inspect ed t he horse's valuables. They st ill wouldn't have learned t he lesson: DON'T I NVEST WHERE YOU DON'T KNOW WHAT YOU'RE DOI NG. I f t hey invest in anot her horse, t hey won't get a gelding, but t hey'll m ake som e ot her m ist ake j ust as laughable. = = = = Do you m ean t o im ply t hat people should j ust put t heir m oney in T- bills? = = = = I t hink t hey can go wit h som e of t he m anaged funds or t rading advisors t hat have proven t rack records. But I would t ake very seriously t he st andard disclaim er t hat says, " Past perform ance is no guarant ee of fut ure result s." Also, I don't t hink you can m ake m oney unless you're willing t o lose it . Unless you have m oney t hat you can afford t o lose and st ill sleep at night , you don't belong in t he m arket . My willingness t o lose is fundam ent al t o m y abilit y t o m ake m oney in t he m arket s. = = = = And t hat 's not t rue of m ost people? = = = = That 's right . Most people com e int o t his business wit hout a willingness t o lose m oney. They also ent er t he m arket wit h unrealist ic expect at ions. Even if t hey're lucky enough t o pick a successful t rading advisor, t hey'll likely t o pull t heir m oney out t he first quart er he has a drawdown. So t hey end up losing even t hough t hey m ay have been in a winning sit uat ion. = = = = Act ually, m y em pirical research has dem onst rat ed t ile exact sam e conclusion. Several years ago, part of m y j ob was evaluat ing out side t rading advisors. I n t he process, I found out som et hing part icularly int erest ing. There was a handful of advisors who had m ade m oney every year. Yet even for t his select group, less t han 50 per cent of t heir closed client account s showed a net profit . That really brought hom e t o m e how poor m ost people are in deciding when t o ent er and exit invest m ent s. I t hink t he nat ural t endency is t o invest m oney wit h a m anager aft er he has had a hot st reak and t o wit hdraw it aft er a losing st reak. Alt hough you discourage people from get t ing int o t his business, let 's say t hat som ebody com es t o you wit h a serious int erest in becom ing a t rader. What do you t ell t hem ? = = = = I know t his is going t o sound pat ronizing, but honest ly, I t ell t hem t o read your first book [ The Com plet e Guide t o t he Fut ures Market s] . I slow t hem down by t elling t hem t o com e back t o m e aft er t hey have digest ed half of t hat book, knowing fall well t hat m ost of t hem will never do t hat . = = = = So t hat 's t he way you t urn people away from t he business. Now t here's a ringing com plim ent on m y work if I ever heard one. = = = = Act ually, j ust picking t he book up is a t hreat ening experience. Seriously, I t hink your book gives people a good idea of t he am ount of work it t akes t o becom e com pet ent in t his business. = = = = I s one of your m ot ivat ions for t rading having t he abilit y t o give a port ion of your profit s t o charit y? ==== Precisely, alt hough I hat e t o put it t hat sim ply. I n m y yout h, I was so idealist ic t hat I t hought t he dollar was t hat unholy Mam m on t hat one m ust resist in order t o do hum anit y som e higher good. I event ually learned t hat wealt h has a great deal of inherent value. When you see som ebody st arving, what he needs is m oney. = = = = I assum e t hat you probably long ago passed t he point where your t rading profit s t ook care of any personal needs or financial securit y you m ight envision. I n your own case, if t he charit y aspect were not t here, do you t hink you would st ill be t rading? = = = = I 'm not sure t hat I would be. I j ust don't know. I ncident ally, let m e correct y our use of t he t erm charit y. I don't t hink in t erm s of charit y. I t hink in t erm s of invest ing in t he poor. I f som eone is st arving and you hand him a buck, you've t aught him t hat what he needs is for som eone t o give him a handout . I prefer t o invest in t he poor- t o provide capit al so t hey can enhance t heir own product ivit y. What t he poor need are cot t age indust ries t hat allow t hem t o becom e self- sufficient . That 's t he t ype of funding I believe in, and it m ay not fit t he convent ional view of charit y. I know what I 'm going t o say can be easily m isconst rued, but if I could set up a syst em where I could m ake m oney off t he poor , t hen I would have achieved m y goal. I know t hat sounds crass. Of course, m y obj ect ive is not t o m ake m oney off t he poor, but t he point is t hat charit y t ends t o spawn dependency. That 's why t he Great Societ y war on povert y was such a failure. I n cont rast , if I can est ablish som eone in a business where he can ret urn m y m oney, t hen I know his sit uat ion is st able. = = = = Would you m ind saying roughly what percent age of your incom e you funnel int o t hese effort s t o help t he poor? = = = = As a sweeping generalizat ion, roughly one- t hird goes t o Uncle Sam , one- t hird I put back int o m y account t o increase m y t rading size, and one- t hird I dispense t o t hese various proj ect s. = = = = I know t hat you've becom e involved wit h I ndians in t he Am azon j ungle whose t ribal cust om s include killing m em bers of neighboring t ribes. Wasn't t here an elem ent of fear in visit ing t his area? = = = = No. They kill only each ot her; t hey don't bot her out siders. One of t heir beliefs is t hat whenever som eone dies, his deat h m ust be avenged by killing som eone from anot her village. When t hat person is killed, his village will t hen seek revenge in t urn, and so on. = = = = You m ean every t une som eone dies, t hey blam e t he deat h on a m em ber of anot her village? I t sounds like t here wouldn't be anybody left before t oo long. = = = = They don't blam e t he d- eat hs of older people or young children on t he evil spirit s of anot her village m em ber, but ot herwise t he answer t o your quest ions is yes. Fort unat ely, t heir killing pract ices are not t oo efficient . However, t heir num bers have dim inished drast ically over m e years, part ially because of disease and

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129 m alnut rit ion, but also because of t his part icular cust om . I should add t hat t he village I visit ed has been convert ed t o Christ ianit y and has given up t his pract ice. = = = = What has been your own involvem ent wit h t his village? = = = = I 've gone down t here for ext ended visit s about four or five t im es since 1982. My effort s are direct ed t o helping t hem progr ess. For exam ple, I helped m ake all t he arrangem ent s for set t ing up a sawm ill oper at ion. The last t im e I visit ed t he village, t hey were building gor geous houses. I f you had seen t he squalor t hey once lived in- children playing wit h cockroaches on dirt floors, rubbing filt h all over t heir lit t le faces- t hen you could underst and t he euphoria I felt when I saw t heir new hom es. = = = = Aren't you concerned t hat by helping West ernize t hese villages, t heir way of life will be dest royed t o t heir ult im at e det rim ent ? = = = = I t 's a com m only held belief here in t he civilized West t hat t he cult ures and life- st yles of isolat ed peoples are t o be valued and pr eserved. And I find t hat view rom ant ically at t ract ive. I would be inclined t o agr ee wit h t his prem ise if only I could find som eone in one of t hese cult ures who would st op laughing at it . An I ndian I know nam ed Bee was once read a newspaper art icle about his beaut iful cult ure. Bee responded by asking, " Where does t his m an live t hat he could be so foolish?" He was t old t hat t he m an lived and worked in Caracas. " Why does he sit up t here in his com fort able office and writ e t his nonsense about us?" Bee asked. " Why doesn't he com e down here wit h his fam ily and j oin us? Then we can all enj oy t his beaut iful place t oget her." They're m yst ified by our lack of com passion. Academ ics m ake com pelling argum ent s ext olling t he beaut y and virt ues of I ndian cult ure, but I agree wit h t he I ndians. = = = = So t he I ndians generally accept t he int rusion of civilizat ion? = = = = Yes. I have never m et an I ndian who didn't want progress- Sure, som e of t hem want t o m aint ain t heir beliefs and cust om s, but t hey all want t he benefit s of civilizat ion. [ Aut hor's com m ent : Alt hough I quest ion t he generalizat ion t hat civilizat ion is beneficial t o t ribal societ ies, having read Rit chie's Vict im of Delusion, w hich describes t he unim aginable brut alit y of life and deat h in t his societ y ( t old from t he perspect ive of m e I ndians) , it is hard t o m e t he loss of t heir way of life.] = = = = Let m e m ake a rat her abrupt t ransit ion from t he Am azon t o t he world of t rading. I know t hat you're considering shift ing from being a privat e t rader t o m anaging public funds. Since you have already been quit e successful t rading your own funds and have a sizable personal account , wouldn't it j ust be easier t o cont inue t o do t he sam e t hing? Why undert ake all t he headaches t hat com e wit h m oney m anagem ent ? = = = = I f dram at ically increasing t he am ount of m oney t r aded is going t o subst ant ially reduce your profit per t rade, t hen your im plicat ion is right : t he profit incent ive fees m ay not provide sufficient com pensat ion for t he degradat ion in t rading profit s. = = = = But in your own case, you obviously feel t hat your approach is not volum e sensit ive. = = = = That 's right , because it 's so long t erm . = = = = Let 's t alk about specifics. On average, how m any t im es a year will your approach signal a shift from long t o short or vice versa in a given m arket ? = = = = Generally speaking, bet ween one and five t im es per year in each m arket . = = = = That 's probably far fewer t han m ost people would t hink. = = = = Right . Of course, I would prefer only one t rade per year. I n fact , per haps m y best t r ade ev er was one t hat I held for over four years. = = = = What t rade was t hat ? = = = = I was long soybean m eal and short soybean oil and j ust kept rolling t he posit ion over. = = = = What kept you in t hat t rade for so long? = = = = Mont hly profit s. [ At t his point , Joe Rit chie ent ers t he room . He is carrying a t ray of coffee and dessert . The int erview wit h Joe cont inues in t he next chapt er.] Five basic t rading principles appear t o be elem ent al t o Mark Rit chie's t rading success. These can be sum m arized as follows: 1. Do your own research. 2. Keep each posit ion size so sm all t hat it alm ost seem s t o be a wast e of your t im e. 3. Have t he pat ience t o st ay wit h a winning posit ion as long as t hat posit ion is working, even if it m eans keeping a single posit ion for years. 4. View risk of open profit s different ly from t he risk as m easured from st art ing equit y in a t rade. The point is t hat in order t o ride winning posit ions t o t heir m axim um pot ent ial, it is necessary t o endure periodic losses in open profit s great er t han t he risk level t hat w ould be advisable when a posit ion is first im plem ent ed. 5. Recognize and cont rol your greed.

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130 Joe Ritchie: The Intuitive Theoretician Joe Rit chie is t he founder and driving force behind CRT. I t is his ideas, concept s, and t heories t hat serve as t he blueprint for t he com plex st rat egies t hat guide t he firm . Alt hough he has never t aken an advanced m at h course, Joe Rit chie is considered by m any t o be a m at h genius- a nat ural. He would have t o be, given t he int ricat e m at hem at ical nat ure of t he t rading m odels em ployed by CRT. Joe describes m at h as som et hing he alm ost feels or m t uit ively underst ands. Rit chie would be t he first t o em phasize t hat t he success of CRT is hardly a solo act . There are m any individuals t hat are int egr al t o m e com pany's achievem ent s. I n our int erviews, Joe insist ed t hat I also t alk t o som e ot her CRT personnel. Here is how one key em ployee described Rit chie's philosophy: " Joe believes in em powering people. He t rust s people. I sincerely believe t hat one of t he reasons we can m ake so m uch m oney is t hat Joe m akes us feel absolut ely com fort able t o risk his m oney." Rit chie m akes a lot of business decisions based on his gut feeling about t he people involved. I f he feels any discom fort w it h t he people, he has no reservat ion about w alking away from even t he m ost lucrat ive vent ure. On t he ot her hand, he has been known t o init iat e m aj or operat ions on not m uch m ore t han a handshake. A recent case in point is his vent ure in launching a com put er com pany in t he form er Soviet Union. The com pany is involved in every phase of t he product ion and m arket ing chain, including developing soft ware, im port ing hardw are, est ablishing service and t rading cent er s, and im plem ent ing a dist ribut ion syst em . This whole elaborat e operat ion sprang t o life because Rit chie was im pressed by an ent repreneurially inclined Russian whom he m et . His t rust and confidence in t his m an was all it t ook t o convince Rit chie t o m ake t he invest m ent com m it m ent . As one CRT em ployee ex plained, " While every ot her U.S. com pany involved in a j oint vent ure in t his region is t rying t o writ e t hree- hundred- page legal docum ent s t o prot ect t hem selves, which don't hold wat er t here anyway, Joe asked t he Russian t o writ e a cont ract t hat he t hought was fair, and Joe signed it on his next t rip t o Moscow." As m ight be expect ed of a m an who has built one of t he world's m ost successful t rading operat ions, Joe Rit chie is dynam ic, energet ic, and brilliant . Work is t ruly fun for him because it is an endless challenge and an ever- changing puzzle. But t here is anot her key aspect t hat delight s Joe Rit chie about his work: t he people. " I love t o com e t o work," he boom s. And he m eans it . I t 's not j ust t hat he loves what he does, but he considers CRT an ext ended fam ily. He appears t o exude a genuine affect ion for his em ployees. = = = = When you first st art ed doing silver arbit rage, you had hardly invent ed t he wheel. Ot her people were already doing t he sam e t hing. Did you do anyt hing different ly in order t o succeed? = = = = We t ried t o do a bet t er j ob of underst anding t he int errelat ionships bet ween m arket s and assessing t he probabilit ies involved. We also t raded m ore aggressively and for a narrower m argin t han t h e ot her br okers. We did t he sam e t hing years lat er in opt ions, when by using m ore accurat e pricing m odels w e w ere able t o quot e such narrow bid/ asked spreads t hat our m ain com pet it ors assum ed we were m aking m arket s t hat w e r e t oo t ight t o be profit able. I f you really have t he m e ch a n ics or t heoret ical value nailed, you can do a lot m ore volum e at a sm aller m argin. = = = = How did t he ot her floor brokers respond t o your com pet ing for t he sam e t ype of business? = = = = They resent ed us because we were so aggressive and were eat ing int o t heir volum e. = = = = But I im agine t hat back t hen you had very low capit alizat ion. How could you have been m uch of a t hreat t o t heir business? = = = = That 's t rue. We probably had one of t he sm allest capit alizat ions on t he floor. Som e of t he ot her key players m ight do a five- hundred- lot arbit rage order, whereas if we did fift y, we would be up t o our lim it . However, we t raded it back and fort h m uch m ore aggr essively, so we ended up wit h a m uch larger proport ion of t he volum e t han m ight be expect ed relat ive t o our t ypical order size. = = = = Was t hat a m at t er of your willingness t o t ake a sm aller edge t han t he ot her brokers? = = = = That was cer t ainly part of it . But t here were a hundred ot her sm all t hings. For exam ple, get t ing bet t er phone clerks, or com ing up wit h fast er ways t o com m unicat e bet ween t he Chicago and New York silver floors. = = = = I don't underst and. Doesn't everyone use t he t elephone? How m uch fast er can yon get ? = = = = You're going t o find t his hard t o believe. When I first cam e t o Chicago, we found t hat a lot of t he people who were doing silver arbit rage didn't even have a phone cler k because t hey didn't want t o pay for one. I nst ead, t hey had a t elephone wit h a lit t le light above it , and when t he m arket changed in New York, t he New York floor clerk would pick up his phone, which would cause t he phone light t o flash in Chicago. When t he Chicago broker saw t he light , he would run over t o t he phone, get t he quot e, hang up t he phone, and run back t o t he pit t o do t he t rade. The t ransm ission t im e t hat was involved was so slow t hat we t hought we could easily beat it by get t ing good phone clerks. = = = = Were m ost people doing it t hat way? = = = = About half of t hem wer e. But even t he ones who were using phone clerks st ill had a t ransm ission t im e of about t hree t o t en seconds. We found t hat if we got t he best phone clerks, m ot ivat ed t hem , and did everyt hing else right , we could cut t hat t im e down t o about t wo seconds. = = = = Essent ially, you were doing t he t rades fast er and t aking t he t rades before t he spreads widened t o t he point where ot her brokers would do t hem . I assum e t hat approach didn't m ake you very popular. = = = = I t m ade us very unpopular, hi fact , t hey t ried t o t hrow us off t he floor. = = = = On what grounds? = = = =

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131 For rule violat ions, such as t he phone clerk verbally calling order s int o t he pit . Technically, t he orders are supposed t o be writ t en down and carried t o t he pit by a runner. However, it was st andard operat ing procedure for or ders t o be called int o t he pit . The exchange realized t hat t hey needed t he ar bit rage act ivit y t o provide liquidit y, so t he rule was not enforced. However, t hat didn't st op t hem from pulling us in front of t he com m it t ee for violat ing t his rule. I n t he end, t hey had t o drop t he issue when t hey realized t hat t rying t o enforce t he rule against one part y and let t ing everyone else violat e it was not going t o work. = = = = You m ake it sound like a real insider's club. = = = = I t was. = = = = I s t h a t t rue of m ost exchanges? = = = = [ Long sigh] I t varies a great deal from exchange t o exchange, but it 's a lot less prevalent t han it used t o be. The com pet it ion has j ust forced changes. = = = = The silver arbit rage operat ion event ually cam e t o an end. What happened? = = = = The silver arbit rage was very profit able during 1973- 74 because t he m arket was so volat ile. However, when t he volat ilit y died down in 1975, t he silver arbit rage becam e a very slow business. I t ried t o convince t he fellow who owned t he com pany I worked for t o t ry som et hing else. I t hought t hat t he soybean cm sh was t he business of choice at t he t im e. [ Soybeans ar e crushed int o t wo const it uent product s: m eal and oil. I f soybean prices ar e low relat ive t o t he product prices, t hen crushing plant s can lock in very at t ract ive profit s by buying soybeans and selling an equivalent am ount of product s. This act ivit y will cause soybean prices t o gain relat ive t o product prices. Conversely, if soybeans are highly priced relat ive t o product s, causing t he profit m argins t o be low or negat ive, crushing act ivit y will be reduced. I n effect , t his developm ent will reduce soy bean dem and, which will decrease soybean prices and reduce product supply, w hich w ill increase product prices. Essent ially, t hese econom ic forces will cause soybean and soybean pr oduct ( m eal and oil) prices t o m aint ain a broadly defined relat ionship. The soybean crush t rader t ries t o buy soybeans and sell product s when soybeans ar e priced relat ively low versus product s and do t he reverse t r ade when soybeans are priced relat ively high.] = = = = What did you do different ly t o give you an advant age over ot her brokers who were doing t he crush? ==== Very sim ple t hings. Many of t he sam e t hings we did in silver. We would keep t he best clerks by paying a good wage and providing t hem wit h t he opport unit y for growt h. We also const ruct ed our own crude slide rules t hat would show t he im plied price for soybeans given different price com binat ions for soybean oil and soybean m eal. This t ool allowed us t o inst ant aneously calculat e t he value of t he m arket , which helped us t ake advant age of t he or der flow m ore quickly. I can't t ell you why t he ot her brokers weren't doing t he sam e t hing, but t hey weren't . = = = = Were you st ill associat ed wit h your original com pany at t he t im e? = = = = Yes. I reached an agreem ent t o swit ch from silver arbit rage t o doing t he soybean crush, wherein I would be responsible for all losses but would split any profit s wit h t he com pany 50/ 50. = = = = I t sounds like heads you win fift y, t ails you lose one hundred- not a ver y good deal. Why did you st ay wit h t he com pany under t hat arrangem ent ? Did you need t he use of t heir seat ? = = = = No. I t was probably a com binat ion of inert ia and loyalt y t o t he com pany for having given m e m y st art in t he business. But event ually I went off on m y own. = = = = Was t hat t he st art of CRT? = = = = Yes, alt hough t he nam e and t he part nership arrangem ent cam e lat er. The m ove int o t he soybean com plex was also charact erist ic of what was t o becom e one of our principles all along- nam ely, not being t ied t o any one business but rat her m oving t o t he m arket s where som et hing int erest ing was going on. When we first form ed a par t nership, t he com pany nam e was Chicago Board Crushers. Then som e t im e lat er we changed t he nam e t o Chicago Research and Trading. [ Mark Rit chie, who has been sit t ing in for t he int erview, int erj ect s.] One of t he reasons we changed t he nam e from Chicago Board Crushers was t hat our secret ary got t ired of explaining t o people who called in why we couldn't crush t heir boards. = = = = You're j oking. = = = = No, seriously. = = = = You j ust m ent ioned t he idea of being flexible enough t o swit ch t o t he m arket s t hat had t he best t rading oppor t unit ies. As I recall, you becam e involved wit h silver again during t he wild 1979- 80 m arket . Were you j ust t rading t he arbit rage, or did you do som e direct ional t rades? = = = = Alm ost exclusively arbit rage. When t he volat ilit y expands dram at ically, t he opport unit ies for profit in arbit rage are great ly enhanced. There was one t rade, however, t hat you could t erm direct ional. This is one of t hose st ories t hat proves t hat it 's bet t er t o be dum b and m ak e a pr ofit t han be sm art and t ake a loss. I n early 1979, som e m yst ery buyer cam e in and bought t went y t housand cont ract s of silver. Nobody knew who it was. I did som e digging around and found t hat t he person who was m anaging t his t rade was a Pakist ani. I happened t o know a Pakist ani who was from t he upper cm st , and t he upper crust of t hat count ry is relat ively sm all. So I asked her if t here wer e any Pakist anis who could have t hat kind of m oney. She said, " No, but t her e are t wo Pakist anis t hat m anage m oney for t he Saudis." She gave m e t he t wo nam es. Sure enough, wit h a lit t le secret invest igat ing, we found t hat one of t hese guys was connect ed t o t he buying. We t hought we had a nice bit of inform at ion.

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132 At t he t im e, silver opt ions were t raded only in London. The out - of- t he- m oney silver calls wer e t rading at very low prices. Even t hough t he m arket was not t hat liquid, I bought a huge am ount of calls. I t ook a ridiculously large posit ion relat ive t o our equit y base, knowing t hat our downside was lim it ed. [ Essent ially, an out - of- t he- m oney call gives a buyer t he right t o buy a cont ract ( silver in t his inst ance) at a specified price above t he current pr ice. I f t he m arket fails t o rise t o t hat price, t he opt ion will expire wort hless, and t he ent ire prem ium paid for t he opt ion will be lost . On t he ot her hand, if prices exceed t he specified price ( called t he st rike price) , t hen t he right t o buy offered by t he call posit ion can result in profit s. I f t he st rike price is significant ly exceeded, t he profit pot ent ial can be huge.] We had lot s of t heories about who m ight be buying all t his silver. But t here was one t heory t hat we had never considered. I t t urns out t hat som e guy had passed off a $20 m illion bum check t o a brokerage office in Dallas. = = = = What did t hat have t o do wit h t he Saudis? = = = = Absolut ely not hing. Apparent ly, he wasn't relat ed t o t he Saudis. He was j ust som eone w ho passed a bad check. So while we t hought we were being very clever, all our analysis act ually proved t o be inaccurat e. The brokerage com pany finally caught t his guy, sold out his posit ion, and silver prices slid down t o under $6.1 couldn't even get out of m y posit ion because t he m arket was so illiquid and I held so m any opt ions t hat I would have got t en virt ually not hing for t he cont ract s if I had t ried t o sell. Essent ially, I ended up being m arried t o t he posit ion. At t hat t im e, I went away for a vacat ion, which was fort unat e, because t he Hunt buying st art ed t o push silver prices sharply higher. I 'm sure t hat if I were ar ound, I would have got t en out at t he first opport unit y of breaking even. By t he t im e I cam e back, t he silver calls were in t he m oney [ i.e., t he m arket price had risen above t he st rike price] , Alt hough I t hought t he m arket was going t o cont inue t o go up, I couldn't st and t he volat ilit y. One day, I decided t o go int o t he silver pit j ust t o get a feel for what was going on. I prom ised m yself t hat I would keep m y hands in m y pocket . At t he t im e, silver was t rading at $7.25.1 decided t o sell t went y- five cont ract s against m y calls j ust t o lock in som e profit s. Before I knew it , I had liquidat ed m y ent ire posit ion. By t he t im e t he calls expired, silver prices had gone up t o about $8.50. = = = = The 1979- 80 silver m arket was one of t he great bull m arket s of all t im e. [ Silver soared from $5 per ounce t o $50 per ounce in a lit t le over a year.] Did you have any inkling of how high prices m ight go? = = = = None what soever. I n fact , even $10 per ounce seem ed ext rem ely far- fet ched. I don't know anybody who bought silver at relat ively low prices and got out at over $20. The t raders who bought silver at $3, $4, $5, and $6 did one of t wo t hings. Eit her, by t he rim e silver got up t o $7, $8, or $9 t hey got out , or t hey rode t he posit ion all t he way up and all t he way down. I 'm sure t here ar e except ions, but I 'v e nev er m et one. I did, however, know t raders t hat went short silver at $9 and $10 because t he price seem ed so ridiculously high and ended up riding t he posit ion unt il t hey had lost t heir ent ire net wort h. That happened t o som e of t he best professionals I knew in t he silver m arket . = = = = Would Hunt have succeeded if t he exchange didn't st ep in and change t he rules by allowing t rading for liquidat ion only, t hereby avert ing a delivery squeeze? = = = = The exchanges didn't hav e t o change t he rules t o prevent Hunt from t aking delivery. According t o t he rules, t he exchange has t he power t o st ep in and say, " Ok, you want silver, you can have your silver, but you're going t o have t o spread out t he delivery periods." Or t hey can allow t rading for liquidat ion only. I f t he exchanges had j ust st ood aside and allowed a noneconom ically driven dem and for delivery, t hey would have been abrogat ing t heir responsibilit ies. At t he t im e t hat t he Hunt s were st anding for delivery of April silver, t he forward cont ract s were t rading at huge discount s. The Hunt s had no im m ediat e econom ic need for delivery. I f all t hey really want ed was ownership of t he silver, t hey could have swit ched t heir April cont ract s int o t he discount ed forward m ont hs, locking in a huge net saving and also freeing up t heir capit al for use in t he int erim . Or t hey could have purchased silver coins in t he free m arket at $35 per ounce when t he April cont ract was at $50. When inst ead of t hese econom ically sensible alt ernat ives t hey insist , " No, no, no, we want t o t ake delivery of t he silver in April," it indicat es t hat t hey're playing a gam e. That 's not what t hese m arket s are here for. So I feel t hat t he Hunt s got exact ly what t hey had com ing t o t hem . A lot of innocent part ies were hurt by t he Hunt act ivit y. For exam ple, t ake a m ine down in Peru whose cost of product ion is under S5 per ounce. When t he price get s up t o $15, t he m ine decides t o lock in a huge profit by hedging t heir next t wo years' w ort h of product ion in t he silver fut ures m arket . This m akes all t he econom ic sense in t he world. However, when t he price keeps on going up t o $20, $25, $30, $35, t hey have t o keep put t ing up m ore and m ore variat ion m argin on t heir short fut ures posit ion. Event ually, t hey m n out of m oney and are forced t o liquidat e t heir posit ion, going broke in t he process. = = = = I know t hat CRT's basic em phasis is opt ion arbit rage, but I 'm curious, do yon do any direct ional t rading? = = = = Yes, for m y own account . I 've always believed t hat t echnical t rading would work. From t im e t o t im e I dabbled in it , and in each caseJt worked very well. However, I didn't like t he way direct ional t rading dist ract ed m e all t he t im e. I t urned m y ideas over t o CRT st aff m em bers who had bot h an int erest in t echnical t rading and t he appropriat e skills. They followed up by developing t echnical t rading syst em s based on t hese concept s and assum ing t he responsibilit y for t he daily t rade execut ions. I rarely look at t he syst em anym ore, except for an occasional glance at t he account st at em ent s. = = = = How long has t he syst em been operat ional? = = = =

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133 Five years. = = = = How has it done? = = = = The syst em has been profit able in four of t he five years it has t raded, wit h an average annual gain of 40 percent for t h e period as a whole. = = = = Did you do anyt hing different in t he losing year? = = = = I ronically, it st art ed out as a fant ast ic year. About halfway t hrough t he year, t he syst em was really sm oking, so we st art ed increasing t he posit ion size very quickly. At one point , we m ust have nearly t ripled it . That was t he only t im e we increased t rading size rapidly. As it t urned out , if we had held t he t rading size const ant , t he syst em would have had a winning year. = = = = I s t here any hum an Judgm ent involved in t his syst em , or is it t ot ally m echanical? = = = = Early on, t here was about a six- m ont h period when hum an j udgm ent was em ployed. = = = = And it was usually det rim ent al? = = = = Unbelievably det rim ent al. = = = = I t 's am azing how oft en t hat 's t rue. = = = = Everyone says t hat .= = = = What is your view of fundam ent al analysis versus t echnical analysis? = = = = Back in t he lat e 1970s, I once gav e a t alk on t echnical analysis at a sem inar. At lunch I ended up sit t ing at t he sam e t able as Richard Dennis. I asked him what percent age of his t rading was t echnical and what percent age was fundam ent al. He answer ed wit h scom in his voice, " I use zero percent fundam ent al inform at ion." The way he answered, I was sorry I had asked t he quest ion. He cont inued, " I don't know how you escape t he argum ent t hat all fundam ent al inform at ion is already in t he m arket ." I asked, " How do you escape t he argum ent t hat all t he t echnical inform at ion is already in t he m arket ?" He said, " I never t hought of t hat ." I adm ired him for t hat . He had a hum ilit y about him t hat I t hink explains a lot of his success. My basic argum ent was t hat t here are a num ber of t echnicians t rading wit h t he sam e inform at ion and t he dist ribut ion of success is a m at t er of who uses t hat inform at ion bet t er. Why shouldn't it be t he sam e wit h fundam ent als? Just because all t he inform at ion is in t he m arket doesn't m ean t hat one t rader can't use it bet t er t han t he next guy. = = = = To a m aj or ext ent , CRT's prom inence is due t o opt ions. I assum e t hat CRT is, in fact , t he world's largest t rader of opt ions. How did som eone wit hout any m at hem at ical t raining- yon were a philosophy m aj or, as I recall- get involved in t he highly quant it at ive world of opt ions? = = = = I have never had a course in m at h beyond high school algebra. I n t hat sense, I am not a quant . However, I feel m at h in an int uit ive way t hat m any quant s don't seem t o. When I t hink about pricing an opt ion, I m ay not know calculus, but in m y m ind I can draw a pict ure of how you would price an opt ion t hat looks exact ly like t he t heoret ical pricing m odels in t he t ext books. = = = = When did you first get involved in t rading opt ions? = = = = I did a lit t le dabbling wit h st ock opt ions back in 1975- 76 on t he Chicago Board of Opt ions Exchange, but I didn't st ay { .vim it . I first got involved wit h opt ions in a serious way wit h t he init iat ion of t rading in fut ures opt ions. By t he way, in 1975 I cram m ed t he Black- Scholes form ula int o a TI - 52 hand- held calculat or, which was capable of giving m e one opt ion price in about t hirt een seconds, aft er I hand- insert ed all t he ot her variables. I t was pret t y cm de, but in t he land of t he blind, I was t he guy wit h one eye. = = = = When t he m arket was in it s em bryonic st age, were t he opt ions seriously m ispriced, and was your basic st rat egy aim ed at t aking advant age of t hese m ispricings? = = = = Absolut ely. I rem em ber m y first day in t he T- bond fut ures opt ions pit , when t he m arket had been t rading for only several m ont hs. Som eone asked m e t o m ake a m arket in a back m ont h. [ The back m ont hs have considerably less liquidit y t han nearby m ont hs.) Since it was m y first day, I felt really out of st ep. I was t oo em barrassed not t o m ake a m arket . So I gave him a fift y- point bid/ ask spread on a hundred- lot order. I said, " Look, t his is m y first day, and I don't really t rade t he back m ont hs. I 'm sorry, but t his is t he best I can do." His j aw dropped and he said, " You're m aking a fift y- t ick m arket on a hundred- lot ! " He couldn't believe anybody was m aking t hat t ight of a m arket . = = = = The bid/ ask spreads were t hat wide back t hen? = = = = Yes, t here was far less volum e t han now. A fift y- or hundred- lot was considered a really large order. = = = = Once you put on a posit ion because t he m arket provided you wit h a large edge for t aking t he ot her side, I assum e t hat you t ried t o hedge t he posit ion t o elim inat e t he risk. However, when you went t o im plem ent an offset t ing posit ion, didn't you face t he sam e problem of wide bid/ ask spreads? = = = = The first t hing you would norm ally do is hedge t he opt ion posit ion by t aking an opposit e posit ion in t he out right m arket , which had m uch broader volum e. Then t he j ob becom es one of whit t ling down posit ions t hat can bit e you, and t here are so m any ways t o do it . For exam ple, if on t he original t rade I sold a call, I would now be looking t o buy ot her calls and could afford t o becom e t he best bidder in t he pit . = = = = Obviously, in t hose early years, t he opt ion m arket was highly inefficient . I t 's pret t y easy t o see how, in t hat t ype of sit uat ion, you could put on posit ions t hat were well out of line, hedge t he risk, and m ake lot s of m oney. However, I 'm sure t hat wit h t he dram at ic growt h in volum e over t he years, t he m arket has becom e m uch m ore efficient , and t hose t ypes of t rades no longer exist . What kind of concept s can be used in t oday's m arket t o m ake m oney? = = = =

133

134 Yes, t he m arket has becom e m uch m or e com pet it ive, but so have we. As long as we st ay a not ch bet t er t han our com pet it ion, t here will st ill be good profit opport unit ies. = = = = So t here are st ill m ispricings in t he m arket ? = = = = Absolut ely. There will always be m ispricings in t he m arket . The not ion t hat t he m arket will t rade at it s precise t heoret ical fair value im plies t hat som eone will hold it t here wit hout get t ing paid. Why should anyone do t hat ? The service of m aking a m arket , like any ot her labor, is one t hat people are not going t o want t o do for free, anym ore t han t hey would want t o wait on t ables for free. There's work involved. There's risk involved. The m arket has t o pay som eone t o do it . I t 's only a quest ion of how m uch. = = = = I s t hat paym ent a bid/ ask spread? = = = = Yes. I f t hat edge did not exist , when som eone walked in wit h a large buy or sell order, w h o would be t here t o t ake t he ot her side? The following sect ion deals wit h t heoret ical quest ions relat ed t o opt ions. Explanat ions for t he layperson are provided wit hin t he bracket ed por t ions of t ext . = = = = What do you t hink are som e of t he t - m cept ual flaws in st andard opt ion pricing m odels? = = = = I don't know how I can answer t hat quest ion wit hout disclosing inform at ion we don't want t o t alk about . = = = = Well, let m e t ake t he init iat ive. For exam ple, is one of t he flaws in t he st andard m odels t hat t hey don't give enough probabilit y weight t o ext rem e price m oves? I n ot her words, act ual price dist ribut ions have fat t er t ails t han are im plied by norm al probabilit y curves. Therefore, people using t he st andard m odels m ight t hen be inclined t o sell out - of- t he- m oney opt ions at lower prices t han would be warrant ed by t he way m arket s really work. = = = = Yes, t hat 's a flaw in t he st andar d Black- Scholes m odel. When we first st art ed, even our biggest com pet it ors didn't seem t o have t hat figured out , and a lot of our profit s cam e t hrough t hat crack. By now, however, all t he serious players have figured it out , and I assum e t hat m any com m ercially available m odels allow for it . I would add, however, t hat it 's one t hing t o recognize t hat t he t ails are fat t er t han norm al, and it 's anot her t o know where t o go from t here. For exam ple, do you sim ply fit your dist ribut ion t o your em pirical observat ions, and price opt ions accordingly? That pat h has som e serious problem s. Do you t ake int o account your hedging st rat egy? Ar e t here ot her variables t hat none of t he available m odels allow for? And, if t here are, would t heir inclusion int roduce so m uch com plexit y int o t he m odel as t o m ake it s applicat ion unweildly? I n ot her words, knowing t hat t he dist ribut ion isn't log- norm al only opens a can of worm s. Frankly, t hough, I st ill can't underst and w hy back t hen t he com pet it ion hadn't at least got t en t he lid off t he can. = = = = Well, I t hink I can answer t hat for you. The standard m at hem at ical curves t hat allow for specific probabilit y st at em ent s j ust don't look t hat way [ Le., don't have fat t er price t ails] . = = = = I t hink t hat probably explains a lot of it , but it presupposes t hat realit y m at ches t he curve in a m at hem at ician's head. Believing t hat can get expensive. = = = = Let m e t ry anot her one. St andard opt ion pricing m odels are price neut ral- t hat is, t hey assum e t he m ost likely point is an unchanged price. Do your opt ion pricing m odels differ by incorporat ing a t rend bias? ==== They don't , but I t hink som e people believe t hat t hey do. There used t o be a r um or t hat CRT gave t his line about being price neut ral and hedged but t hat we really m ade our m oney on direct ion. We didn't t ry t o dissuade people from believing t hat , because it m ade people m ore willing t o t rade wit h us. But now, since t he cat is probably out of t he bag anyway, I 'll confirm it . Our price m odels are neut ral. = = = = Hypot het ically, let 's say t hat you developed a m odel t hat had a 60 percent probabilit y of being right on t he direct ion of t he m arket . I f you incorporat ed t hat t rend proj ect ion, t hen your opt ion pricing m odel would be skewed, and t heoret ically you could do bet t er. = = = = The obvious rej oinder t o t hat quest ion is t hat if you t hink t here is a direct ional bias, set up a separat e account t o t r ade t hat idea, but in your opt ion account , t rade flat . You'll get t he sam e benefit , and if not hing else you'll segregat e t he r esult s due t o each approach. = = = = Do you believe t hat over t he long run t here's an edge t o being a seller of prem ium ? = = = = Not t hat I 'm aware of. = = = = Which do you consider a bet t er predict or of fut ure act ual volat ilit y: hist orical volat ilit y or im plied volat ilit y? [ Theoret ical m odels em ployed t o est im at e an opt ion's value use a num ber of known input s ( e.g., current price of t he underlying m arket , num ber of days unt il t he opt ion expirat ion) and one key unknown fact or: t he volat ilit y of t he m arket unt il expirat ion. Since t his fact or is unknown, all t he st andard opt ion pricing m odels assum e t hat t he fut ure volat ilit y will be equal t o t he recent volat ilit y. The opt ion price indicat ed by t his assum pt ion is called t he fair value. Som e people assum e t hat if t he m arket price for t he opt ion is higher t han t he fair value, t he opt ion is overpriced, and if it is low er t han t he fair value, it is underpriced. An alt ernat ive int erpret at ion is t hat t he m arket is sim ply assum ing t hat volat ilit y in t he period rem aining unt il t he opt ion's expirat ion will be different from t he recent past volat ilit y, called t he hist orical volat ilit y. The volat ilit y assum pt ion em bedded in t he m arket price is called t he im plied volat ilit y. I f opt ion prices are a bet t er predict or of fut ure volat ilit y t han is t he recent past v olat ilit y, t hen t he quest ion of whet her an opt ion is overpriced or underpriced is not only irrelevant but act ually m isleading. I n essence, t he quest ion posed above

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135 is equivalent t o asking whet her t here is any reason t o assum e t hat t he st rat egy of buying opt ions priced below t heir fair value and selling t hose t hat are above t heir fair value has any m erit .] = = = = I m plied volat ilit y seem s bet t er t o m e. = = = = Concept ually or em pirically? = = = = To m e it seem s pret t y obvious concept ually. The im plied volat ilit y is a st at em ent of what all t he players in t he m arket , having cast t heir vot es, believe is a fair price for fut ure volat ilit y. Hist orical volat ilit y is not hing m ore t han a num ber repr esent ing past volat ilit y. = = = = I n t he early days of opt ion t rading, however, when t he m arket s were highly inefficient , did you use a st rat egy of buying opt ions t hat were well below t heir hist orical volat ilit y- based fair value and selling t hose t hat were well above t heir fair value? = = = = No, we didn't even do it back t hen. We never assum ed t hat ( he hist orical volat ilit y was a reliable guide t o an opt ion's t rue value. = = = = How, t hen, did you det erm ine when an opt ion was out of line? = = = = By m aking a bid/ ask spread where you believed you could find som e ot her t rade t o lay off t h e volat ilit y risk and st ill leave a profit m argin. We were m aking j udgm ent s only about whet her an opt ion was overpriced or under priced r elat ive t o ot her opt ions, not about whet her it was m ispriced relat ive t o t he underlying m arket . = = = = There's been a lot of t im e and energy expended in developing im proved opt ion pricing m odels. I f t he m odel- derived price is not as good an indicat or of an opt ion's t rue value as t he current m arket price, does it really m ake all t hat m uch difference which t heoret ical m odel is used t o derive opt ion values? = = = = I t hink it does. You st ill need t he m odel t o det erm ine relat ive values. I n ot her words, you're t rying t o det erm ine whet her a given opt ion is overpriced or underpriced relat ive t o ot her opt ions, not necessarily whet her it 's underpriced or overpriced in any absolut e sense. I f t wo m odels have different opinions about t he relat ive values of t wo opt ions, t hen t he people using t hose t wo m odels are going t o t rade wit h each ot her, and t hey can't bot h be right . Yet neit her t rader m ay have an opinion about whet her a given opt ion is overpriced or underpriced, sim ply about whet her it is overpriced or underpriced relat ive t o ot her opt ions. = = = = Do you believe t hen t hat your abilit y t o develop opt ion pricing m odels t hat provide m ore accurat e m easurem ent s of relat ive opt ion values t han do t he st andard opt ion pricing m odels is part of t he explanat ion behind CRT's success? = = = = The m odels are im port ant , but t he crit ical elem ent is t he people. To m ake a com pany t his size work like a clock t akes ext rem ely unusual people. * * During t he int erview, t hree ot her CRT em ployees- Gene Frost , Gus Pellzi, and Niel Nielson- had ent ered t he room and now begin t o part ake in t he conversat ion.* * = = = = How does CRT differ in t his respect from ot her t rading com panies? = = = = GUS: People who have int erviewed here have t old m e t hat what separat es us from ot her com panies is t hat t he ot her firm s appear t o be solely int erest ed in t heir t echnical com pet ence- t heir educat ion and experience. CRT, on t he ot her hand, also t ends t o place a large em phasis on t he person and how w ell t hat person will int errelat e wit h t he ot her people in t he work group. = = = = What kind of people docs CRT look for? = = = = GENE: I n t he earlier years, we placed som e em phasis on hiring t he bright est people. One person we hired was a world cham pion go player. He had a great m ind. I t was like put t ing a hum an com put er in t he pit . One day he m ade a bad t rade, panicked, and couldn't bring him self t o cover t he posit ion and adm it he had m ade a m ist ake. He wait ed unt il t he end of t he day and st ill didn't get out . Luckily, Joe caught t he error at night , but it st ill ended up cost ing us $100,000. Even t hough t his fellow w as brilliant , he had a charact er flaw t hat allowed t he error t o get out of hand. Whet her t his guy cracked because of som e insecurit y in not want ing t o look bad, or because of som e ot her reason, in t he end it com es down t o a charact er flaw. Joe has m ade t he com m ent t hat he would rat her have a good t rader he could t rust t han a brilliant t rader he couldn't . When we hire people, we look for t hree t hings: charact er, charact er, and charact er. GUS: I t hink we t ry t o hire people who are less self- cent ered and m ore t eam players t han is t ypical for t his indust ry. A lot of ot her firm s m ay also use t hese words, but I don't t hink t hey are as int egral a part of t he com pany as t hey are at CRT. I t doesn't m ean t hat we always get it right , but j ust t rying seem s t o have put us ahead. JOE: I would describe our people as t hose who t ake as m uch pleasure in t he success of t heir group as t hey do in t heir individual success. We're not looking for people who sacrifice t heir good for t he good of som eone else, but rat her people who can t ake pleasure in t he success of t he group. People wit h t his at t it ude enhance t he value of everyone around t hem . When you put t oget her people who are not worried about whet her t hey, individually, are get t ing enough credit , you have a t rem endous advant age over t he com pet it ion. = = = = How do you ident ify whet her som eone is doing a good j ob if m any people are input t ing int o t he final result ? = = = = JOE: You can t ell. The people who work wit h t he person know, and you can ask him and he'll t ell you. I recent ly spent som e t im e reviewing an em ployee at CRT. He had writ t en out pages of inform at ion showing what he was doing and an out line of his priorit ies. Aft er about an hour of t his, I finally said, " Look, how do you t hink you have been doing? How would you rat e yourself? Not how busy have you been. Not how hard

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136 have you worked. But how have you really been doing?" He t hought for a m inut e and said, " Well, I t hink I should have been fired." He proceeded t o give m e an honest evaluat ion, including his short com ings. He knows how he's doing, bet t er t han if I were looking over his shoulder, and he r eally want s t o do t he right t hing. I n general, if I t rust som eone t o ev aluat e him self, he'll do so and t end t o be his own t oughest crit ic. = = = = Look, not everyone m ay have t he right t alent s t o do t he j ob properly. Som eone can com e in here and sincerely say, I love t he idea of CRT and I want t o be a t eam player," but st ill lack t he innat e t alent t o do t he j ob. Or a person m ight t hink he can do t he j ob and find out lat er t hat he can't . Maybe he's not quick enough, or m aybe he's t oo em ot ional. That has t o happen. How do you deal wit h t hat t ype of sit uat ion in an organizat ion like t his? = = = = JOE: Just like you do anyplace else. But t he difference is t hat if t he person is not self- cent ered, it 's so m uch easier t o find out t hat he's not right for t he j ob. He'll adm it it so m uch m ore quickly. When you get t he right t ype of person, and he finds out t hat he can't do t he j ob, he'll com e t o you. = = = = Do t he ot her people on t he t eam som et im es com e and say, " This person is j ust not working out "? ==== NI EL: Sure, t hat happens. But when it does, t here's a very st rong effort t o find a place som ewhere else at CRT for t hat person. That has happened over and over again. = = = = And does t hat work? = = = = NI EL: When we have a person whom we believe has t he right t ype of at t it ude, it succeeds far m ore oft en t han it doesn't . = = = = What dist inguishes t raders who succeed from t hose who fail? = = = = JOE: Successful t raders t end t o be inst inct ive rat her t han overly analyt ical. = = = = Why is being analyt ical det rim ent al t o being a good t rader? = = = = JOE: Because it seem s t o m ask int uit ive t rait s and abilit ies. I n fact , t he m ost analyt ical people t end t o be t he worst t raders. = = = = What ot her t rait s dist inguish t he good t raders? = = = = JOE: Hum ilit y- t he abilit y t o adm it when t hey're wrong. = = = = Doesn't t he fact t hat t here's m ore com pet it ion from ot her sophist icat ed firm s doing t he sam e t ype of t rading st rat egies cut int o your profit m argins? = = = = GUS: I t has. The m argins are a lot t hinner t han t hey used t o be. = = = = How do you handle t hat ? = = = = JOE: The m ar gins go down, but t he volum e goes up. Also, in any business, t he profit m argin shrinks only up t o a cert ain point . The m argin can't shrink so m uch t hat an efficient person in t hat business can't put bread on t he t able. Therefore, if you can be t he m ost efficient , t here should always be a profit m argin- m aybe not all t he t im e but cert ainly over t he long run. I believe t hat 's t rue of virt ually any business. = = = = CRT is t he preem inent firm of it s t ype. What m akes t he com pany different ? = = = = JOE: At CRT we believe in t he philosophy t hat people work best when t hey work for each ot her. People t hink t hat CRT's success is due t o som e secr et com put er m odel. However, I believe t hat CRT has succeeded because we build t eam s. We t ry t o give people a lot of aut horit y and pay t hem what t hey're wort h. I 'm oft en asked what is t he reason for CRT's success, and I 'm willing t o t ell people because ( A) t hey won't believe m e and ( B) even if t hey did believe m e, t hey couldn't t rain t hem selves t o do t he sam e t hing- t o t rust people and t o give up absolut e cont rol. Ot her people who do t his t ype of t rading oft en approach it t oo m echanically. People who are m at hem at ically orient ed believe t hat if you can j ust get t he form ula right , it solves t he whole problem . I t doesn't . Most businesses t end t o t hink t hat you work wit h one brain and a whole bunch of m echanical execut ioners. To build a m achine t hat uses m any different brains t hat are qualit at ively cont ribut ing different t hings is an art . Most people don't w ant t o do it t hat way. Usually som eone want s t o believe t hat it 's his t hinking t hat is m aking t hings run, and t here doesn't t end t o be sufficient credit or responsibilit y given t o ot her people. That 's not t he way t hings work here. For m e, t here's a kind of m agic around here, and I don't know if t hat 's som et hing you can pick up on or not . Wit hout t hat , CRT would have been a m uch sm aller t rading com pany. We could have st ayed in business and m ade a profit , but not hing com pared t o where we are now. = = = = When you say "wit hout t hat ," are you referring t o t he int errelat ionship am ong t he people? = = = = JOE: Yes, t hat 's t he st uff t hat m akes it a blast t o com e t o work. I consider m yself t o be unbelievably lucky t o be able t o com e t o work in t his kind of environm ent , wit h t hese people. Joe Rit chie provides living proof t hat creat ive t hinking can be m ore powerful t han com plex analysis. Alt hough he has no form al m at hem at ical t raining, by j ust t hinking about how opt ions should work Rit chie was able t o develop an opt ion pricing m odel t hat , j udging by CRT's perform ance, m ust be bet t er t han all t he academ ically derived m odels com m only in use. The t ype of t rading done by CRT has lit t le direct relevance t o individual t raders. The prim ary lessons t o be drawn from t his int erview , I believe, are not relat ed t o t rading, but rat her m anagem ent . The enorm ous financial success and widespread em ployee loyalt y enj oyed by CRT is no doubt a consequence of Joe Rit chie's m anagerial philosophy: Share t he responsibilit y and share t he profit s. This policy m akes so m uch com m on sense t hat you wonder

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137 why

m ore

com panies

don't

use

it .

Corporat e

Am erica, are you list ening?

* * / / Not e/ / * * : / / Readers unfam iliar wit h opt ions m ay wish t o read Ehe Appendix in or de r t o underst and t he t rading- relat ed references in t his chapt er./ /

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138 Blair Hull: Getting the Edge Blair Hull cam e t o t rading by way of t he blackj ack t ables. This is not as st range as it m ay sound, since t here are act ually very st rong par allels bet ween t he t wo act ivit ies. The point is not t hat success in t rading is akin t o luck in gam bling, but rat her t hat consist ent winning in bot h is a m at t er of st rat egy and discipline, not luck. Luck plays a role only over t he short t erm , where it s pot ent ial adverse im pact m ust be neut ralized by m oney m anagem ent cont r ols. Aft er t he casinos caught on t o Hull's blackj ack t eam , he sought anot her avenue for applying probabilit y t heory t o m aking m oney. He found t he sam e general principles could be em ployed t o profit from t he m ispricings t hat occurred in t he opt ion m arket s. Hull st art ed wit h $25,000 in lat e 1976 and by t he st art of 1979 had m ult iplied his st ake t went yfold. He cont inued t o score consist ent profit s in t he subsequent years, averaging roughly 100 percent per year ( excluding t hose years in which he t ook sabbat icals) . I n 1985, he launched Hull Trading Com pany t o allow for a m ore widespread applicat ion of his t rading st rat egies. The com pany, which began wit h a skelet on st aff of five, expanded rapidly, reaching nearly one hundred em ployees by m id- 1991. I f t he growt h in personnel can be described as arit hm et ic, t he expansion of com put ers w as geom et ric. HTC has an ent ire floor in it s office building devot ed t o it s com put er equipm ent . Anot her opt ion t rader wit h t he Chicago Board Opt ions Exchange ( CBOE) who m aint ains an office in t he sam e building quipped, " The building had t o put in anot her bank of air condit ioners on t he roof because Hull's com put ers w ere sucking up all t he cool air." Hull's com pany em ploys com plex st rat egies, t rading a broad range of int errelat ed opt ion m arket s against each ot her in order t o profit from t em porary m ispricings, while sim ult aneously keeping t he firm 's net risk exposure t o m inim al levels. HTC is a m arket m aker on a wide variet y of exchanges, including t he CBOE, t he Chicago Mercant ile Exchange, t he Am erican St ock Exchange, t he New York St ock Exchange, and various foreign exchanges. They account for over 10 percent of t he t ot al t rading volum e in a num ber of opt ions in which t hey m ake m arket s. All t he posit ions t aken by t he com pany's t raders, who now num ber t went y - five, are const ant ly m onit ored in real t im e. St rat egies are cont inuously revised t o t ake int o account changes in bot h m arket prices and posit ions held by t he firm , wit h a real- t im e lag of only t wo seconds. Now you get t he idea why Hull needs all t hose com put ers. A graph of HTC's t rading profit s looks like a sim ulat ion in one of t hose t rading syst em ads, except in t his case t he result s are real. A st art ing st ake of $1 m illion in 1985 grew t o $90 m illion by m id- 1991, aft er expenses. ( The gross t rading profit s during t his period were subst ant ially great er, approxim at ing $137 m illion.) The really rem arkable achievem ent is t he firm 's apparent m odest risk level despit e t hese very subst ant ial gains. Since it s incept ion, HTC has been profit able in fift y- eight of six- nine m ont hs ( aft er expenses) , wit h only five of t hese m ont hs regist ering a net t rading loss ( before expense allocat ions) . This int erview was conduct ed in a conference room at HTC. I found Hull relat ively relaxed and open in discussing his career. I part icularly liked his candidness in t alking about his blackj ack- playing experiences. = = = = How did you first get involved in t he m arket s? = = = = My int erest probably dat es back t o when m y grandfat her chart ed st ocks. I didn't really underst and what he was doing, but t he idea of having capit al working for you was appealing. The desire t o learn about t he financial m arket s led m e t o business school at Sant a Clara Universit y. Aft er graduat ing, I got a j ob as a securit y analyst at Blair and Com pany. Exact ly t hree m ont hs aft er I st ar t ed, t he West Coast research depart m ent was elim inat ed during t he bear m arket of 1969. = = = = Did you learn anyt hing about t he m arket s during your brief st int t here? = = = = I learned what financial analyst s do. I learned about Graham and Dodd and fundam ent al analysis.* I t hought t hat approach was t oo subj ect ive it couldn't be quant ified or syst em at ized. So I didn't want t o have anyt hing t o do wit h it . = = = = Aft er your j ob was elim inat ed, did you get anot her posit ion as an analyst ? = = = = No, I got a j ob selling t im e on large com put ers. However, t hat posit ion was essent ially a m arket ing slot , and I was int erest ed in doing analyt ical work. Aft er about a year , I left t o t ake a j ob in operat ions research for Kaiser Cem ent . At t hat t im e, I got int erest ed in playing blackj ack by reading a book called Beat t he Dealer by Ed Thorp. From 1971 t o 1975, I went t o t he Nevada casinos regularly. = = = = Did you live in Nevada at t he t im e? = = = = No, I lived in California. But I would t ake a blackj ack t rip every chance I got . I probably spent about five days a m ont h in Nevada during t hat t im e. I n a sense, I owe everyt hing t hat I have t o t he st at e of Nevada. I t not only provided m e w it h m y original t rading st ake, but t he bet t ing experience t aught m e a lot of t hings t hat allowed m e t o becom e a successful t rader. = = = = Would it be fair t o say t hat Thorp's book was in som e way responsible for your success as a t rader? ==== * Huil is referring t o t he book Securit y Analysis by Graham and Dodd, which is considered by m any t o be t he bible of fundam ent al analysis in t he st ock m arket . The book cer t ainly t aught m e about t he m et hodology of blackj ack. Wit hout t his knowledge, I don't t hink I would be in t he t rading business t oday. = = = = What was t he basic st rat egy espoused by t he book? = = = = I n t he basic rules of blackj ack, t he house has a sm all edge. However, if a lot of sm all cards have been

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139 dealt - t hat is, t he deck is rich in t ens and aces t hen t he odds can shift in favor of t he bet t or by, say. 1 t o 2 per cent . [ Tens refer t o t he point value of t he cards and include all pict ure cards as well as t ens.] * = = = = Would it be a m at t er of keeping t rack of t he cards and placing very sm all bet s, or not bet t ing at all, whenever t here were a relat ively large am ount of aces and t ens out ? = = = = Right . That 's essent ially what I did. I would place m aybe five bet s an hour using t hat m et hod. = = = = My im age of a blackj ack t able is where you sit down and are cont inually dealt hands* From a pract ical st andpoint , how do you bet so select ively wit hout it appearing aw kward? = = = = My st rat egy was t o play only t he hands t hat had an advant age. I st ood back and did what was called back- count ing. You can get away wit h t hat if you're bet t ing sm all am ount s of m oney. = = = = Were you im m ediat ely successful using t his t echnique? = = = = Act ually, in m y first at t em pt , I m ade only about fift y bet s and ended up wit h a net loss. At t hat point , I got a lit t le m ore involved in calculat ing '* The obj ect of blackj ack is t o get a t ot al card count great er t han t he dealer, but not higher t han t went yone. Each card has a point value equal t o it s face, except for pict ure cards, which each have a value of t en. and aces, which can be count ed as eit her one or eleven at t he opt ion of t he player, A blackj ack is a t wo- card hand consist ing of an ace and a t en- card- I f a player is dealt a blackj ack, he wins one and one- half t im es his bet , unless t he dealer dr aws t he sam e hand, in which case t he result is a t ie. I f t he dealer alone draws a blackj ack, all players lose aut om at ically. A player m ay draw as m any cards as he want s as long as his t ot al rem ains under t went y- one. I f his t ot al exceeds t went y- one, he loses aut om at ically. The m ore concent rat ed t ens and aces are in t he deck, t he bet t er t he odds for t he player how m any bet s it would t ake t o m ake sur e t hat I would be a winner over t he long run. = = = = I n ot her words, t he reason fift y bet s didn't work was t hat fift y was t oo sm all a num ber and st ill left t he odds of winning t oo close t o even. = = = = Right . I knew t hat if I kept on playing wit h t he edge in m y favor, event ually I would com e out ahead. Following Thorp's advice, I st art ed wit h a base of $120 and placed bet s bet w een $1 and $4. Aft er t wo years, I was ahead about $10,000. Around t his t im e, I becam e friends wit h anot her blackj ack player who t old m e about a t eam of players t hat were doing quit e well. He said, " This is a very secret ive t eam , so I can't give you t he leader's nam e. But I will give him your nam e, and m aybe he'll cont act you." A couple of m ont hs lat er, m y friend was killed in an aut om obile accident , and I assum ed t hat put an end t o any chances of cont act ing t he t eam . About a year lat er, t he organizer of t he t eam called m e. Act ually, during t he int erim , I had t ried t o put t oget her m y own t eam . However, I wasn't t oo successful in recruit ing qualified m em bers. For exam ple, one t im e we were supposed t o m eet at t he Sahara in Las Vegas, which is t he cit y we always played in. One of t he players, however, knew only of a Sahara in Lake Tahoe. So t hat 's where he went . All weekend long, we couldn't figure out where he was. = = = = Why were you int erest ed in a t eam approach inst ead of cont inuing t o play solo? = = = = Whet her you're playing blackj ack or t rading, your profit abilit y depends on your edge and how m any t im es you get t o apply t hat edge. The t eam approach provides t wo advant ages. First , assum e t hat over a weekend of playing, t he odds of m y com ing out ahead are t w o out of t hree. By com bining banks wit h anot her person, t he t ot al num ber of t rading days would be doubled and, as a result , t he probabilit y of winning would rise t o t hree out of four. The m ore players you com bine, t he bet t er your chances of a successful out com e. = = = = I n ot her words, if you have t he edge, by great ly increasing t he num ber of bet s, t he probabilit y of success appr oaches cert aint y. I t sounds as if you had creat ed a m inicasino wit hin a casino, wit h t he casino t aking t he sucker bet s. What is t he ot her advant age you referred t o? = = = = The t eam approach allows you t o increase t he m axim um bet size. Theoret ically, t he largest bet you can m ake should be one- fift iet h of your capit al. I f you have $1,000, t hat m eans your biggest bet should be $20. I f five players wit h $1,000 apiece com bine, however, t he m axim um bet size increases t o $100. = = = = Are you saying t hat each person could det erm ine his m axim um bet size based on t he com bined capit al base of all t he players wit hout any increase in his individual risk? = = = = That 's correct . = = = = Did t he t eam accept you as a m em ber? = = = = The t eam had a series of t est s t hat one had t o t ake in order t o becom e a m em ber. I t hought I was a very skillful player, but I act ually failed t he t est . I had t o increase m y skills in order t o becom e a m em ber of t he t eam . = = = = What were your short com ings? = = = = They were in all areas. I had som e flaws in basic st rat egy. I didn't count t he cards fast enough. I didn't est im at e decks accurat ely. = = = = How do you est im at e t he size of t he deck? = = = = The casinos t ypically used four- deck shoes. The t eam used eight different deck sizes in one- half deck increm ent s. You would pract ice ident ifying t hese different st acks, unt il you could t ell t hem apart from across t he room . = = = = What m et hod did t he t eam use t o count cards? = = = = They used a m et hod called t he Rev er e Advance Point Count : t wos, t hrees, and sixes w ere assigned a value of t wo, fours a value of t hree, fives a value of four, sevens a value of one, eight s a value of zero, nines

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140 a value of m inus t wo, and t ens a value of m inus t hree; aces were kept as a separat e count . The higher t he count - m at is, t he m ore high cards rem aining undealt - t he m ore favorable t he odds for t he players. = = = = Did t he count have t o be st andardized by t he num ber of cards rem aining? = = = = Yes. The t rue count is t he raw count divided by t he num ber of decks rem aining. So if t he raw count is t en and t here ar e t wo decks rem aining, t he t rue count is plus five. I f t here is only one- half deck rem aining, t he t rue count is plus t went y. What you're really concerned about is t he densit y of high cards in t he undealt deck. = = = = Did Thorp use a sim ilar approach in his book? = = = = Thorp st art ed out wit h a t en and non- t en count . I n his second book, he revised t hat so t wos t hrough sixes had a value of plus one, sevens, eight s, and nines were neut ral, and t ens and aces had a value of m inus one. = = = = So, in essence, t he Revere Adv ance Point Count was a m ore sophist icat ed version of t he Thorp approach. = = = = Right . There's a basic t rade- off bet ween accuracy and difficult y in keeping t he count . Even t he Rever e approach doesn't represent t he opt im al solut ion based on probabilit y t heory. But if you use a m ore com plicat ed ( and presum ably m ore accurat e) count ing m et hod, you would be prone t o m aking m ore errors. = = = = Was it hard t o keep t rack of t he t rue count ? = = = = I t t akes a lot of pract ice, and you need t o hav e discipline. Also, you develop m ent al short cut s. For exam ple, if you see a five and a t en t oget her, you aut om at ically associat e t he com binat ion as plus because t he five has a value of plus four and t he t en a value of m inus t hree. = = = = How m uch t im e did you act ually spend in honing t hese skills? = = = = I nit ially, it t akes a lot of t im e. Aft er a while, it 's a m at t er of pract icing a couple of hours before each t rip. = = = = Were you shocked when you flunked t he t eam 's t est ? What happened aft erwards? = = = = There was a bat t ery of t en different t est s. I was inform ed as t o t he lack of m y knowledge. I pract iced for about a m ont h and ret ook t he t est successfully. = = = = How m any people were part of t he t eam at t he t im e? = = = = When I j oined, t here were eight m em bers, but it event ually grew t o about t went y. = = = = Does t his t ype of operat ion depend on a great deal of t rust and honest y? I f you com bined banks and played independent ly, how did players know how t he ot her m em bers were really doing? = = = = I n t he lat er st ages, we act ually st art ed using polygraphs. I have bot h t aken and adm inist ered t hem . I n t he early days, t here weren't any polygraphs; people j ust t rust ed each ot her. = = = = At what point did people st art becom ing suspicious of ot her m em bers of t he t eam ? = = = = [ He laughs.] I t becam e obvious t hat one of t he players was skim m ing off t he t op. = = = = Because t here's a lot of cont roversy about polygraphs, I 'm curious about whet her you believe t hat t he t est s act ually work. = = = = Generally speaking, I believe t hey're about 85 per cent accurat e. I 've t aken four and adm inist ered about six. There's no quest ion t hat t he process of get t ing ready for t he polygraph and adm inist ering t he t est can get inform at ion from people. I n one case, I lit erally saw t he blood drain from a person's face when I asked a quest ion. I 've had adm issions before, during, and aft er polygraphs. Som et im es t he inform at ion you t urn up is m inor- for exam ple, a person not account ing for expenses accurat ely. Som et im es t here are bigger issues involved. For exam ple. one fellow was playing for anot her t eam at t he sam e t im e he was playing for us, which involved passing on propriet ary inform at ion t o a com pet it or. = = = = Did t he t eam operat e as a t eam or j ust sim ply separat e individuals using a com m on bank? = = = = There w ere several versions of t eam s. This part icular large t eam used a m et hod in which t here w as a Big Player and several card count ers. The card count er s were spread out over several t ables and would bet relat ively sm all. They would t hen signal t he Big Player when t he count was very favorable. = = = = Was t his done t o be less obvious? = = = = Right . I f t his guy isn't looking at t he cards, how could he be count ing t hem ? = = = = How long did it t ake for t he casinos t o learn of t he t eam 's exist ence? = = = = A lit t le over six m ont hs. We st art ed playing very big. We j ust kept building and building, and pret t y soon we were playing lim it , and t hey knew who we were. = = = = Did t hey know you were all part of t he sam e t eam , or did t hey j ust know you individually? = = = = They knew each of us, but t hen t hey slowly st art ed t o pick up t he associat ions. There was a det ect ive agency t he casinos em ployed t hat specialized in finding card count ers. The agency classified car d count ers in t he sam e cat egory as dice cheat s or slot m achine drillers. Essent ially, t he casinos don't want t o have skillful players. And I underst and t hat . I wouldn't eit her if I owned a casino. = = = = I s it easy t o spot a card count er because he's not playing every hand? = = = = I t 's easy t o spot him even if he is playing every hand. = = = = Because of t he variat ion of bet size- bet t ing low on low- probabilit y hands? = = = = Yes. I f I st ood behind som eone playing wit h a large am ount of m oney, I could t ell very quickly at what level of advant age or disadvant age he was playing. = = = = Did you originally t hink t he t eam would last longer before t he casinos caught on? = = = = I t hink if we had been a lit t le m ore discreet , t he t eam could have last ed longer. One of t he problem s was t hat one of t he m em bers of t he t eam was m ore int erest ed in writ ing a book t han in t he cont inued success of t he t eam . [ The book Hull is referring t o is The Big Player, by Ken Ust on; Holt , Rinehart and Winst on, 1977.]

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141 I ronically, I w as t he one w ho t alked t he ot her part ners int o allow ing him t o be a Big Player. I t proved t o be t he st art of t he t eam 's downfall. People have a basic need t o be recognized. He had a need t o be recognized- even by t he casinos. Unt il you get barred, t he casinos haven't recognized t hat you're a good player. There are direct parallels t o t rading in t he m arket s. = = = = Let 's t alk about t hat connect ion. = = = = I t 's t he sam e t hing. The people who want t o be recognized as t he great est t raders are pr obably not t he great est t raders. Egos get in t he way of t he process. I n m y opinion, you never want t o be t he largest player in t he pit . = = = = Before I get t o t he connect ion bet ween blackj ack and t rading, I 'm j ust curious: I s it st ill possible t o beat t he casinos using t he card count ing m et hod t oday? = = = = Absolut ely. I f I didn't have any m oney, t hefe's no doubt in m y m ind about where I would go. = = = = Then why don't t he casinos use larger decks or reshuffle m ore frequent ly so as t o m ake card count ing unfeasible? = = = = First of all, t he prevalence of blackj ack st rat egy books act ually helps t he casinos by giving people t he hope of winning. Also, it 's not t he m at hem at ical skill t hat 's crit ical t o w inning, it 's t he discipline of being able t o st ick t o t he syst em . There are v ery few people who can dev elop t he skills t o get t he edge, and far few er st ill who can wit hst and t he losses em ot ionally and st ill st ick wit h t he syst em . Pr obably only one in five hundred people has t he necessary discipline t o be successful. = = = = Did t he t eam s on which you played help enforce t he necessary discipline? = = = = To som e ext ent , t he t eam helps you t o develop discipline. I t 's alm ost like t he arm y- you have t o do t hings under cert ain condit ions and you have t o have a cert ain skill level. The discipline is im posed by t he t eam as a self- regulat ory process. I t 's very difficult for an individual t o have t he sam e level of discipline. = = = = So t he casinos leave it feasible t o win in blackj ack by card count ing because t here are m ore people who m isapply t he st rat egies for winning. = = = = Absolut ely. = = = = What elem ent of t he blackj ack playing experience do you believe cont ribut ed t o your success as a t rader? = = = = The ex perience of going t hrough ext ensive losing periods and having t he fait h t o st ick wit h t he syst em because I knew t hat I had t he edge was som et hing t hat helped m e a great deal when I went int o t he pit . Also, t he risk cont rol experience was very beneficial. I n blackj ack, even if you have t he edge, t here ar e going t o be periods of significant losses. When t hat happens, you have t o cut back your bet size in order t o avoid t he possibilit y of ruin. I f you lose half your st ake, you have t o cut your bet size in half. That 's a difficult t hing t o do when you're down significant ly, but it 's essent ial t o surviving. = = = = The way you express it , blackj ack and t rading are very sim ilar. = = = = That 's right . All you need is a m at hem at ical advant age and t he m oney m anagem ent cont rols t o assure t hat you st ay in t he gam e. Everyt hing else t akes care of it self. = = = = What happened aft er t he t eam was uncovered? = = = = For a while, I used t he sam e principles t o organize sm aller t eam s. I kept a low profile by being a count er inst ead of t he Big Player and playing in ot her locat ions, like At lant ic Cit y. When I got t ired of t raveling so m uch, I t ried t o find ot her ways of applying probabilit y t heory. For a while, I t ried poker, but I found t hat , alt hough 1 had all t he m at hem at ics down pat , I didn't have t he appropriat e skills. Every t im e I had t he hand and bet large, everybody folded, and every t im e I bluffed, everybody st ayed in. = = = = Now correct m e if I 'm wrong. I n blackj ack, t he rules are absolut ely dict at ed. The dealer has t o draw anot her card or he has t o st ick, depending on his card count , whereas in poker, people have m ore choice, and reading your opponent becom es a fact or. Therefore, even if you have t he edge m at hem at ically, if people can read your em ot ions correct ly or you can't read t heirs, you lose t he edge. = = = = Right , you lose t he edge in a m aj or way. Bluffing is an essent ial elem ent of t he gam e. There's a m at hem at ician who has writ t en som e very good books on poker st rat egy, but he's never been able t o m ake any m oney playing poker. = = = = Do you believe t hat som e of t he successful floor t raders are successful because t hey're good at reading people? = = = = Absolut ely. To som e ext ent , you can sense when anot her m arket part icipant is in t rouble. I n ot her words, he's offering at a quart er and you can j ust read t hat he needs t o get out . So even if you want t o buy at a quart er, you'll wait , because you know he's event ually going t o reduce his offer t o an eight h. This approach was never an im port ant elem ent in m y own t rading, however. Most of t he m oney I 've m ade has been t he result of being on t he right side of t he t heoret ical value. = = = = When did you act ually get involved in t rading? = = = = During t he period when I was winding down m y involvem ent in black- j ack, I st art ed t o work on som e opt ion valuat ion m odels. = = = = Was your m odel sim ilar t o t he st andard m odels, such as Black- Scholes? = = = = Act ually, t he paper on t his m odel was published in 1973. I was unfam iliar wit h t he lit erat ure, so in 1975 I was busy const ruct ing t his m odel, which in fact had already been developed. I n t at e 1976,I applied t o be a m arket m aker on t he Pacific St ock Exchange. = = = = What was your t rading m et hod? = = = =

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142 Each day, I ran a com put er program t hat generat ed t heoret ical value sheet s, which t old m e what each opt ion was wort h at a cert ain st ock price. Essent ially, I walked around t he pit s wit h t hese sheet s, and any t im e an opt ion was out of line wit h m y t heoret ical m odel, I bought or sold it . = = = = So when you first st art ed in opt ion t rading, you were looking for opt ions t hat were out of line wit h t heir t heoret ical value. = = = = That 's right . = = = = That raises an int erest ing quest ion. Since t heoret ical values are based on hist orical volat ilit y, doesn't t hat approach im ply t hat hist orical volat ilit y is a bet t er predict or of fut ure volat ilit y t han im plied volat ilit y? [ For a det ailed discussion of t he concept s under lying t his quest ion, see t he Joe Rit chie int erview, pages 35657.] = = = = No. Act ually, em pirical st udies have shown t hat im plied volat ilit y is bet t er t han hist orical volat ilit y in predict ing t he act ual fut ure- volat ilit y. = = = = Then how could you m ake m oney by t rading based on m ispricings relat ive t o your m odel? = = = = The real key is relat ive value. I t doesn't m at t er what m odel you use, as long as you apply it consist ent ly across all opt ion prices. What I was really concerned about was t he price of opt ions relat ive t o each ot her. I would adj ust t he m odel- im plied prices so t hat t he at - t he- m oney im plied price w as in line w it h t he m arket price. For exam ple, if t he m odel said t he at - t he- m oney opt ion was wort h 3 but t he opt ion was act ually t rading at 3 1/ 2, t hen I would raise t he volat ilit y assum pt ion in t he m odel so t he at - t he- m oney opt ion would also be priced at 3 1/ 2. Once you m ake t hat adj ust m ent , all t he ot her opt ion values should be in line wit h t he m arket . Then I would m erely buy t hose opt ions t hat were t rading cheaper and sell t hose t hat were m ore expensive. = = = = I n ot her words, we're not t alking about looking at whet her t he m arket is out of line wit h t he m odel, but rat her whet her t he individual opt ions in a specific m arket are out of line relat ive t o each ot her. = = = = Yes. I would say t hat in t he early periods, m ost of m y m oney was m ade in t hose t ypes of t rades. = = = = Besides t he fact t hat t he m at hem at ical m odels are forced t o est im at e t he unknown fut ure volat ilit y by using past volat ilit y, are t here any ot her pot ent ial pit falls in using t hese m odels? = = = = Most of t he m odels assum e t hat st ock opt ions follow a log- norm al dist ribut ion. I n fact , I found out t hat t he act ual price dist ribut ions of virt ually all financial m arket s t end t o have fat t er t ails t han suggest ed by t he lognorm al dist ribut ion. = = = = To put t hat in lay t erm s, you're saying t hat t he st andard m at hem at ical m odels do not provide an accurat e reflect ion of how opt ions should be priced in t he real world because of t he t endency of ext rem e price m oves t o occur far m ore frequent ly t han im plied by t he st andard assum pt ions in t hese m odels. = = = = Correct . = = = = This would im ply t hat it m akes m ore sense t o be a buyer of deep out - of- t he- m oney opt ions t han m ight be assum ed based on a m odel. = = = = That 's t rue- especially in pot ent ial t akeover sit uat ions. = = = = Given t his bias, m ight you not be m isled t o be willing t o sell a deep out - of- t he- m oney opt ion versus anot her opt ion m ore readily t han you should? = = = = Yes, absolut ely. I n all classes of opt ions, if you believed t he m odel, you would sell m ore of t hese opt ions. = = = = Were you losing m oney doing t hat ? = = = = No. I was consist ent ly m aking m oney, but t hat kind of st rat egy- selling deep out - of- t he- m oney opt ionsonly leads t o consist ent profit s unt il a cat ast rophe ar ises. Then you lose it all, plus som e. = = = = Were you lucky not t o hit a cat ast rophe using t hat approach? = = = = I was lucky in hit t ing cat ast rophes t hat did not t ake m e out of t he gam e, even t hough t hat could have happened. = = = = Can you give m e a specific exam ple? = = = = I n 1981,1 had financed a t rader on t he Am erican St ock Exchange who sold out - of- t he- m oney opt ions in a t akeover sit uat ion. I lost about one- t hird of m y capit al in t hat one t rade. Em ot ionally I handled it very w ell. Unfort unat ely, about a week lat er, I had anot her large loss in a short out - of- t he- m oney call posit ion in Kennecot t . I r onically, even t hough m y posit ion was relat ively sm all, t he overnight m ove was so enorm ous t hat t he loss was subst ant ial. Aft er t hese t wo t akeovers, I had lost about half m y m oney. = = = = How long had you been t rading at t hat t im e? = = = = About four and a half years. = = = = Am I underst anding you correct ly? These t wo t rades alone wiped out approxim at ely half of t he cum ulat ive profit s you had m ade on t he presum ably t housands of t rades up t o t hat point ? = = = = Right . = = = = How had you done over t he four years up t o t his point in t im e? = = = = I n m y first t wo years in t he business, I had back - t o- back 400 percent r et urns. Thereaft er, I averaged roughly 100 percent per year. = = = = What about 1981, t he year in which you had t hese t wo big hit s? = = = = I st ill ended t he year wit h a net profit . = = = = Were your t rading profit s m ade st rict ly by t aking advant age of m ispricings? = = = = Right . The speculat ors are usually on one side of t he m arket . For exam ple, t hey m ay be buying out - of-

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143 t he- m oney calls. At t he sam e t im e, inst it ut ional invest ors m ight be doing buy writ es, which would be selling long- t erm calls. To som e ext ent , a sm art m arket m aker is a risk t ransfer agent . He would buy t he calls from t he inst it ut ions and sell t he ot her calls t o t he speculat ors, t rying t o balance t he overall posit ion so t hat t here is as lit t le net risk as possible. = = = = Were you always t ot ally hedged? = = = = I always t ried t o be relat ively hedged. I n a t akeover sit uat ion, however, you m ight t hink t hat you are hedged, but t he price m ove occurs so quickly t hat you really aren't . = = = = You m ent ioned t hat speculat ors are usually on t he buy side of opt ions. I n general, do you believe t here is a m ispricing t hat occurs because people like t o buy opt ions? = = = = I f you com pare hist orical graphs of im plied volat ilit y versus hist orical volat ilit y across a spect rum of m arket s, you will see a dist inct t endency for im plied volat ilit y being higher- a pat t ern t hat suggest s t hat such a bias exist s. = = = = Does t hat im ply t hat being a consist ent seller of opt ions is a viable st rat egy? = = = = I believe t here's an edge t o always being a seller, but I wouldn't t rade t hat way because t he im plied risk in t hat approach is t oo great . But t o answer your quest ion, generally speaking, I believe t he buyer of opt ions has t he disadvant age. = = = = I n t akeover sit uat ions, are t here som et im es clues t hat som et hing is going t o happen- for exam ple, an opt ion suddenly st art ing t o t rade significant ly beyond where it should be t rading? = = = = Of course. I n fact , in recent years, som e of t he regulat ory people have st art ed t o look at t hese t hings. There are also som e t raders who use indicat ors called wolf det ect ors. These t raders m onit or t he m arket s for unusual price m oves in t he underlying st ock, or sudden increases in volum e, or a j um p in im plied volat ilit y for t he out - of- t he- m oney opt ions. These t ypes of indicat ions are used as a warning t hat t here m ay be a wolf out t here, so t o speak. But t hat 's not m y approach. = = = = How do you prot ect yourself against t he possibilit y t hat t here m ay be a surprise t akeover in a st ock in which you hold a significant short out - of- t he- m oney call posit ion? = = = = I n individual st ocks, you play t he high capit alizat ion issues, which t end t o have inform at ion t hat is already in t he m arket place. You t end t o get far fewer sudden m oves when t rading t he high capit alizat ion st ocks. = = = = Do you ever do any direct ional t rades? = = = = Maybe a couple of t im es a year, I m ight get are st r ong idea for a direct ional t rade. Alt hough t hese t ypes of t rading ideas are infrequent , t hey're usually right . = = = = Can you give m e an exam ple? = = = = When I was t rading on t he Pacific St ock Exchange, I bought t housands of calls in McDonnell Douglas. At t he t im e, t here had been a num ber of DC- 10 crashes, and ( here was som e speculat ion t hat t hey would never fly again. I went hom e and t old m y wife about t he large posit ion I had in t hese calls. She was absolut ely horrified. She said, " Those planes [ DC- 10s] are never going t o fly again. We're going t o be broke." = = = = Was t his opinion based on t he news coverage prevalent at t he t im e? = = = = Yes. I t was t he clim ax of fear in t he public. You could say m y wife t aught m e t o be a cont rarian. That t rade t aught m e a lot about t he m ar ket place. When nobody want s t o t ouch t he m arket , t hat 's t he t im e you have t o st ep up. = = = = Do you rem em ber any ot her direct ional t rades? = = = = On t he day following t he 508- point crash in t he Dow Jones index [ Oct ober 19, 1987] , due t o a com binat ion of pervasive fear in t he m arket and t he increased capit al requirem ent s by t he clearing firm , we couldn't find anybody t o execut e our orders in t he Maj or Market I ndex [ MMI ] t raded on t he Chicago Board of Trade. As a result , I was forced t o go over t here and t rade in t he pit m yself. I heard rum ors t hat t he Chicago Mercant ile Exchange was considering calling a t rading halt . [ The CME t rades t he S&P 500 index fut ures cont ract .] I f t rue, t his would have represent ed a drast ic act ion. I im m ediat ely ran t o call up m y desk t o t ry t o resear ch what had happened aft er past t rading halt s. However, aft er about t hirt y m inut es, t hey couldn't find out anyt hing. I sensed t hat t he CME was about t o halt t rading. 1 called back t he desk and said, " Make sure t hat we're long on any t rading halt ." = = = = Why did you want t o be long? = = = = Because t he fear was all out of proport ion t o realit y. I had t o be a buyer. We have a philosophy t hat involves always t rying t o provide liquidit y t o t he m arket . The Mere ev ent ually halt ed t rading and about t hree m inut es lat er a com m ission house brok er was t rying t o get a bid on a one- hundred- lot sell order. The m arket was t rading at 290 and nobody was bidding any size. I bid 285 and he sold m e a hundred. A few m inut es lat er, he sold m e anot her fift y at t he sam e price. Those were t he only t rades t ransact ed at 285. The m arket closed at 400 t hat day. = = = = Of course, in hindsight , t hat was a great t rade- you ended up buying t he low. But couldn't t he rat ionale of buying because fear was out of proport ion t o realit y also have been used as a reason t o go long t he previous day when t he Dow Jones collapsed by over 500 point s? = = = = There was a specific event t ied t o t he t im ing of t hat t rade: t he CME was going t o halt t rading. = = = = Any ot her direct ional t rades t hat com e t o m ind? = = = = I went long t he st ock m arket on t he m orning of January 15, 1991, t he day of Bush's or iginal m idnight ult im at um deadline t o Hussein. Everybody t hought t he m arket w ould go down 150 point s if t he war st ar t ed. I t hought , " How bad can t his war be?"

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144 = = = = Your assum pt ion was t hat Bush would m ove as soon as he could? = = = = My assum pt ion was t hat t he uncert aint y had t o dim inish, and t herefore I had t o be long t he m arket . My st rat egy was t o put on half t he posit ion t hat m orning j ust before t he deadline expirat ion and t he ot her half aft er t he war had st art ed. = = = = Put t ing on t he first half before t he st art of t he war cert ainly proved t o be t he right m ove. But do you rem em ber w hy you didn't wait t o put on t he ent ire posit ion unt il aft er t he war had act ually st art ed? = = = = I t was j ust a m at t er- of t he fear and uncert aint y in t he m arket . My head t rader put t hat t rade in t he LTG account . A few years earlier, I had crit icized one of m y arbit rage t rader s for want ing t o t ake a net long posit ion by saying, " What do you t hink, you have a line t o God?" So put t ing t he t rade in t he LTG account was his way of m aking fun of m e. = = = = Did you end up buying t he ot her half of t he posit ion aft er t he war had st art ed? = = = = No. I would have put it on if t he m arket had opened down, but inst ead t he m arket opened up sharply higher. = = = = Your m ain profit abilit y, however, doesn't com e from direct ional t rades? = = = = That S&P 500 t rade am ount ed t o close t o $4 m illion in about t hirt y m inut es, which cert ainly helped our P and L for t hat day. But overall, I would say t hat t hose t ypes of t rades account for only about 5 percent of t he firm 's t ot al t rading profit s. Our basic m et hodology is st ill buying undervalued securit ies and selling overvalued securit ies. I t all goes back t o t he blackj ack philosophy t hat , if you have t he edge, in t he long run, you'll m ake m ore m oney by doing a lot of t ransact ions. = = = = Have your st rat egies changed t rom t he basic concept of buying t he cheap opt ions and selling t he m ore expensive ones? = = = = Speed has becom e m uch m ore im port ant and strat egies have becom e m uch m ore com plex. = = = = I s t hat because t he easier plays are gone? = = = = This is always a horse race, and unless you're m nning very fast , t hey're going t o cat ch you. = = = = Do you now have t o focus on int erm arket t rades inst ead of int ra- m arket t rades? Has t he single m arket m ispricing disappeared? = = = = Absolut ely. Your ret urn on capit al would be very sm all if you weren't t rading across m arket s. = = = = There are m any ot her m aj or Grm s, such as CRT, ut ilizing sim ilar t rading st rat egies. Don't you find yourself com pet ing wit h t hese ot her firm s for t he sam e t rades? How do you avoid get t ing in each ot her's way? = = = = You have t o realize who is driving t he m arket . None of us would be here if it weren't for t he inst it ut ions who want t o do t he t rades. They have a need t o alt er t heir risk profile, and we t ake t he ot her side. Also, we do differ from som e of t hese ot her firm s you m ent ioned in t hat we look for t he less obvious offset s. = = = = What does t hat m ean? = = = = I t 's an out gr owt h of m y days as a floor t rader. I was one of t he slowest floor t rader s ever. Because som eone else would always get t o t he prim ary m arket first , I had t o look som eplace else. I would end up offset t ing a t rade in a m ark et t hat was not as highly correlat ed. For exam ple, if t he OEX opt ions were priced high and t he arbit rage t r aders wer e sellers, t hey would offset t hese posit ions in t he S&P 500. I nst ead, I would end up hedging t he posit ion in t he NYFE [ New York Fut ures Exchange] and MMI , because t he ot her OEX t raders would already have hit t he S&P 500. [ The OEX cont ract is based on t he S&P 100, w hich is ext rem ely highly correlat ed wit h t he S&P 500 but less correlat ed wit h t he ot her st ock indexes, such as t he NYFE and MMI .] = = = = Having t oured your operat ion, I find it difficult t o believe t hat you're st ill one of t he slowest t raders. ==== Well, probably not anym ore. We'r e highly aut om at ed now. But m y on- t he- ft oor experience has m ade us m uch m ore inclined t o look for less obvious m arket s in which t o offset t rades. We look for t rading opport unit ies bet ween less correlat ed m arket s. = = = = Do yon t ry t o keep t he firm 's t ot al posit ion basically hedged all t he t im e? = = = = I t ry t o have a zero delt a port folio [ a port folio t hat is neut ralized relat ive t o direct ional m oves in t he m arket ] . The net delt a of t he firm 's port folio [ i.e., t he cont ract equivalent net long or short posit ion] is reevaluat ed wit hin t wo seconds each t im e any of t he t raders m akes a new t rade. There is a feedback process so t hat each t rader knows t his inform at ion inst ant aneously and t herefore knows in which direct ion t o lean. = = = = I n ot her words, if t he firm 's net posit ion is long, t he t raders lean t o finding m ispricings t hat require im plem ent ing a posit ion wit h a bearish bias. = = = = Exact ly. I n essence, each t rader is really t rading a firm st rat egy. = = = = I s each t rader responsible for hedging his own t rades? = = = = No. We have t went y- five t raders, one of whom is responsible for doing t he hedging [ i.e., assuring t hat t he firm 's net exposure t o price changes is as close t o zero as possible] . You m ight say he's t he air t raffic cont roller. = = = = So t he individual t raders can buy what ever t hey t hink is cheap and sell what ever t hey t hink is high, even if it 's a one- sided t rade, because t hey know t hat t he air t raffic cont roller will m ake sure t hat t he firm 's net posit ion st ays close t o neut ral = = = = Exact ly. When t here's an edge on a t rade, pan of t he cost of t aking t hat t rade is t hat you have t o give up som e of t hat edge t o som ebody else in order t o hedge it . The beaut y of t his syst em is t hat t he cost of

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145 hedging is very sm all. = = = = Covered calls [ buying a st ock and selling a call against it ] are frequent ly prom ot ed as t rading st rat egies. As we bot h know, doing a covered call is I dent ical t o selling a put I s t here ever any st rat egic rat ionale for im plem ent ing a covered call inst ead of a short put , or is t he form er prom ot ed because it involves a double com m ission, or perhaps t or sem ant ic reasons- t hat is, even t hough t he t wo t rades are ident ical, t he covered call sounds like a less risky proposit ion t han a short put posit ion? = = = = I don't know how t o art iculat e t he fraud t hat is som et im es per pet rat ed on t he public. A lot of st rat egies prom ot ed by brokers do not serve t he int erest of t heir client s at all. I alm ost feel guilt y w hen t aking t he ot her side of a covered call posit ion, because it 's obvious t hat t he cust om er is operat ing under a m isconcept ion. = = = = Then you agree t hat anyone who want s t o do a covered call would be bet t er off sim ply selling a put , assum ing t hat he plans t o init iat e and liquidat e t he st ock and call posit ions sim ult aneously? = = = = Right . I f you want t o guarant ee an inferior st rat egy, do covered calls. = = = = I could never underst and t he logic.... = = = = You've got t he gam e. = = = = On expirat ion, sm all m oves in t he underlying st ock can m ake a big difference in whet her an opt ion expires profit ably or unprofit ably. I t seem s like t here m ust be a t rem endous t em pt at ion for people wit h a large opt ion posit ion t o t ry t o influence t he price of t he st ock at expirat ion. Does t hat happen? = = = = When I was a t rader on t he Pacific St ock Exchange, t wo sm aller m arket m akers want ed t o pin t he price of a part icular st ock t o t he st rike. They want ed t o sell t he st ock on t he expirat ion dat e and m ake sure all t he calls and put s went out w ort hless. They enlist ed t he aid of a lar ge m arket m aker in t his schem e. The large m arket m aker agreed t o j oin t heir group and pin t he st ock at t he st rike. I nst ead, he t ook t he opposit e posit ion and t ook t hem bot h out of t he gam e. [ He laughs at t he recollect ion.] Act ually, t here is a nat ural t endency for st ocks t o finish at or near t he st rike. A few years ago I did som e st at ist ical w ork t hat w as quot ed in t he Wall St reet Journal. Speculat ors t end t o be long t he slight ly in- t hem oney calls and t hey usually sell t heir opt ion posit ions prior t o ex pirat ion because t hey don't want t o ex ercise t hem . For exam ple, let 's say a st ock is t rading at 60 1/ 2. Most of t he open int erest will be in t he 60 calls. The public, w hich is long t he 60 calls, w ill t end t o sell t his posit ion as expirat ion approaches. The m arket m aker will be on t he ot her side of t his t rade, and in order t o hedge him self he has t o sell t he st ock. This chain of event s t ends t o push t he price of t he st ock t oward t he nearest st rike price at expirat ion. I found t hat , st at ist ically, a st ock is about t wice as likely t o finish wit hin one- quart er of a point of t he st rike price at an opt ion expirat ion t han m ight be expect ed if t here were no correlat ion involved. = = = = Do you use t his finding in any way? = = = = Yes, we play t his st rat egy because it pr ovides an edge. = = = = Any advice for t he nonprofessional who t rades opt ions? = = = = The OEX RAES ( Rem ot e Aut om at ic Execut ion Syst em ) is t he public's edge. The syst em provides an aut om at ic execut ion wit hin t en seconds or so. = = = = Why do you say it 's t he public's edge? = = = = Because m arket m akers have agreed t o be on t he ot her side. When m arket s t urn ext rem ely volat ile, t he m arket m akers cannot updat e t hese quot es fast enough. Therefore, t he public cust om er has a t rem endous edge in t hose t ypes of m arket s. = = = = Why should a cust om er ever go t o an open out cry execut ion if he can use t his aut om at ic syst em ? ==== The RAES only accept s or ders of t en cont ract s or less. I f t he order size does not exceed t his lim it , t he cust om er would generally be bet t er off using t his execut ion syst em . = = = = What do you t hink are som e of t he key charact erist ics or t rait s of a successful opt ions t rader? = = = = You can't list en t o t he news. You have t o go wit h t he fact s. You need t o use a logical approach and have t he discipline t o apply it . You m ust be able t o cont rol your em ot ions. = = = = Anyt hing else? = = = = Consist ency. You need t o go for t he sm all t heoret ical edges inst ead of hom e runs. = = = = I s t here a cert ain personalit y t ype t hat is best suit ed t o being a successful t rader? = = = = Based on m y experience wit h t he t raders I 've hired, I would say t hat successful blackj ack, chess, and bridge players are m ore likely t o fit t he profile of a good opt ions t rader. = = = = What are som e of t he m isconcept ions you have found people have about t he m arket ? = = = = They t end t o list en t o rum ors. They'r e t oo int erest ed in who's buying or selling. They t hink t hat t ype of inform at ion is im port ant ; yet it rarely m eans anyt hing. = = = = Do you feel t hat your past experience on blackj ack t eam s influenced you in m oving t oward a t eam t rading approach? = = = = The experience was helpful in being able t o successfully build a t rading t eam . = = = = Did you ent er t his business t hinking you were going t o be a t eam t rading leader as opposed t o an individual t rader? = = = = I act ually went int o t he business t hinking I could aut om at e ever yt hing and t hat a m achine would do it all. = = = = When did you realize t hat wasn't going t o happen? = = = = I haven't realized t hat yet . I 'm st ill working on it [ he laughs] . We reward people who aut om at e. We want

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146 people t o work t oward t hat goal. Som e people are fond of saying, " Even a poor syst em could m ake m oney wit h good m oney m anagem ent ." This cont ent ion is com plet e nonsense. All t hat good m oney m anagem ent will do for a poor st rat egy is t o assure t hat you will lose m oney m ore slowly. For exam ple, no m oney m anagem ent sy st em can ev er be designed t o m ake m oney playing roulet t e, because t he edge is against you. ( The odds would be exact ly even, but t he zero and double zero give t he house a decisive advant age.) I n fact , if you are playing a poor st rat egy ( one where t he edge is against you) , your best chance for com ing out ahead is t o apply t he ext rem e of bad m oney m anagem ent - risk everyt hing on one t rade. = = = = Why? = = = = Because t he longer you play wit h a negat ive edge, t he great er t he probabilit y of event ual financial ruin. Probably t he m ost basic requirem ent for successful t rading is t hat you m ust have som e well- defined m et hod, or, in ot her words, a specific approach t hat gives you an edge. That approach could be buying undervalued securit ies and selling overvalued securit ies, as it is for Hull, or it could be som e bet t er- t han- breakev en way of select ing price direct ional t rades. Wit hout such a m et hod, or edge, you will event ually lose, because t he odds are 50/ 50 before t ransact ion cost s. I f you don't know what your m et hod is, you don't have one. ( By t he way, buying a st ock because your brot her- in- law gives you a t ip is not a m et hod.) The Hull int erview also helps underscore t he dist inct ion bet ween gam bling and bet t ing or t rading w it h an edge. Part icipant s in t he m arket m ay well be gam bling. I f you don't have a m et hod ( i.e., an edge) , t hen t rading is every bit as m uch a gam ble as bet t ing in t he casinos. But wit h a m et hod, t rading- or for t hat m at t er, even blackj ack- becom es a business rat her t han gam bling. Fort unat ely for t raders, whereas t he casinos can bar players because t hey becom e t oo pr oficient , t he m arket has no way of elim inat ing t he skillful t raders ( ot her t han behaving in a m anner t hat seem s t o confound t he great est num ber of people t he gr eat est am ount of t im e) . Therefore, if you can devise a m et hod t o beat t he m arket , no exchange can com e t o you and say, " We've not iced t hat you're m aking t oo m uch m oney. You can't t rade here any m ore." Once you have a m et hod, you st ill need m oney m anagem ent t o prevent an adverse st r eak from t aking you out of t he gam e. I t is crit ical t o keep in m ind t hat even if you have t he edge, you can st ill lose all your m oney. Therefore, t he bet or t rade size m u&t be sm all enough t o keep t he probabilit y of such an event very low. So t he appropriat e quot e is, " Even a good syst em can lose m oney wit h poor m oney m anagem ent ," rat her t han t he fallacious cont ort ion of t his t hem e quot ed at t he st art of t his sect ion. This sam e t hem e is colorfully described in Ken Ust on's The Big Player, t he book w rit t en about t he blackj ack t eam t hat Hull described in. t he int erview: List ening t o Barry narrat e his horror st ory. Ken t hought back t o a day several weeks earlier when a broker friend who count ed cards had com e over t o his apart m ent t o discuss his favorit e subj ect - losing. Ever since ext rem e negat ive swings had led t o his personal Las Vegas wipeout several years ago, t he m an approached t he blackj ack pit conservat ively. He warned Ken about t he dangers of t he t eam 's escalat ing bet t ing level. " Those swings are wild, Kenny. I 'm t elling you, t hey can really hurt you. Wat ch out . So far you guys have been lucky, but t hose swings are t here." Anot her pert inent lesson t hat Hull applied t o blackj ack, as well as t rading, is t hat if you have a winning m et hod, you m ust have t he fait h t o keep applying it even during losing periods. The t rick, however, is t o reduce t he risk by reducing your bet or t rade size so t hat t he rat io bet ween risk and equit y st ays relat ively const ant . Alt hough Hull is predom inant ly an arbit rage t rader, he occasionally t akes direct ional t rades, which have t ended t o be quit e successful. Hull's rules for direct ional t rading, alt hough not explicit ly st at ed, can be inferred from t he int erview: 1. Trade infrequent ly and only when you have a st rong idea. 2. Trade t he opposit e side of t he predom inant news st ories. 3. Tim e your t rade t o coincide wit h an event t hat has t he pot ent ial t o lead t o a panic clim ax. * * / / Not e/ / * * : / / Readers unfam iliar wit h opt ions m ay wish t o read t he Appendix in order t o underst and t he t rading- relat ed references in t his chapt er./ /

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147 Jeff Yass: The Mathematics of Strategy Teff Yass st art ed as an opt ion t rader on t he floor of t he Philadelphia • J St ock Exchange in 1981. He was so ent hralled by t he opport unit ies in opt ion t rading t hat he ent iced a num ber of his college friends t o t ry t rading careers. During t he early 1980s, he t rained six of t hese friends as t raders. I n 1987, Yass and his friends j oined t o form Susquehanna I nvest m ent Group. The firm has grown rapidly and now em ploys 175 people, including 90 t raders. Today, Susquehanna is one of t he largest opt ion t rading firm s in t he world and one of t he largest ent it ies in program t rading. Yass seeks out nuances of m arket inefficiencies t hrough com plex refinem ent s of st andar d opt ion pricing m odels. However, t he essence of Yass's approach is not necessarily having a bet t er m odel but rat her placing great er em phasis on applying m at hem at ical gam e t heory principals t o m axim ize winnings. To Yass, t he m arket is like a giant poker gam e, and you have t o pay very close at t ent ion t o t he skill level of your opponent s. As Yass explains it in one of his poker analogies, " I f you're t he sixt h best poker player in t he world and you play wit h t he five best players, you're going t o lose. On t he ot her hand, if your skills are only average, but you play against weak opponent s, you're going t o win." Yass will fact or in his percept ion of t he skill and knowledge of t he per son on t he ot her side of a t rade and adj ust his st rat egy accordingly. He is willing t o subj ugat e or r evise his own m arket views based on t he act ions of t hose he considers bet t erinform ed t raders. Yass has a quick m ind and t alks a m ile a m inut e. We st art ed t he int erview in his Philadelphia office aft er m arket hours and finished at a local rest aurant . Alt hough I had m y doubt s about Yass's r est aurant select ion abilit ies ( for reasons t hat will quickly becom e evident ) , t he food was superb. Unfort unat ely, t he food qualit y was m at ched by t he r est aurant 's" popularit y, and hence noise level, leaving m e wit h casset t e r ecor dings wort hy of t he deciphering capabilit ies of t he CI A. We obviously appeared t o be a bit st r ange t o a gr oup of nearby diners who upon leaving couldn't resist inquiring why we were recording our dinner conversat ion. = = = = When did you first get int erest ed in m arket s? = = = = When I was a kid. I loved t he st ock m arket . I used t o t ear t he paper out of m y fat her's hands t o check t he st ock quot es. = = = = Did you t rade any st ocks as a kid? = = = = I loved TV dinners. The first t im e I t ried a Swanson's TV dinner , I t hought it was so delicious and such a great idea t hat I want ed t o buy t he st ock. I found out t hat Swanson's was ow ned by Cam pbell, and I got m y fat her t o buy t en shares of t he st ock for m e. = = = = Do you st ill love TV dinners? = = = = Yes, and I also love all airplane food. I agree wit h Joan Rivers, who says she's suspicious of anyone who claim s t hey don't like airplane food. = = = = I am not sure I st ill want t o go t o dinner wit h you lat er. So what happened t o Cam pbell aft er you bought it ? = = = = The st ock never went anywhere. = = = = Fin not surprised. = = = = I t went up event ually. I would have done OK if I had held on t o it for t he next t hirt y years. = = = = Was t hat your first st ock m arket t ransact ion? = = = = Yes. = = = = How old were you t hen? = = = = Eleven. = = = = Did you buy any ot her st ocks as a kid? = = = = When I was about t hirt een, I bought East ern Airlines. I flew t o Florida at t he t im e, and I t hought it was a good airline. I also bought a realt y com pany t hat event ually went bankrupt . I always lost . I rem em ber m y fat her saying t o m e, " The st ock was around a long t im e before you bought it . Just because you bought it now doesn't m ean t hat it suddenly has t o go up." I n high school, I discovered opt ions. I would check t he opt ion closing prices and find what I t hought were huge m ispricings. For exam ple, one t im e Alcoa closed at $49 and t he 45 call was t rading only $2 1/ 2 above t he 50 call. By buying t he 45 call and selling t he 50 call, I would lose $2 1/ 2 if t he st ock w ent dow n $4 or m ore, but I would win $2 1/ 2 if t he st ock went up $1 or m ore. I t seem ed like a great bet . I convinced m y fat her t o do t he t rade for m e. The st ock went up, and t he t rade worked out . = = = = Did you do any ot her opt ion t rades in high school aft er t hat ? = = = = No, I discovered t hat t he closing opt ion price print ed in t he newspaper w as really j ust t he last sale, which could be very st ale. For ex am ple, an opt ion m ight have finished t he day 11 bid/ 12 offered, but if t he last sale was at 13, t hat 's t he price t hat would be print ed in t he paper. Once I discovered t hat t hese quot es were not real, I realized t hat m ost of t he t rading opportunit ies t hat I found were really nonexist ent . = = = = How did you even know about opt ions in high school? = = = = The com pany m y fat her worked for issued warrant s when t hey went public. I asked m y fat her t o explain warrant s t o m e. Since a warrant is not hing m ore t han a long- t erm opt ion, I underst ood t he basic concept . = = = = Aft er you graduat ed from college, did you go on t o graduat e school? Or did you go direct ly t o work? ==== My plan was t o t ake a year off and t ravel across t he count ry. I did, however, end up going on one

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148 int erview wit h an invest m ent house, which I won't nam e. I was int erviewed by t he head of t he opt ions depart m ent . I t hink I m ight have insult ed him , and I didn't get t he j ob. = = = = Since you're not nam ing t he firm , why don't you be m ore specific. = = = = Well, our conversat ion went som et hing along t he following lines: He said, "So, you t hink you can m ake m oney t rading opt ions." I t hen t old him about what I t hought was im port ant in m aking m oney in t he opt ions m arket . He asked m e, " Do you know t his year's high and low for I BM?" I answered, " I t hink t he low was 260 and t he high was 320, but it 's absolut ely irrelevant . I f you're wast ing your t im e t hinking about m at , you're on t he wrong t rack com plet ely." He said, " Well, / know what it is; I t hink it is very im port ant ." I replied, " Great ! Just hire m e and I 'll show you why it 's im m at erial." I n our subsequent conver sat ion he indicat ed t hat he didn't know t he definit ion of bet a [ a t echnical t erm used t o describe a st ock's volat ilit y relat ive t o t he overall m arket ] . He said, " I don't bot her m yself wit h t hat kind of st uff." I said, " Terrific! Just hire m e, and I 'll explain it t o you and show you how t o use it ." Am azingly, I didn't get t he j ob. [ He laughs heart ily at t he recollect ion.] = = = = I know t hat you're a serious poker buff and apply m any of t he st rat egies of t he gam e t o opt ions. When did you first develop an int erest in poker? = = = = I st art ed playing poker during college. My friends and I t ook poker very ser iously. We knew t hat over t he long run it wasn't a gam e of luck but rat her a gam e of enorm ous skill and com plexit y. We t ook a m at hem at ical approach t o t he gam e. = = = = I assum e t hat you've played at casino poker gam es. I 'm curious, how does t he t ypical Las Vegas gam e break down in t erm s of t he skill level of t he players? = = = = I n a t ypical gam e wit h eight players, on average, t hree are pro, t hree are sem ipro, and t wo are t ourist s. = = = = That sure doesn't sound like very good odds for t he t ourist s! = = = = You have t o be a very good player t o com e out ahead over t he long m n. = = = = Given t hat high skill level, what percent age of t he t im e do you act ually walk away a winner? = = = = On average, I guess t hat I win about 55 percent of t he t im e. = = = = Does it bot her you when you lose? = = = = I t doesn't bot her m e at all. I know t hat I 'm playing correct ly, and I under st and t hat t her e is not hing t hat you can do t o sm oot h out t he volat ilit y. I rarely second- guess m yself when I lose, since I know t hat in t he short run m ost of t he fluct uat ions are due t o luck, not skill. = = = = I s t he st rat egy in poker prim arily a m at t er of m em orizing t he odds for various hand com binat ions? ==== No, m em orizat ion plays a very sm all role. Underst anding t he probabilit ies sufficient ly well t o know which hands t o play and which hands not t o play is im port ant , but t hat 's j ust basic knowledge. The really great poker player s have an underst anding of proper bet t ing st rat egy. What inform at ion do you get when your opponent bet s? What inform at ion do you give up when you bet ? What inform at ion do you give up when you don't bet ? We act ually use poker st rat egy in t raining our opt ion t raders, because we feel t he parallels are very st rong. I believe t hat if I can t each our t rainees t he correct way t o t hink about poker, I can t each t hem t he right way t o t rade opt ions. = = = = Can you give m e a specific exam ple? = = = = Assum e t hat you're cert ain t hat you have t he best hand, and t he last card has j ust been dealt . What do you do? A novice t rader would say, " I would bet t he lim it." However, t hat is oft en not t he right m ove- even if you're sure t hat your opponent will call. Why? Because som et im es when you pass, he'll bet , giving you t he opport unit y t o raise, in which case you'll win double t he bet size. I f you t hink t hat t h- e probabilit y is bet t er t han 50 per cent t hat he'll bet , you're bet t er off checking. By using t hat st rat egy, som et im es you'll win not hing ext ra when you had a sure chance t o win a single bet size, but m ore oft en, you'll win double t he bet size. I n t he long run, you'll be bet t er off. So, whereas bet t ing when you have t he best hand m ay seem like t he right t hing t o do, t here's oft en a bet t er play. = = = = What is t he analogy t o opt ion t rading? = = = = The basic concept t hat applies t o bot h poker and opt ion t rading is t hat t he prim ary obj ect is not winning t he m ost hands, but rat her m axim izing your gains. For exam ple, let 's say you have t he opport unit y t o buy one hunded calls of an opt ion you believe is wort h 3 1/ 4 at 3, giving you an expect ed $2,500 profit . Most m arket m akers wou I d say t hat you j ust buy t he opt ion at 3 and t ry t o lock in t he profit . However, in realit y, t he decision is not t hat sim ple. For ex am ple, if you est im at e t hat t here is a 60 percent probabilit y of being able t o buy t he sam e opt ion at 2 3/ 4, your best st r at egy would be t o t ry t o buy at 2 3/ 4, even t hough doing so m eans t hat 40 percent of t he t im e you're going t o m iss t he t r ade ent irely. Why? Because 60 per cent of t he t im e you're going t o win $5,000. Therefore, over t he long run, you'll average a $3,000 gain [ 60 per cent of $5,000] in t hat t ype of sit uat ion, which is bet t er t han a sure $2,500 gain. = = = = Were you aware of t hat analogy when you first st art ed t rading opt ions? = = = = Yes, t he pok er world is so com pet it ive t hat if you don't fully capit alize on every advant age, you're not going t o survive. I absolut ely underst ood t hat concept by t he t im e I got down t o t he opt ions floor. I learned m ore about opt ion t rading st rat egy by playing poker t han I did in all m y college econom ics courses com bined. = = = = Are t here any ot her exam ples you can give t hat provide an analogy bet ween poker st rat egy and

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149 opt ion t rading? = = = = A classic exam ple we give all our t rainees is t he following: Assum e you're playing seven card st ud, and it 's t he last round of bet t ing. You have t hree cards in t he hole and four aces showing; your opponent has t he t wo of clubs, t hree of clubs, nine of diam onds, and queen of spades showing. You're high wit h four aces. The quest ion we ask is: " What bet do you m ake?" The t ypical response is, " I would bet as m uch as I can, because I have four aces and t he odds of m y winning are huge." The corr ect answer is ... = = = = You pass, because if he can't beat you, he's going t o fold, and if he can beat you, he'll raise and you'll lose m ore. = = = = That 's right . He m ight have t he four, five, and six of clubs in t he hole. You can't win anyt hing by bet t ing; you can only lose. He knows what you have, but you don't know what he has. = = = = So what is t he analogy t o opt ion t rading? = = = = Let 's say t hat I believe an opt ion is wort h $3. Norm ally, I would be willing t o m ake a m arket at 27/ 8/ 3 1/ 8 [ i.e., be a buyer at 2 7/ 8 and a seller at 3 1/ 8] . However, let 's say a brok er whom I suspect has superior inform at ion asks m e for a quot e in t hat opt ion. I have not hing t o gain by m aking a t ight m arket because if I price t he opt ion right , he'll pass- t hat is, he won't do anyt hing- and if I price it wrong, he'll t rade, and I 'll lose. Along t he sam e line, if a broker wit h superior inform at ion is bidding significant ly m ore for an opt ion t han I t hink it 's wort h, t here's a very good chance t hat he's bidding higher because he knows som et hing I don't . Therefore, I m ay not want t o t ake t he ot her side of t hat t rade, even t hough it looks like an at t ract ive sale. The point is t hat opt ion t rading decisions should be based on condit ional probabilit y. I m ay have t hought t hat an opt ion was wort h X, but now t hat som eone else want s t o bid X + Y, I m ay have t o revise m y est im at e of t he opt ion's value. The lesson we t ry t o t each our t raders is t hat anyt hing t hat seem s very obvious should be double- checked. A great exam ple t o illust rat e t his concept is a puzzle posed years ago by Fisher Black of t he Black- Scholes opt ion pricing m odel fam e. I m agine t hat you're on " Let 's Make a Deal," and you have t o pick one of t he t hree doors. You pick door No. 1. Mont y Hall says, " OK, Carol, open door No. 2." The big prize is not behind door No. 2. Mont y Hall, of course, knows which door t he prize is behind. The way he played t he gam e, he would never open t he door wit h t he real prize. Now he t urns t o you and asks, " Do you want t o swit ch t o door No. 3?" Do you st ay wit h door No. 1 or swit ch? [ Reader: You m ight wish t o t hink of your own answer before reading on.] = = = = The obvious answer seem s t o be t hat it doesn't m ake a difference, but obviously t hat m ust be t he wrong answer = = = = The correct answer is t hat you should alw ays swit ch t o door No. 3. The probabilit y t hat t he prize is behind one of t he t wo doors you did not pick was originally t w o- t hirds. The fact t hat Mont y opens one of t hose t wo doors and t here is not hing behind it doesn't change t his original probabilit y, because he w ill alw ays open t he w rong door. Therefore, if t he probabilit y of t he prize being behind one of t hose t wo doors w as t wo- t hirds originally, t he probabilit y of it being behind t he unopened of t hose t wo doors m ust st ill be t wo- t hirds. = = = = I don't underst and. This show was wat ched by m illions of people for years, and yet no one realized t hat t he odds were so heavily skewed in favor of swit ching! = = = = You have t o r em em ber t hat you're t alking about a show where people had t o wear funny rabbit ears t o get picked. The t hing t hat confuses people is t hat t he process is not random . I f Mont y random ly chose one of t he t wo doors, and t he prize w as not behind t he select ed door, t hen t he probabilit ies bet ween t he t wo rem aining doors would indeed be 50/ 50. Of course, if he random ly select ed one of t he t wo doors, t hen som et im es t he prize would be behind t he opened door , which never happened. The key is t hat he didn't random ly select one of t he doors; he always picked t he wrong door, and t hat changes t he probabilit ies. I t 's a classic exam ple of condit ional probabilit y. I f t he probabilit y of t he prize being behind door No. 2 or door No. 3 is t wo- t hirds, given t hat it 's not door No. 2, what is t he probabilit y t hat it 's door No. 3? The answer, of course, is t wo- t hirds. I ronically, four weeks aft er m y int erview wit h Jeff Yass, t he New York Tim es ran an art icle on t he exact sam e puzzle. The Tim es art icle report ed t hat when Marilyn Vos Savant answered t his puzzle correct ly in her Parade colum n in response t o a reader's inquiry, she received nearly a t housand crit ical ( and m isguided) let t ers from Ph.D.s, m ost ly m at hem at icians and scient ist s. The Tim es art icle engender ed it s own slew of let t ers t o t he edit or. Som e of t hese provided part icularly lucid and convincing explanat ions of t he correct answer and are reprint ed below: To t he Edit or: Re " Behind Mont y Hall's Doors: Puzzle Debat e and Answer?" ( front page, July 21) : One reason people have t rouble underst anding t he correct solut ion t o t he puzzle involving t hree doors, t wo wit h goat s behind t hem and one wit h a car, is t hat t he problem uses only t hree doors. This m akes t he assum ed, but incorrect , probabilit y of picking t he car ( 1 in 2) appear t oo close t o t he act ual probabilit y ( 1 in 3) and t he solut ion difficult t o arrive at int uit ively. To illust rat e bet t er t he right answer- t hat a player should swit ch t he door picked first aft er one of t he ot her t wo has been opened by Mont y Hall, t he gam e- show host - suppose t he gam e were played wit h 100 doors, goat s behind 99 and a car behind 1. When first offered a door, a player would realize t hat t he chances of picking t he car ar e low ( 1 in 100) . I f Mont y Hall t hen opened 98 doors wit h goat s behind t hem , it would be clear t hat t he chance t he car is behind

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150 t he rem aining unselect ed door is high ( 99 in 100) . Alt hough only t wo doors would be left ( t he one t he player picked and m e unopened door) , it would no longer appear t hat m e car is equally likely t o be behind eit her. To change m e pick would be int uit ive t o m ost people. Cory Franklin Chicago, July 23, 1991 To t he Edit or- : As I recall from m y school days, when you are dealing wit h t ricky, confusing probabilit ies, it is useful t o consider t he chances of losing, rat her t han t he chances of winning, t hus: Behind t wo of t he t hree doors t here is a goat . Therefore, in t he long run, t wice in t hree t ries you will choose t he goat . One goat - bearing door is elim inat ed. Now t wo t im es out of t hr ee when you have a goat , t he ot her door has a car. That 's why it pays t o swit ch. Kari V. Am at neek San Diego, July 22, 1991 And finally t here was t his it em : To t he Edit or: Your front - page art icle July 21 on t he Mont y Hall puzzle cont roversy neglect s t o m ent ion one of t he behind- t he- door opt ions: t o prefer t he goat t o t he aut o. The goat is a delight ful anim al, alt hough parking m ight be a problem . Lore Segal New York, July 22, 1991 The point is t hat your senses deceive you. Your sim plist ic im pulse is t o say t hat t he probabilit ies are 50/ 50 for bot h door No. 1 and door No. 3. On careful analysis, however, you realize t hat t here is a huge advant age t o swit ching, even t hough it w as not at all obvious at first . The m oral is t hat in t rading it 's im port ant t o exam ine t he sit uat ion from as m any angles as possible, because your init ial im pulses are probably going t o be wrong. There is never any m oney t o be m ade in t he obvious conclusions. = = = = Can you give m e a t rading exam ple of a sit uat ion where t he obvious decision is wrong? = = = = Let 's say a st ock is t rading for S50 and an inst it ut ion com es in wit h an offer t o sell five hundred of t he 45 calls at $4 1/ 2. The inst inct ive response in t hat t ype of sit uat ion is: " Great ! I 'll buy t he calls at $4 1/ 2, sell t he st ock at $50, and lock in $1/ 2 profit ." I n realit y, however, nine t im es out oft en, t he reason t he inst it ut ion is offering t he call at $4 1/ 2 is because it 's fairly cert ain t hat t he st ock is going lower. = = = = Does t his t ype of sit uat ion ever happen- t hat is, an inst it ut ion offering t o sell opt ions at a price below int rinsic value [ t he m inim um t heoret ical value, which is equal t o t he difference bet ween t he st ock price and st rike price- $5 in Yass's exam ple] ? = = = = I t happens all t he t im e. = = = = I don't underst and. What would be t he m ot ive t o sell t he opt ion below it s int rinsic value? = = = = I n t he exam ple I gave you, t he inst it ut ion m ay be very cert ain t hat t he st ock is going t o t rade below $49 1/ 2, and t her efore a price of $4 1/ 2 for t he 45 call is not unreasonable. = = = = Even if t hey have good reason t o believe t hat t he st ock will t rade lower, how can t hey be t hat sure of t he t im ing? = = = = The st raight forward answer is t hat t hey know t hey have a m illion shares t o sell, and t hat t hey m ay have t o be willing t o offer t he st ock at $49 t o m ove t hat t ype of quant it y. I t all com es down t o condit ional probabilit ies. Given t hat t his inst it ut ion is offering t he opt ion at below it s int rinsic value, w hich is m ore likelyt hey're so naive t hat t hey're virt ually writ ing you a risk- free check for $25,000, or t hey know som et hing t hat you don't ? My answer is, given t hat t hey want t o do t his t rade, t he odds are you're going t o lose. When I first st art ed out , I would always be a buyer of opt ions t hat were offered at prices below int rinsic value, t hinking t hat I had a locked- in profit . I couldn't underst and why t he ot her sm art t raders on t he floor weren't m shing in t o do t he sam e t rades. I event ually realized t hat t he reason t he sm art t raders weren't buying t hese calls was t hat , on average, t hey were a losing proposit ion. = = = = I f ifs not illegal, why wouldn't t he inst it ut ions regularly sell calls prior t o liquidat ing t heir posit ions? I t seem s t hat it would be an easy way t o cushion t he slippage on ex it ing large posit ions. = = = = I n fact , t hat is a com m on st rat egy, but t he m arket m akers have wised up. = = = = How has t he opt ion m arket changed in t he t en years t hat you have been in t he business? = = = = When I first st art ed t rading opt ions in 1981 all you needed t o m ake m oney was t he st andard BlackScholes m odel and com m on sense. I n t he early 1980s, t he basic st rat egy was t o t ry t o buy an opt ion t rading at a relat ively low im plied volat ilit y and sell a relat ed opt ion at a higher volat ilit y. For exam ple, if a large buy order for a part icular st rike call pushed it s im plied volat ilit y t o 28 percent , w hile anot her call in t he sam e st ock was t rading at 25 percent , you would sell t he higher- volat ilit y call and offset t he posit ion by buying t he lower- volat ilit y call. = = = = I assum e t hese t ypes of discrepancies exist ed because t he m arket was fairly inefficient at t he t im e. ==== That 's correct . At t hat t im e, a lot of opt ion t raders st ill didn't adequat ely underst and volat ilit y and basic opt ion t heory. For exam ple, if a call was t rading at a 25 percent volat ilit y, which was relat ively low for t he opt ions in t hat st ock, m any t raders didn't under st and t hat you didn't have t o be bullish on t he st ock t o buy t he call- I f you were bear ish on t he st ock, you could st ill buy t he underpriced call by sim ult aneously selling t he st ock, yielding a com bined posit ion equivalent t o a long put . The m ore m at hem at ical m arket m akers underst ood t hese t ypes of relat ionships and were able t o exploit pricing aberrat ions. Now everybody underst ands t hese relat ionships, and you no longer see sit uat ions in which different opt ions in a sam e st ock are t rading at significant ly different volat ilit ies- unless t here's a good fundam ent al reason for t hat difference in

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151 pricing. Now t hat everybody underst ands volat ilit y, t he m aj or bat t le is in t he skewness in opt ion pricing. = = = = Can you explain what you m ean by " skewness" ? = = = = To explain it by exam ple, t he OEX t oday was at 355. I f you check t he opt ion quot es, you will see t hat t he m arket is pricing t he 345 put s m uch higher t han t he 365 calls. [ The st andard opt ion pricing m odels would act ually price t he 365 calls slight ly higher t han t he 345 put s.] = = = = Are opt ions prices always skewed in t he sam e direct ion? I n ot her words, are out - of- t he- m oney put s always priced higher t han equiv- alent ly out - of- t he- m oney calls? = = = = Most of t he t im e, put s will be high and calls wilt be low. = = = = I s t here a logical reason for t hat direct ional bias? = = = = There are act ually t wo logical reasons. One I can t ell you; t he ot her I can't . One basic fact or is t hat t here is a m uch gr eat er probabilit y of financial panic on t he downside t han on t he upside. For exam ple, once in a great while, you m ay get a day wit h t he Dow down 500 point s, but it 's far less likely t hat t he Dow will go up 500 point s. Given t he nat ure of m arket s, t he chance of a crash is always great er t han t he chance of an overnight runaway euphoria. = = = = Did t he m arket s always price put s significant ly higher t han calls for t hat reason? = = = = No. The m ar ket didn't price opt ions t hat way unt il aft er t he Oct ober 1987 cr ash. However, I had always felt t hat t he chance of a huge down- m ove was m uch great er t han t he chance of an upm ove of equivalent size. = = = = Did you reach t he conclusion about t he bias in favor of larger downm oves based on a st udy of hist orical m arket s? = = = = No, not hing t hat elaborat e. Just by w at ching m arket s, I not iced t hat prices t end t o com e down m uch harder and fast er t han t hey go up. = = = = Does t his direct ional bias apply only t o st ock index opt ions? Or does it also apply t o individual st ock opt ions? = = = = The opt ions on m ost m aj or st ocks are priced t hat way [ i.e., put s are m ore expensive t han calls] , because downside surprises t end t o be m uch great er t han t he upside surprises. However, if a st ock is t he subj ect of a t akeover m m or, t he out - of- t he- m oney calls will be priced higher t han t he out - of- t he- m oney put s. = = = = Do your t raders use your opt ion pricing m odels t o m ake basic t rading decisions? = = = = Anyone's opt ion pricing m odel, including m y own, would be t oo sim plist ic t o adequat ely describe t he real world. There's no way you can const ruct a m odel t hat can com e close t o being as inform ed as t he m arket . We t rain our m arket m aker s t o underst and t he basic assum pt ions underlying our m odel and why t hose assum pt ions are t oo sim plist ic. We t hen t each t hem m ore sophist icat ed assum pt ions and t heir price im plicat ions. I t 's always going t o be a j udgm ent call as t o what t he appropriat e assum pt ions should be. We believe we can t rain any int elligent , quick- t hinking person t o be a t rader. We feel t raders are m ade, not born. = = = = Essent ially t hen, you st art off wit h t he m odel proj ect ions and t hen do a seat - of- t he- pant s adj ust m ent based on how you believe t he various m odel assum pt ions are at variance wit h current realit ies. = = = = Exact ly. = = = = Can you give an exam ple of how t his adj ust m ent process works? = = = = A current exam ple is NCR, which is a t akeover t arget of AT&T. AT&T's bid is $110, and t he st ock is current ly t rading at approxim at ely $106. I f t he t akeover goes t hr ough, t he buyer of t he st ock st ands t o m ake about $2. ( About half of t he difference bet ween t he current price and t he t akeover bid represent s int erest rat e cost s on carrying t he st ock.) I f, on t he ot her hand, t he t akeover falls t hrough, t hen t he st ock can drop sharply- t o about $75 based on curr ent m arket est im at es. I n t his part icular case, t he relat ively close calls are essent ially wort hless, because t he st ock is unlikely t o go abov e $110. On t he ot her hand, t he m uch furt her out - of- t he- m oney 90 put s have som e chance of gaining significant value in t he event t he t akeover fails. Thus, in t his t ype of sit uat ion, t he out - of- t he- m oney put s will be priced m uch higher t han t he equivalent out of- t he- m oney calls. = = = = I n ot her words, t his is an exam ple of how an opt ion pricing m odel could yield very m isleading proj ect ions in a real- world sit uat ion. = = = = Right , because t he st andard m odel assum es t hat t he probabilit y of any individual t ick being up or dow n is 50/ 50. That , however, is not t he case here because t here's a m uch great er probabilit y for a large price decline t han a large price rise. At one t im e, t he m at hem at ical t ypes t raded st raight off t heir m odels, and in a sit uat ion like t he one I have j ust described, t hey would sell t he out - of- t he- m oney put s because t hey appear ed t o be priced t oo high. However, t he seat - of- t he- pant s t y pes would look at t he sit uat ion and r ealize t hat t here w as a r eal possibilit y of t he st ock wit nessing a large decline [ i.e., a breakdown in t he case of a t akeover] . The t raders using a com m onsense approach would end up buying t he out - of- t he- m oney put s from t he m at hem at ical t ypes and t aking t hem t o t he cleaners in t he process. Event ually, t he m at hem at ical t ypes caught on. = = = = I n your day- t o- day operat ions, do you basically st art off by looking at t he m odel and t hen m aking cert ain m ent al adj ust m ent s? = = = = Exact ly. Our basic philosophy is t hat we have t rem endous respect for m arket opinion. For exam ple, if we believe an opt ion is wort h $2 and a knowledgeable m arket m aker is bidding $2 1/ 2, we assum e t hat nine t im es out of t en he's going t o be right , because he's t rading one st ock and we'r e t rading five hundred. We will t hen t ry t o figure out why he's bidding $2 1/ 2. I f we can ident ify t he reason and we disagr ee wit h it , t hen we

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152 m ay sell t he opt ion because it 's overpriced. But m ost of t he t im e, we'll decide t hat his knowledge is bet t er t han ours, and we'll end up adj ust ing our valuat ion on t he ot her opt ions in t hat st ock and t hen buying t hese ot her opt ions or t he st ock it self. = = = = When you adj ust your opt ion valuat ions because som eone else is bidding at a price t hat appears t o be rem oved from t he t heoret ical value, are you sim ply assum ing t hat t hey know m ore about t he given com pany? = = = = Yes, inform at ion doesn't exact ly flow perfect ly, like t hey t each you in Finance 101. Frequent ly, t he inform at ion w ill show up first in t he opt ion m arket . A lot of t hese insider t rading cases involve opt ions, and we're t he people who lose t he m oney. For exam ple, j ust t oday t hey caught an em ployee of Marion Labs who obviously had inside inform at ion t hat Dow was going t o offer a t akeover bid for t he com pany. This person had bought five hundred of t he July 25 calls at $1 [ t ot al cost : $50,000] , and t he next day t he opt ions were wort h $10 [ t ot al posit ion value: $500,000] . I n t he old days- before opt ions- som eone wit h t his t ype of inform at ion m ight buy t he st ock, and even assum ing 50 percent m argin, t he profit per cent age wouldn't be t hat large. However, now, by buying opt ions, t raders wit h inside inform at ion can increase t heir profit leverage t rem endously. Som et im es I feel sorry for som e of t hese people because, unt il t he recent barrage of publicit y regarding insider t rading, I 'm not sure t hat m any of t hem even realized t hey were breaking t he law. However, since t hey com e t o t he opt ions m arket first , we're t he ones on t he ot her side of t he t rade get t ing picked off. = = = = I don't underst and. Doesn't t he SEC scrut inize t he order flow when t here's an announced t akeov er t o m ake sure t here are no suspicious orders? = = = = Yes, t hey do, and t hey'r e get t ing part icularly effect ive in cat ching people t rading on insider inform at ion. They have also becom e m uch m ore efficient in ret urning m oney t o t hose on t he ot her side of t hese t rades. However, in earlier years, t he process t ook m uch longer. One fam ous exam ple involved Sant a Fe, an oil com pany t hat was a t akeover t arget by t he Kuwait is in 1981. At t he t im e, t he st ock was at $25 and t he opt ion t raders on t he floor filled an order for one t housand 35 calls at $1/ 16. Short ly aft erwards, t he st ock j um ped from $25 t o $45 and t he opt ions went from $1/ 16 t o $10. The floor t raders had a virt ual overnight loss of about $1 m illion. Alt hough t hey event ually got t heir m oney back, it t ook years. I f you're a m arket m aker and you'r e broke, wait ing t o get your capit al back is not pleasant . You live in fear t hat you're going t o be t he one selling t he opt ion t o an inform ed source. Event ually, everyone get s picked off, because if you t ry t o avoid it com plet ely, you're going t o pass up a lot of good t rading oppor t unit ies. I n a nut shell, if you're t oo conservat ive, you won't do any t rades, and if you're t oo aggressive, you're going t o get picked off a lot . The t rick is t o t ry t o st rike a balance bet ween t he t wo. = = = = Can you t hink of a recent exam ple in which you were picked off? = = = = The opt ions for Com bust ion Engineering are t raded on t he Pacific Coast Exchange. The opt ions rarely t rade. One m orning, we received a call from t he board broker ( t he exchange em ployee responsible for m anaging order im balances) . He said t here was an order t o buy sev eral hundred opt ions and inquired whet her we want ed t o t ake t he ot her side. The st ock was t rading at around $25, and we agreed t o sell t hree hundred of t he 25 calls at approxim at ely $2 1/ 2. Ten m inut es lat er, t rading in t he st ock was halt ed, and t here was an announcem ent t hat t he com pany was being t aken over by a European corporat ion. When t rading resum ed several m inut es lat er, t he st ock reopened at $39, and we were out over $350,000 in a m at t er of m inut es. I t t urned out t hat t he buyer was on t he board of direct ors of t he acquiring com pany. = = = = What ult im at ely happened? = = = = I n t his part icular case, we've already got t en our m oney back. The SEC ident ified t he buyer quickly, and because t he individual was a high- level foreign execut ive who didn't even realize he was doing anyt hing illegal, he ret urned t he m oney wit hout any com plicat ions. = = = = Given t hat considerat ion, aren't you always ret icent t o t ill a large opt ion order in a m arket t hat norm ally doesn't t rade ver y oft en? = = = = There's always t hat t ype of ret icence, but if you want t o be in t he business, it 's your j ob t o fill t hose t ypes of orders. Besides, in t he m aj orit y of cases, t he orders are legit im at e and not hing happens. Also, under norm al circum st ances, we hedge t he posit ion aft er we fill t he opt ion order. I n t he case of Com bust ion Engineering, t he st ock st opped t rading before we had a chance t o buy it as a hedge against our posit ion. We st ill would have lost m oney, but not as m uch as we did being com plet ely unhedged. The m ore successful t he SEC is in cat ching people t rading on inside inform at ion- and lat ely t hey seem t o be cat ching everyone- t he t ight er t he bid/ ask spreads will be. Every t rade we do involves som e risk prem ium for t he possibilit y t hat t he ot her side of t he t rade repre sent s inform ed act ivit y. Therefore, if everyone believes t hat t he SEC is going t o cat ch all inside t raders, t hen t he m ar ket will price away t hat ext ra risk prem ium . I n essence, it 's really t he average invest or who ends up paying for insider t rading t hrough t he wider bid/ ask spreads. = = = = When st ocks have large overnight m oves, is t hat t ype of price act ion norm ally preceded by a pick up m t he opt ion volum e? = = = = Alm ost always. I f you go over t he volum e dat a for st ocks t hat were t aken ov er, you'll Find t hat t here was alm ost always a flurry of opt ion t rading before t he ev ent . = = = = Do you do any direct ional t rading? = = = = None. I t 's m y firm belief t hat t he m arket 's wisdom is far great er t han m ine. I n m y opinion, t he m arket 's

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153 pricing of an it em is t he best m easur e of it s value. The odd t hing about believing in efficient m arket s is t hat you have t o surrender your beliefs and ego t o t he m arket s. Several years ago, a direct or of t he Office of Managem ent and Budget m ade a st at em ent t hat budget proj ect ions should be based on t he assum pt ion t hat long- t erm int erest rat es would event ually decline t o 5 t o 6 percent , at a t im e when rat es were over 8 per cent . The m arket - im plied int erest rat e level reflect s t he net int elligence of t housands of t raders bat t ling it out daily in t he bond m arket . I n com parison, t he 0MB direct or's personal opinion doesn't m ean anyt hing. I f he's basing governm ent policy on t he assum pt ion t hat long- t er m int erest rat es will be 5 t o 6 percent , when t he m arket 's best guess is 8 percent , he's doing grave harm t o societ y. Presum ably, if he were sm art enough t o pr edict int erest rat es bet t er t han t he m ar ket , he could m ake a fort une t rading t he bond m arket , which he obviously can't do. My guess about where int erest rat es will be in t he next t went y years is bet t er t han t hat of alm ost any econom ist , because all I have t o do is look at w here t he bond m arket is t rading. I f it 's t rading at 8 percent , t hat 's m y proj ect ion. Som eone can spend m illions of dollars developing an elaborat e int erest rat e forecast ing m odel, and I 'll bet you t hat over t he long run t he bond m arket 's forecast will be bet t er. The general principle is t hat if you can give up your ego and list en t o what t he m arket s are t elling you, you can have a huge source of inform at ion. = = = = I know t hat your bot t om - line advice t o people regarding t rading is: Don` t t hink t hat you can beat t he m ar ket However, is t here any advice you can offer for t hose who do part icipat e in t he m arket s? = = = = I f you invest and don't diversify, you're lit erally t hrowing out m oney. People don't realize t hat diversificat ion is beneficial even if it reduces your ret urn. = = = = Why? = = = = Because it reduces your risk even m ore. Therefore, if you diversify and t hen use m argin t o increase your leverage t o a risk level equivalent t o t hat of a nondiversified posit ion, your ret urn will probably be great er. = = = = I t end t o agree. I like t o say t hat diversificat ion is t he only free lunch on Wall St reet = = = = The way I would put it is t hat not diversifying is like t hrowing your lunch out t he window. I f you have a port folio and are not diversifying, you're incinerat ing m oney every year. The t y pe of professional opt ion arbit rage t rading in which Yass engages obviously has lit t le direct relevance t o m ost ordinary t raders. However, t here are st ill som e significant m essages here t hat have broader applicat ion. Perhaps Yass's m ost im port ant point is t hat it is crit ical t o focus on m axim izing gains rat her t han t he num ber of wins. One obvious applicat ion of t his concept is t hat regar dless of your t rading st yle, a bet t ing ( i.e., t rading) st rat egy t hat increases t he st akes on t rades deem ed t o have a higher probabilit y of success could significant ly enhance t he final result s. Anot her point em phasized by Yass is t hat our init ial im pressions are oft en w rong. I n ot her words, beware of act ing on t he obvious. / / * * Not e: * * / / / / Readers unfam iliar wit h opt ions m ay wish t o read t he Appendix in order t o underst and t he t rading- relat ed references in t his chapt er./ /

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154 PART VII The Psychology of Trading

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155 Zen and the Art of Trading " W e h a s m e t t h e e n e m y, a n d it is u s. " The fam ous quot e from Walt Kelly's cart oon st rip, " Pogo, " would provide as fit t ing a one- line sum m at ion of t he art of t rading as any. Tim e and t im e again, t hose whom I int erviewed for t his book and it s predecessor st ressed t he absolut ely crit ical role of psychological elem ent s in t rading success. When asked t o explain what was im port ant t o success, t he Market Wizards never t alked about indicat ors or t echniques, but rat her about such t hings as discipline, em ot ional cont rol, pat ience, and m ent al at t it ude t ow ard losing. The m essage is clear: The key t o winning in t he m arket s is int ernal, not ext ernal. Ze n a n d t h e Ar t of Tr a din g One of t he hazards of doing a book of t his sort is t hat you can go t hrough t he ar duous process of t ransform ing a ram bling 250- page raw t ranscript int o a readable 25- page chapt er only t o have t he int erview subj ect wit h hold perm ission t o use t he m at erial. ( I n order t o pr ovide an at m osphere conducive t o openness on t he part of t hose I int eriewed, I felt it necessary t o offer t hem t he right of final refusal.) One of t he t raders I int erviewed, an individual who had m ade several hundred m illion dollars in t rading profit s for his firm , felt t hat t he result ing chapt er, w hich cont ained a lot of copy relat ed t o int uit ion, dream s, East ern philosophy, and t rading anecdot es, present ed an im age of him t hat would be viewed ask ance by his corporat e client s. I prevailed upon him , however, t o allow m e t o use t he following excerpt anonym ously, as I felt it offered an unusual and insight ful perspect ive on t rading. = = = = I st ill don't underst and your t rading m et hod. How could you m ake t hese huge sum s of m oney by j ust wat ching t he screen? = = = = There was no syst em t o it . I t was not hing m ore t han, " I t hink t he m arket is going up, so I 'm going t o buy." " I t 's gone up enough, so I 'm going t o sell." I t was com plet ely im pulsive. I didn't sit down and for m ulat e any t rading plan. I don't know where t he int uit ion com es from , and t here are t im es when it goes away. = = = = How do yon recognize when it goes away? = = = = When I 'm wrong t hree t im es in a row, I call t im e out . Then I paper t rade for a while. = = = = For how long do you paper t rade? = = = = Unt il I t hink I 'm in sync wit h t he m arket again. Every m arket has a rhyt hm , and our j ob as t rader s is t o get in sync wit h t hat rhyt hm . I 'm not really t rading when I 'm doing t hose t rades. There's t r ading being done, but I * m not doing it . = = = = What do you m ean you're not doing it ? = = = = There's buying and selling going on, but it 's j ust going t hrough m e. I t 's like m y personalit y and ego are not t here. I don't even get a sense of sat isfact ion on t hese t r ades. I t 's absolut ely t hat obj ect ive. Did you ever read Zen and t he Art of Archery? = = = = No, I have t o adm it , I m issed t hat one. = = = = The essence of t he idea is t hat you have t o leam t o let t he arrow shoot it self. There's no ego involved. I t 's not , " I 'm shoot ing t he arrow, and I 'm releasing it ." Rat her, t he arrow is shot , and it 's always right . The sam e concept applies t o t rading. There's no sense of self at all. There's j ust an awareness of what will happen. The t rick is t o different iat e bet ween what you want t o happen and what you know will happen. The int uit ion knows what will happen. I n t rading, j ust as in archery, whenever t here is effort , force, st raining, snuggling, or t rying, it 's wrong. You're out of sync; you're out of harm ony wit h t he m arket . The perfect t rade is one t hat requires no effort . = = = = You t alk about knowing what will happen. Can you give m e an exam ple? = = = = The current decline in t he m ark versus t he yen is som et hing t hat I j ust knew would happen. = = = = Before t he m ark went down versus t he yen, it had t rended in t he ot her direct ion for quit e som e t im e. How did you know when t he t im ing was right for t he t rade? = = = = The t rigger was act ually a Freudian slip. I was t alking about t he yen/ m ark rat e wit h anot her t rader when it was t rading at 87.80. I kept on referring t o t he price as 77.80. The ot her t rader finally said, " What are you t alking about ?" I realized t hat I was off by t en big figures in m y price references. Obviously, t here was som e part of m e t hat was looking for t he rat e t o go down t o t hat level. I t was lit erally bubbling out of m e.

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156 Charles Faulkner: The Mind of an Achiever Charles Faulkner abandoned graduat e school ( he was st udying psy- cholinguist ics at Nort hwest ern Universit y) aft er becom ing enam ored wit h t wo early books writ t en by Richard Handler and John Grinder, t he cofounders of Neuro- Linguist ic Program m ing ( m ore on NLP in t he int erview) . St art ing in 1981, Faulkner st udied ext ensively wit h Grinder and t hen wit h Bandler and ot her key NLP codevelopers, becom ing a cert ified NLP t rainer in 1987. Faulkner's focus has been on m odeling hum an excellence, wit h proj ect s t hat have included accelerat ed lear ning, physician decision m aking, and fut ures t rading. Faulkner is also a consult ant , NLP sem inar leader, and program designer and aut hor of several audio t ape program s applying t he t echniques of NLP. I m et Charles Faulkner when he approached m e aft er a t alk I had given at a fut ures indust ry sym posium . During m y speech, I had m ade several references t o t his volum e, which at t he t im e was about half- com plet ed. Faulkner explained t hat he had been doing research and consult ing direct ed at helping t raders over com e m ent al im pedim ent s t o success. I t old him t hat I was quit e int erest ed in his work because it Not e: I D several inst ances in t his int erview , where I t hought iE w ould help clarify or expand t he inform at ion, I supplem ent ed Faulkner's responses wit h adapt ed excerpt s from t he Night ingale- Conant t ape series NLP: The New Technology of Achievem ent NLP, for which Faulkner was t he program designer and principal coaut hor. m ight fit as a feat ure in t he new book but t hat m y scheduling on t hat t rip did not leave enough t im e for an int erview. He gave m e a boxed t ape set , asking m e t o see what I t hought about it . The t ape series dealt wit h applying NLP t o various aspect s of achievem ent . Alt hough t here are a num ber of NLP elem ent s t hat I have t rouble relat ing t o, cert ain segm ent s of t he series m ade great sense t o m e and seem ed helpful in increasing m ot ivat ion and focusing goals. Overall, I was sufficient ly im pressed wit h Faulkner's t ape series t o schedule anot her t rip t o Chicago t o int erview him . A port ion of NLP is concerned wit h st udying t he cues people provide t hrough t heir gest ures, eye m ovem ent s, language, and voice int onat ions. Faulkner has obviously had a great deal of experience honing t hese int erpr et at ive skills, and he st ruck m e as being ext rem ely percept ive. He had t hought fully arranged for t he use of a privat e conference room in a hot el near t he airport in order t o m axim ize our t im e t oget her. You're a Neuro- Linguist ic Program m ing t rainer. That 's not going t o m ean very m uch t o m ost readers of t his book. Let 's st art wit h a layperson's definit ion of NLP. Act ually, Nat ural Learning Processes m ight have been a bet t er nam e. NLP's principal cofounders, Richard Bandler, an inform at ion scient ist , and John Grinder, a professor of linguist ics, define NLP as t he st udy of hum an excellence. NLP st udies great achievers t o pinpoint t heir m ent al program s- t hat is, t o learn how great achievers use t heir brains t o produce result s. They began t heir st udy wit h ext raordinarily t alent ed t herapist sindividuals who consist ent ly produced posit ive changes in t he lives of ot hers. Succeeding t here, t hey went on t o st udy t alent ed people in ot her fields- m anager s, negot iat ors, at hlet es, and art ist s- t o find what t hose individuals did t o get t heir out st anding result s. The m odels of t he nat ural learning processes t hese people used t o becom e ext raordinary in t heir fields can be used by anyone wishing t o excel. To underst and how NLP works, let m e m ake an analogy t o t he beginning of m odem skiing. Unt il t he 1950s, m ost people t hought skiing was a m at t er of nat ural t alent . You eit her had t he t alent t o do it , or you didn't . Then som et hing happened t hat changed t he sport forever. Film s were m ade of som e of Europe's great skiers t o ident ify all t he m ovem ent s t hat charact er ized t hem . I t was found t hat t hey all had cer t ain t echniques in com m on. Beyond t hat , it was discovered t hat t he t echniques of t hese except ional skiers could be t aught t o anyone. All kinds of people could learn t o be very good skiers. The key was t o ident ify t he m ovem ent s t hat m ade a great skiert he essence of t heir skills- so it could be t aught t o ot hers. I n NLP we call t hat essence a m odel. The sam e basic principles can be applied t o any ot her endeav or or t o various aspect s of hum an int errelat ionships. I like t o describe NLP as soft war e for t he brain. I t provides m ent al program s t hat allow you t o develop new abilit ies and have m ore of t he kinds of experiences you want . As evident by NLP` s m iddle nam e, linguist ics plays a pivot al role. I 'm not at all clear how linguist ics can dram at ically affect behavior. Can you give m e an exam ple? How do our brains process language? The answer is very, very lit erally. People oft en say t hings like, " Don't worry" or " Don't t hink about it ." What happens if I t ell you not t o t hink about a problem ? Well, despit e what I said, you'll t hink about t hat problem . That 's because our brains cannot underst and put t ing som et hing in negat ive language. I n order t o know what not t o t hink about , our brains have t o first t hink of it . Consider t he exam ple of experienced t raders t elling new t r aders, " Don't t hink about t he m oney. Rem em ber, don't t hink about t he m oney." Alt hough t hat m ay sound like good advice, what 's going t o happen? The new t raders will repeat t hat phrase t o t hem selves unt il t hey are lit erally obsessing about t he m oney. Because of t he way our brains process language, which is lit erally, NLP recom m ends t aking negat ive t hought s and st at ing t hem in posit ive t erm s. I nst ead of saying w hat you don't want , st at e what you do want . I nst ead of advising a t rader, " Don't t hink about t he m oney," it would be far m ore effect ive t o say, " Focus your at t ent ion on following your m et hod." = = = = What are t he basic principles of NLP? = = = = NLP is based on principles different from t hose in psychology. Five essent ial principles or presupposit ions guide NLP. The first is: The m ap is not t he t errit ory. The m ap is our t hought s and feelings; t he t err it ory is

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157 realit y. We respond t o our t hought s and feelings about realit y; w e don't respond t o realit y. This is good news because it m eans t hat it is possible t o get a bet t er m ap- a bet t er way t o t hink and feel. The second fundam ent al principle of NLP is: Experience has a st ruct ure. I n ot her words, t he way in which m em ories are arranged in our m inds det erm ines what t hey will m ean and how t hey will affect us. I f we can change t he st ruct ure of our m em ories, we will experience t hose event s in our lives different ly. Change t he st ruct ure of our t hought s and our experiences will change aut om at ically. The t hird m aj or principle of NLP is: I f one person can do it , anyone else can leam t o do it . This is t he great prom ise of NLP. Excellence and achievem ent have a st ruct ure t hat can be copied. By m odeling successful people, we can leam from t he experience of t hose who have already succeeded. I f we can leam t o use our brains in t he sam e way as t he except ionally t alent ed person, we can possess t he essence of t hat t alent . The fourt h basic principle is: The m ind and body are part of t he sam e syst em . I f you change your m ind about som et hing, your abilit ies will change. I f you change your post ure, breat hing, or ot her part s of your physiology, your t hought s will change. The great psychiat rist R. D. Laing used t o say, " Change your m ind, change your body. Change your body, change your m ind." The fift h principle is: People have all t he resources t hey need. I n NLP, an im age, a sound, or a feeling is a resource. Our brain has t he abilit y t o see inner pict ures. Whet her t hese pict ures begin as fuzzy or clear, t hey can be built up int o great m ot ivat ing visions. I nner voices can crit icize us or t hey can encourage and guide us. Any feeling we've had in our lives- confidence, challenge, indom it able will, what ever it is- even if we've only had it once, can be t ransferred t o any sit uat ion in our lives where we want or need it . = = = = When you say, " The m ap is not t he t errit ory," do you m ean t hat people have dist ort ed views of realit y t hat lead t hem ast ray? = = = = NLP believes t hat all m aps ( m ent al and physical) are a dist ort ed, or select ed, view of realit y. A t opographical m ap, a st reet m ap, and a weat her m ap all provide different views of t he sam e t errit ory and all are t rue represent at ions. Usefulness, rat her t han t rut hfalness, will guide you t o want a different m ap at different t im es. The different form s of m arket analysis can be seen as different m aps of t he sam e t er rit ory. Out st anding t raders seek t o have m aps t hat m ost closely m at ch t he m arket t errit ory in a way t hat is useful for t hem . Of course, not all m aps are t rue or useful. Let m e offer one exam ple t hat is part icularly significant for t raders. I t relat es t o t he st at ist ical concept of regression t o t he m ean. This m at hem at ical phenom enon im plies t hat if you do ext rem ely well, you're likely t o do m ore poorly t he next t im e, while if you do very poorly, you're likely t o do bet t er t he next t im e. This pat t ern is an inevit able consequence of t he law of averages and t ends t o skew t raders' percept ions and evaluat ions of t heir own per form ance. For exam ple, if a t rader does very well in one period and only average in t he next , he m ight feel like he failed. On t he ot her hand, if t he t rader does v ery poorly in one period, but average in t he next , he'll probably feel like he's doing dram at ically bet t er. I n eit her case, t he t rader is very likely t o at t ribut e t he change of result s t o his syst em or his feelings rat her t han t o a nat ural st at ist ical t endency. The failure t o appreciat e t his concept will lead t he t rader t o creat e an inaccurat e m ent al m ap of his t rading abilit y. For exam ple, if t he t rader swit ches from one syst em t o anot her when he's doing part icularly poorly, t he odds are t hat he'll do bet t er at t hat point in t im e even if t he new syst em is only of equal m erit , or possibly even if it is inferior. Yet t he t rader will at t ribut e his im provem ent t o his new syst em . I n cont rast , super t raders underst and t he concept of regression t o t he m ean and use it t o t heir advant age inst ead of being m isled by it . I ncident ally, t he sam e phenom enon also explains why so m any people say t hey do bet t er aft er t hey have gone t o a m ot ivat ional sem inar. When are t hey going t o go t o a m ot ivat ional sem inar? When t hey're feeling part icularly low and inact ive, I n a sense, it doesn't m at t er what t he pr esent er does, because st at ist ically, on average, t hese people will do bet t er hi t he period aft erwar ds anyway- whet her or not t hey at t ended t he sem inar. But since t hey did, t hey'll at t ribut e t he change t o t he sem inar. = = = = I n t he sem inar exam ple you j ust cit ed, isn't it also possible t hat people will feel and perform bet t er because of t he placebo effect ? For t hat m at t er, isn't it possible t hat t he result s at t ribut ed t o NLP m ay also be a placebo effect ? = = = = I n part , t his cont ent ion m ay be valid, and it fascinat es m e t hat t his is supposed t o be a crit icism . Medical science researchers t ake t he view t hat t he placebo effect is som et hing bad. You can hear it in t heir language: " We have t o rule out t he placebo effect ." However, Bandler and Grinder looked at it different ly. They saw t he placebo effect as a nat ural hum an abilit y- t he abilit y of t he brain t o heal t he rest of t he body. This act ually present s excit ing possibilit ies. What if t his abilit y can be called fort h w hen w e w ant it or need it ? What if our brains can lit erally m ake us feel bet t er? NLP is concerned wit h result s. I f t he favorable result s are part ially due t o t he placebo effect - t hat is, t he nat ural abilit y of t he brain t o affect how we feel, heal, and funct ion, m ent ally and physically- let 's use it deliberat ely. = = = = NLP m akes claim s of being able t o change behaviors and feelings very quickly t hrough sim ple m ent al exercises. Can you give m e an exam ple of such an exercise in order t o give readers who are com plet ely unfam iliar wit h NLP som e flavor of t he approach? = = = = Let m e offer an exam ple t hat will probably be of use t o m ost of your readers. We've all been in t rading sit uat ions where t he m arket m oved dram at ically against our posit ion. The quest ion is: How unset t ling or disconcert ing was it ? What happens w hen you're in a sim ilar sit uat ion a couple of weeks or even a couple of m ont hs lat er? I f you begin t o experience som e of t he sam e unset t ling feelings j ust t hinking about it , you've condit ioned yourself j ust like Pavlov's dogs. This is w hat NLP calls " anchoring." I f t hese feelings are dist urbing your t rading decision concent rat ion, use t he following NLP t echnique t o neut r alize t hem .

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158 Quickly go t hrough your m ovie of t hat dist urbing sit uat ion and pick out one fram e, like a st ill phot ograph, t hat sym bolizes for you t he whole disappoint m ent . When you've found it , not ice whet her you see yourself in t hat st ill snapshot of t hat t im e. That is, do you see t hat earlier you, dressed as you were back t hen, in t hat phot o? You probably won't , and t his is usually t he case. So in your m ind's eye, begin t o pull back so t hat m ore and m ore of t he scene becom es visible, unt il you can see your earlier self in t he scene. I m agine t hat scene rendered in t he st yle of a fam ous paint er, as if it w ere a Renoir, a van Gogh, or even a Licht enst ein. Now consider what kind of fram e m ight be m ost appropriat e around t his pict ure. Perhaps a big old- fashioned gold fram e m ight seem right , or m aybe you'll choose a m odem st eel fram e. You m ight even want t o add a m useum light . Take a m om ent t o appreciat e t his pict ure as one of t he fram ed m em ories in your m ind. Now not ice your feelings about t hat t im e. Most people will find t hat t heir dist urbed or anxious feelings have been great ly reduced, or even com plet ely elim inat ed. This NLP process det aches our em ot ions from t he m em ory. I t 's like an em ot ional reset but t on and provides a real- world exam ple of t he NLP principle: Experience has a st ruct ure. By changing t he st r uct ure, we change t he experience. Taking j ust t he few m inut es t o do t his exercise will allow a t rader t o regain his em ot ional obj ect ivit y. Anot her way t o change dist urbing m em ories is t o do t he following: Think of t hat incident of disappoint m ent and m n it back t o t he beginning, like it 's a m ovie. Now put on circus m usic, or t he William Telt Overt ure, bet t er k nown as m e t hem e t o t he " Lone Ranger" TV series. Any rich, com pelling m usic will do, especially if it m ism at ches t he em ot ions of your m em ory. Pick a t une, and st art it playing nice and loud as you rewat ch t hat incident in a new way. Once t he m em ory has played t hrough t o it s end wit h t he m usic, t hen rewind it t o t he beginning. Now play t hat scene again wit hout t he m usic. Not ice your response t o it t his t im e. For som e people, t he incident has becom e hum orous, even ludicrous. For m any, t he previous feelings of disappoint m ent have been neut ralized, or at least great ly m it igat ed. Obviously, one approach is m ore visual and t he ot her m ore audit ory. Depending on whet her a person has a st ronger visual or audit ory sense, one of t hese t wo approaches will work bet t er t han t he ot her. = = = = Good, t hat helps clarify t he t ype of process involved. Give m e anot her exam ple = = = = The following is an exam ple of how t o t ransfer feelings of confidence ( or for t hat m at t er any em ot ional st at e) from one t im e of your life t o anot her. As wit h m any NLP t echniques, t he following will work m ore deeply and com plet ely when done in a relaxed, int errupt ion- free environm ent . There are m any t im es in your life when you've felt confident . Go back in your m em ories t o a part icular t im e when you felt abundant ly confident . Relive t he m om ent , seeing what you saw and hearing what you heard. As you begin t o reexperience t hat confidence and feel it building, im agine a colored circle on t he floor around you. As t he feeling get s st rong, exhale as you st ep out of t he circle, leaving t hose confident feelings inside t he circle. ( I am fully aware t hat t hese sound like st range inst ruct ions.) Now t hink of a specific t im e in t he fut ure when you want t o have t hat sam e confidence. As you begin t o t hink about t hat specific fut ure t im e and place, st ep back int o t he circle and spont aneously feel t hose confident feelings again. You have j ust anchored t oget her t hat fut ure t im e and your feelings of confidence from your past . To t est w het her t his has worked, t hink of t hat specific fut ure t im e. You'll feel som e of t hat confidence as you do. This feeling is now aut om at ic and will be t here wit hout your t hinking about it when t hat fut ure sit uat ion arrives. This exercise can be repeat ed for as m any different fut ure occasions and as m any different feelings as you would like. = = = = Why doesn't success bring happiness? What does? = = = = I t hink it 's because people base t heir ideas of success on out dat ed m odels or pat t erns of w hat it m eans t o be successful. For exam ple, som eone m ight have t he idea t hat in order t o be successful he or she m ust have a cert ain kind of house, a cert ain kind of car, and a cert ain kind of spouse. They're using t hose t hings as evidence for whet her t hey are a success, but t hey're leaving t hem selves out of t he pict ure. They don't ever act ually st ep int o t hat pict ure and ask, "Do I really want t o live t his t ype of life?'" So I recom m end t hat people not m erely visualize what it would be like t o act ually live t he t ype of life t hey are t rying so hard t o achieve, but t o st ep int o t hat life and m ent ally experience sev eral weeks or m ont hs. When people do t his exercise, t hey m ay find t here are t hings t hey want t o change, and I recom m end t hey m ake t hose changes. Aft er all, since t hey're working so hard for t his fut ure, it ought t o be one t hey'll enj oy when it arrives. = = = = Are you saying t hat t he reason people don't find happiness aft er achieving t heir goals is because t hey have t he wrong goals? = = = = I t 's because t hey aren't going for goals t hat will fulfill t hem . They're st riving for goals t hat societ y, or t heir fam ily, or t he m edia t old t hem t o have. We are inundat ed wit h all t hese im ages of how we'll know whet her we are successful. For exam ple, what is valuable in t his cult ure in a spouse? We know t he answer from all t he advert isem ent s we see- som eone who is young and at t ract ive. But what else is im port ant ? I t hink people som et im es get lost ; t hey don't explore what success m eans for t hem . = = = = How can people ident ify what goals would m ake t hem happy? = = = = One NLP exercise t hat deals wit h t his quest ion is having people im agine t hem selves at t he end of t heir lives. Som e people are r eluct ant t o do t his exercise, but when I t ell t hem t o go ahead and im agine t hat it 's been a very long, healt hy, and act ive life, t hey're m ore willing t o t ry it . Then I ask t hem t o look back on what t hey have accom plished, and see whet her t hey wish t hey had done som et hing else or som et hing m ore. Alt hough it 's a m ind t rick, by adopt ing t his end- of- life perspect ive, unconscious expect at ions are revealed, and people find it easier t o m ake an assessm ent about what t hey really want t o fill t heir lives. I ask m y client s, " What is really wort h t he t im e of your life?"

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159 The idea for t his exercise cam e out of an experience I had when I was in college. I worked as an orderly in a hospit al ward t hat t y pically had lot s of elderly pat ient s. Over t he cour se of t hree years, I spoke t o hundreds of people who were near t he end of t heir lives. I asked t hese people how t heir lives had been, what t hey liked about t heir lives and what t hey regret t ed, if anyt hing. = = = = What did you find out ? = = = = I found out t hat falling in love at ninet een was im port ant . I found out t hat t he willingness t o t ake risks int o t he unknown, like leaving one's sm all hom et own, was im port ant . On t he ot her hand, j ust sim ply ret iring because of age was som et hing m any of t hem felt was t he biggest m ist ake of t heir lives. One t hing t hat really st ruck m e was t hat not one of t hese people said t hey t ruly regret t ed anyt hing t hey had act ually done- what t hey regret t ed was what t hey hadn't done. They regret t ed t hat t hey had wast ed t heir lives on pet t y pursuit s. They hadn't ident ified t heir im port ant values and t hen done ever yt hing t hey could t o fulfill t hem . The les son I learned from t his experience was t he sam e one em phasized years lat er in NLP: I f we don't live t rue t o our values and fulfill t hem , we experience disappoint m ent and em pt iness. = = = = How do you know whet her t he goals you're pursuing are t he ones t hat will fulfill your values? = = = = I t 's useful t o t hink in t erm s of a m ission. A m ission isn't som et hing you force on yourself or const ruct out of your current concerns; rat her, it 's som et hing t hat you discover wit hin. As John Grinder once asked, " What do you love so m uch t hat you would pay t o do it ?" I f you don't have st rongly held values, it will be hard t o clearly define a m ission, and you will have lit t le m ot ivat ion t o achieve your goals. However, if your goals support your values and you have a clear sense of m ission, t hen your m ot ivat ion will be equally st rong. = = = = I s st rong m ot ivat ion a com m on charact erist ic of t raders who excel? = = = = St rong m ot ivat ion is a com m on charact erist ic am ong t hose who excel in any field. There are t wo different t ypes of m ot ivat ion, or what NLP calls t wo direct ions of m ot ivat ion: eit her t oward what we want or away from what we don't want . For exam ple, consider how people respond t o waking up in t he m orning. When t he alarm goes off. one person m ight m um ble t o him self, " Oh no, let m e sleep j ust a lit t le longer," and hit t he snooze but t on. Then when t he alarm goes off again, and he sees pict ures of him self rushing t o get ready for work, he t hinks, ''No big deal, I 'll wear t he sam e clot hes as yest erday and skip breakfast ," as he hit s t he snooze but t on anot her t im e. When t he alarm goes off a few m inut es lat er, his brain begins showing him pict ures of get t ing t o work lat e and having t o explain it t o his boss. He decides he'll drive t o work fast er and goes back t o sleep again. But when t he alarm goes off t he next t im e, his inner voice says, " You m ust get up! " He sees pict ures of his client s wait ing im pat ient ly and his boss yelling and scream ing, t hreat ening t o fire him . When t hese pict ures in his m ind's ey e becom e big enough^ bright enough, close enough, and loud enough, t hen he says, " OK, I 'll get up." He's finally m ot ivat ed. Anot her person, when he hears t he alarm go off in t he m orning, t hinks about all t he great t hings he's going t o do t hat day. He sees him self accom plishing new goals and wakes up raring t o go. This person is also m ot ivat ed. I n fact , he probably wakes up before t he alarm . The person who wouldn't get up unt il he saw im ages like his boss yelling at him has an " Away From " m ot ivat ional direct ion. His m ot ivat ion is t o get away from pain, discom fort , and negat ive consequences. He probably picks friends who won't bot her him . He's not likely t o m ake a career m ove unt il he can't st and his j ob anym ore. He m oves away from what he doesn't want . The person who can't wait t o get out of bed has a " Toward" m ot ivat ional direct ion. He m oves t oward pleasure, rewards, and goals. He probably picks friends who st im ulat e him . He m akes career m oves t o reach bigger opport unit ies. He m oves t oward what he want s. People can have bot h t ypes of m ot ivat ion- Away From and Toward- but m ost people specialize in one or t he ot her. They are very different ways of get t ing m ot ivat ed, and bot h are useful in different sit uat ions. = = = = The benefit s of Toward m ot ivat ion seem pret t y obvious, but how would an Away From m ot ivat ion be beneficial? = = = = Your quest ion reflect s a com m on percept ion. The benefit s of Toward m ot ivat ion are m ore obvious. People who m ove t oward goals are great ly valued in our societ y. You can see it in t he language of t he Help Want ed ads, which liberally use t erm s such as " self- m ot ivat ed" and " go- get t er." However, t he Away From direct ion of m ot ivat ion has got t en a bad rap. Anot her way of t hinking about t his m ot ivat ion is t hat it is away from problem s. Many people who use Away From m ot ivat ion are problem solvers. You can hear it in t heir language. They'll say, " Excuse m e, but we have a problem here." They see a problem and have t o solve it . Som et im es t hey get so involved in t he problem t hat t hey m ay forget where t hey are going, but t hey will solve t he problem . The Toward m ot ivat ed people are so m ot ivat ed t oward t heir goals t hat t hey m ight not even consider what problem s t hey m ight run int o or what difficult ies t o prepare for along t he way. Ther efore, bot h t ypes of m ot ivat ion are useful. = = = = Are you im plying t hat people wit h Away From m ot ivat ion are likely t o be as successful as t hose wit h Toward m ot ivat ion? = = = = That 's right . The Toward m ot ivat ion m ay be enshrined in success m agazines, but t he less appreciat ed Away From m ot ivat ion individuals can also be very successful. A perfect exam ple is Mart in Zwieg, t he fam ous st ock forecast er. He m anages over a billion dollars in asset s. His st ock let t er and books are am ong t he m ost respect ed in t he indust ry. When Zwieg t alks about st rat egy, he says, " DON'T fight int erest rat e t rends. DON'T fight m arket m om ent um ." He uses Aw ay From m ot ivat ion t o m inim ize loss. Many out st anding t raders reveal an Away From m ot ivat ion when t hey t alk about " prot ect ing t hem selves" or " playing a great defense." They're only willing t o t ake so m uch pain in t he m arket before t hey get out . As Paul Tudor Jones said in your

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160 int erview, " I have a short - t erm horizon for pain." = = = = Cert ainly t here m ust be som e disadvant ages t o having an Away From m ot ivat ion. = = = = Sure. People who are m ot ivat ed away from t hings oft en experience a lot of pain and worry before t hey are m ot ivat ed. I f t hey let t he st ressful anxiet y level get t oo high, it will affect t heir healt h. St ress m anagem ent classes are filled wit h t hese people. I t would be m ore useful for t hem t o leam t o accept less pain before t aking act ion t han t o learn t o m anage it bet t er. Also, t he furt her away t hey get from t he problem , t he less serious it appears, and hence t hey lose som e of t heir m ot ivat ion. As a result . Away From m ot ivat ion t ends t o m n hot and cold. Finally, people wit h Away From m ot ivat ion won't necessar ily know where t hey'r e going t o end up because t heir at t ent ion is on what t hey don't want , not on what t hey do want . = = = = Do successful t raders t end t o have one t ype of m ot ivat ion versus t he ot her? = = = = Very oft en t hey com e in wit h a developed Towar d m ot ivat ion- t oward success, t oward m oney- t hat 's why t hey got int o t he m arket s in t he first place. However, t hose t hat are prim arily Toward m ot ivat ed m ust spend t he t im e and energy t o develop t he Away From m ot ivat ion required for proper m oney m anagem ent . I n m y st udies of t raders I 've found t hat it 's nearly im possible t o be a really successful t rader wit hout t he m ot ivat ion t o get away from excessive risk. = = = = Obviously, m ot ivat ion is crit ical t o achieving goals. I s t hat t he only crit ical fact or, or is t here m ore t o it ? = = = = NLP research has shown t hat five condit ions m ust be m et in order for a goal t o be achievable. First , t he goal m ust be st at ed in posit ive t erm s. I t 's not get t ing rid of som et hing- for exam ple, " I don't want t o lose m oney." Rat her, it needs t o be st at ed in posit ive t erm s- for exam ple, " I want t o prot ect m y asset s." The second condit ion is t hat t he goal needs t o be yours. " They want m e t o t rade larger," is an exam ple of a goal t hat does not m eet t his condit ion. I nst ead, if your goal is, " When m arket condit ions warrant it , I 'm going t o double m y t r ading size," you're m uch m ore likely t o reach t hat goal. Third, t he goal m ust be specific. Not hing ever happens in general. The m ore richly det ailed t he descript ion of your goal- what you'll see, hear, and feel when you get it - t he bet t er. The fourt h condit ion adds t he when, where, and wit h whom . The fift h condit ion for achieving a goal is ant icipat ing t he effect s of t he goal. I s it w ort hwhile and desirable in it self and in it s effect s? This brings us full circle t o having goals we really want and t hat will fulfill us. = = = = The very first condit ion you st at ed as crit ical in achieving your goal is t hat t he goal be st at ed in posit ive t erm s. Wouldn't t hose wit h Away From m ot ivat ion have difficult y in fulfilling t his condit ion? = = = = The underlying m ot ivat ion m ay be one of get t ing Away From som et hing negat ive, but t he goal can st ill be st at ed in posit ive t erm s. For exam ple, som eone's m ot ivat ion for being a successful t rader m ight be t o get away from povert y. So t he goal m ight be t o set a personal record in profit s for t he com ing year. An Away From m ot ivat ion and a posit ive goal can work t oget her t o pr ovide t horough m ot ivat ion and out st anding result s. = = = = How did you first get involved in working wit h t raders? = = = = I n 1987,1 w as approached by St eve Bianucci, a young Treasury bond floor t rader who was working wit h Pet e St eidlm ayer's Mark et Logic School [ St eidlm ayer has since left t he school] and looking t o m ake t he t ransit ion from t he floor t o posit ion t rading. He want ed t o know if NLP could be used t o build a working m odel of a great t rader. I was int rigued by his quest ion, and it served as t he cat alyst for a research process t hat is st ill ongoing. = = = = What kind of research? = = = = Observing gr eat t raders t o const ruct a m odel of t rading excellence. = = = = Wasn't it difficult t o gain access t o such t raders? I have t rouble im agining t hat m any of t hem would willingly agree t o be t he subj ect s of ext ended obser vat ion and m odeling. = = = = I n t he case of floor t raders, such as Tom Baldwin [ a phenom enally successful T- bond floor t rader profiled in Market Wizards] , direct observat ion was quit e easy, requiring not hing m ore t han access t o t he t rading floor, which I got . I n t he case of Pet e St eidlm ayer [ a highly successful fut ures t rader and t he invent or of Market Profile- an analyt ical m et hodology t hat relies heavily on t he st udy of int raday volum e] , he offered classes and I was able t o observe him direct ly. Finally, in t he case of som e supert raders, t he observat ion was one st ep rem oved- wat ching video t apes of t heir t rading and list ening t o t heir t alks or int erviews. Jim m y Rogers, Paul Tudor Jones, and Richard Dennis [ t hree of t he best t raders of our generat ion, who were also profiled in Market Wizards] fall int o t his last cat egory. I lat er saw Dennis on a fut ures indust ry panel t hat you m oderat ed and det erm ined m y inferences about his t rading st rat egies and em ot ional m anagem ent st yle wer e accurat e. = = = = Can you give m e a t ypical exam ple of a t rader who cam e t o you for help? = = = = I recent ly worked wit h a m an who is a good t rader. However, every t im e he get s ahead, he ends up giving back a good part of his pr ofit s. While I was working wit h him , it cam e out t hat he knew lot s of t raders who m ade m oney but who, in his words, were " not wonderful hum an beings.'" He want ed t o be successful as a t rader, but he was worried about becom ing like t hem . His unconscious solut ion t o t he problem was t o not becom e t oo successful. His beliefs also had a ver y rest rict ing effect on his personal life. He t hought t hat he had t o put t rading first - t hat t rading m eant t hat he couldn't have a personal life or a fam ily. Using NLP t o change t hose beliefs helped evolve t hat part of him self t hat he had m ist akenly t hought was sabot aging his t rading. This w as a part icularly grat ifying experience for m e, because I saw him reclaim a part of his life t hat he t hought he couldn't have as a t rader.

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161 He recent ly called m e t o say he had t ripled his posit ion size t o over a t housand cont ract s. By resolving his inner conflict , he freed up m ent al power t o bet t er wat ch for opport unit ies and im prove his t rading. = = = = What different iat es t hose who excel at t rading from t he vast m aj orit y of t raders? = = = = One crit ical elem ent is beliefs. I n his book Peak Perform ers, Charles Garfield report ed t hat t he key elem ent t hese individuals share is a t ot al belief in t he likelihood of t heir own success. Cont rast t his w it h Dr. Michael Lem er's research, published in his book Surplus Powerless- ness, in which he found t hat m ost people feel t hat t hey have very lit t le power over t heir lives. He based his conclusions on t housands of int erviews conduct ed wit h people from a wide cross sect ion of occupat ions. This general cont rast bet ween peak perform ers and t he m aj orit y of t he populat ion serves equally w ell in explaining an essent ial difference bet ween t he out st anding t raders and all ot her m arket part icipant s. The supert raders have an absolut e confidence in t heir abilit y t o w in- a confidence confirm ed by com pet ence in t he m arket s. Cont rast t his w it h m ost t raders who lack confidence in t heir syst em or approach and t he t ypical t endency of m any t raders t o blam e ot hers ( t heir broker, floor t raders, and so on) for t heir result s. = = = = Beyond confidence in t heir own success, what are som e of t he ot her charact erist ics of successful t raders? = = = = Anot her im port ant elem ent is t hat t hey have a per cept ual filt er t hat t hey know well and t hat t hey use- By percept ual filt er I m ean a m et hodology, an approach, or a syst em t o under st anding m arket behavior. For exam ple, Elliot ! Wave analysis and classical chart analysis are t ypes of percept ual filt ers. I n our research, we found t hat t he t ype of per cept ual filt er doesn't really m ake m uch of a difference. I t could be classical chart analysis, Ganri, Elliot t Waves, or Market Profile- all t hese m et hods appear t o work, provided t he person knows t he percept ual filt er t horoughly and follows it . = = = = I have an explanat ion as t o why t hat m ay be t he case. = = = = I 'd cert ainly be int erest ed in hearing it . = = = = I believe a lot of t he popular m et hodologies are really vacuous. = = = = [ He laughs.] Aha! That 's a pret t y provocat ive st at em ent . You've got m y at t ent ion. = = = = All t hese t echnical m et hods are based on price. I n effect , t hey're all different - colored glasses for looking at price. Proponent s of RSI and St ochast ics ( t wo popular overbought / oversold indicat ors) would see price pat t erns filt ered t hrough t hese price- derived series. Gann analysis ent husiast s would see t he price pat t erns t hrough a Gann- based int erpr et at ion. I n t hese cases and ot hers, t raders accum ulat e experience on price pat t erns- albeit from different perspect ives. Som e of t he m et hodologies em ployed, however, are probably t ot ally wort hless. I t 's sim ply t hat inst ead of looking at prices t hrough clear glass, t raders who use t hese m et hods are looking at prices t hrough different - colored t int s. The m et hod, or t int shade, is a m at t er of individual preference. To ext end t he analogy, I would com pare t hese m et hods t o nonprescript ion sunglasses: t hey change t he view but don't necessarily im prove t he vision. The bot t om line is t hat t hese m et hods seem t o work only because t he people who use t hem have developed som e sort of int uit ive experience about price. ==== That act ually fit s pret t y w ell wit h m y own view. People need t o have a percept ual filt er t hat m at ches t he way t hey t hink. The appr opriat e per cept ual filt er for a t rader has m ore t o do wit h how well it fit s a t rader's m ent al st rat egy, his m ode of t hinking and decision m aking, t han how well it account s for m arket act ivit y. When a person get s t o know any percept ual filt er deeply, it helps develop his or her int uit ion. There's no subst it ut e for experience. = = = = What ot her charact erist ics t ypify successful t raders? = = = = Anot her im port ant elem ent am ong t raders who ex cel is t hat t hey have an effect ive t rading st rat egy. I 'm using t he word " st rat egy" in an NLP sense, m eaning a series of int ernal represent at ions, m ent al pict ures, words, and feelings, leading t o a desired out com e: winning t rades. One t rader can act decisively, while anot her m ay be paralyzed by indecision. The difference lies in t heir st rat egies. = = = = I 'm afraid you are lost m e. I n your use of t he word, what t ypifies t he st rat egies of successful t raders? ==== An effect ive t rading st rat egy will have t he following charact erist ics. First , it will be aut om at ic. Given a specific sit uat ion, t he t rader will know what t o do wit hout second- guessing him self. Second, a good st r at egy will be congm ent - t hat is, it won't creat e any int ernal conflict . Third, t he st rat egy will incorporat e Away From m ot ivat ion by including som e specific risk cont rol plans. Fourt h, part of t he st rat egy w ill involve im agining t he t rade from t he perspect ive of already being in t he posit ion and considering what m ight be wrong wit h t he t rade before put t ing it on. Fift h, an effect ive t rading st rat egy w ill provide specific evidence t hat w ill allow t he t rader t o evaluat e t he m erit s of a t rade. = = = = Are t here any ot her charact erist ics com m on t o successful t raders? = = = = Managem ent of one's em ot ional st at e is crit ical. The t ruly except ional t raders can st and up t o anyt hing. I nst ead of get t ing em ot ional when t hings don't go t heir way, t hey rem ain calm and act in accordance wit h t heir approach. This st at e of m ind m ay com e nat urally. Or som e people m ay have ways of cont r olling or dissipat ing t heir em ot ions. I n eit her case, t hey know t hey want t o be em ot ionally det ached from feelings regarding t heir posit ions. When a posit ion is going against him , Pet e St eidlm ayer's at t it ude appears t o be: " Hm m , look at t hat ." He observes his own posit ions wit h scient ific det achm ent . By st aying calm , out st anding t raders get t he necessary feedback t o det erm ine whet her or not t heir approach needs t o be revised. = = = = I s having t he proper em ot ional st at e an int rinsic qualit y? Or can it be learned? = = = =

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162 Bot h. Som e out st anding t raders j ust appear t o be t hat way- t hey have a nat ural scient ific det achm ent - while ot hers have learned t o exercise a m ilit ary- like cont rol over t heir em ot ions. Eit her approach will work, but t hese t raders are t he ex cept ions. Trading act ually t ends t o at t ract people who are ill suit ed t o t he t ask- t hose who are enam ored wit h m aking lot s of m oney; people who are willing t o t ake high risks; individuals who seek excit em ent or who react t o t he world wit h em ot ional int ensit y. = = = = How do you t each t hese t ypes of people t o adopt t he kind of m ent al st at e appropriat e t o successful t rading? = = = = One t hing I do is t o have t hem act ually get up, st ep back, and im agine seeing t hem selves sit t ing in t heir chairs. I get t hem t o calm ly wat ch as if t hey were observing som eone else doing t he t rading. I also have t hem do ot her NLP exercises t hat are designed t o achieve t he sam e goal. = = = = And j ust doing t his t ype of sim ple m ent al exercise is sufficient t o creat e perm anent behavioral changes? For exam ple, are you im plying t hat previously high- st rung t raders will aut om at ically respond calm ly in crisis sit uat ions, sim ply by virt ue of having done such m ent al exercises? = = = = I f som eone is very high- st rung, it m eans he's part icularly em ot ional, and it m ay t ake m ore work t o m ake sure t he result s st ick, but overall, t he answer is yes. I know t hat it sounds hard t o believe, but our brains learn very quickly. I f you change t he way t he brain perceives a sit uat ion, you will change t he way it will respond t o t hat sit uat ion forever. Of course, som et im es t here ar e ot her conflict ing considerat ions. One of m y earliest client s was a very em ot ional t rader who had a successful syst em but couldn't follow it . I t aught him som e t echniques for em ot ionally det aching from t he m arket . I wat ched him applying t hese t echniques one day, and it really worked. I n j ust a few hours, he was up $7,000. But j ust as I was savoring a sense of self- sat isfact ion, he t urned t o m e and in a m onot one voice said, " This is boring." I t hought t o m yself, Uh- oh. I would like t o say t hat I helped him solve his problem and t hat he m ade m illions of dollars and lived happily ever aft er. No, t he guy blew out . He knew how t o go int o an em ot ionally det ached st at e, but he didn't like t o be t here. This experience t aught m e t hat som e people ar e in t he m arket s because t hey like t he ex cit em ent . Since t hen, I 've learned t o help people who have t hat need for excit em ent t o find it in ot her places in t heir lives and t o schedule it , so t heir brain get s t he idea t hat t his process is not about denial but about appropriat e t im es and m eans of expression. = = = = Anyt hing t o add regarding t rait s t hat different iat e winning from losing t raders? = = = = A final crit ical charact erist ic dist inguishing winning t raders from losing t raders relat es t o what I 've t erm ed " operat ing m et aphors." An operat ing m et aphor det erm ines how we view t he world, and it shapes our beliefs, act ions, and life- st yles. Som e of t he m et aphors used by t raders t o describe t he m arket are a wom an, war, and a gam e, t o nam e a few of t he m ore com m on ones. As an exam ple of t he gam e or puzzle- solving m et aphors, Richard Dennis says, " I t 's like playing a hundr ed chess gam es at once." Pet e St eidlm ayer says he's " solving t he m arket s." Paul Tudor Jones sum s it up wit h, " I t 's a gam e, and m oney is a way t o keep score." Each operat ing m et aphor will lead a t rader's brain t o a different set of beliefs and a different approach t o t he m arket s, wit h som e being m ore effect ive t han ot hers. Cont rast t he m et aphors I j ust cit ed wit h som e of t he oper at ing m et aphors I 've t ypically heard around t he t rading floor. " I got t orn up t oday," m akes t he m ar ket int o a beast of prey. " We t ook a hit " reflect s t hinking t hat t he m arket is a war and t he speaker a wounded part icipant . Which m et aphor will result in your feeling m ore obj ect ive about t he m arket - playing a gam e, even a high- st akes gam e, or defending yourself from an at t acking wild anim al? The answer is obvious. The difference is in what is suggest ed by t he m et aphor. I n t he gam e, t here are winners and losers, but your survival isn't at st ake, as it is wit h being at t acked by a wild anim al. You m ay respond brilliant ly t o save yourself from t he beast , but t hat m et aphor doesn't encourage you t o learn and pract ice long- t erm st rat egies and t act ics t he way a gam e does. Having an operat ing m et aphor appropriat e t o your t rading st yle is fundam ent al t o success. = = = = Can you t ell who will be a successful t rader and who will not ? = = = = Yes, based on how well t hey m at ch t he profiles of successful t raders in regards t o t he areas j ust discussed: beliefs, percept ual filt er, st rat egy, em ot ional- st at e m anagem ent , and operat ing m et aphors. On a less t echnical level, I can say t hat aft er years of st udying t raders, t he best predict or of success is sim ply whet her t he person is im proving wit h t im e and experience. Many t raders unconsciously acknowledge t heir lack of progress by cont inually j um ping from one syst em or m et hodology t o anot her, never gaining t rue proficiency in any. As a result , t hese people end up wit h one year of experience six t im es inst ead of six years of experience. I n cont rast , t he superior t raders gravit at e t o a single approach- t he specific approach is act ually not im port ant - and becom e ext rem ely adept at it . What is NLP's view of t he relat ionship bet ween t he conscious and unconscious m inds? The propert y of t he conscious m ind is t o reflect on t hings, " Am I where I want t o be?" " I s t his a good t rade?" I n ot her words, it 's concerned wit h evaluat ion. I t 's not t he proper t y of t he conscious m ind t o change t hings. To offer you an analogy, when I lived in Colorado, I had a friend from t he Bast visit m e. One day, I suggest ed t hat we go horseback riding. We rent ed horses from a st able. I don't know if you've ever rent ed horses from a st able, but t he horses know t he pat hs, and t hey also assess t he experience of t he rider when he get s on, I had a lit t le experience; m y friend had none. We got on our horses, and t hey began t o t rot . Off in t he dist ance, t here was a line of t rees in front of us. The closer we got t o t he t rees, t he fast er t he horses began t o run. I knew exact ly what was going on. The horses were planning t o knock us off by running t hrough t he t rees and t hen go back t o t he st ables and t ake

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163 t he rest of t he day off. 1 ducked down as m y horse and I went t hrough t he t rees. Meanwhile, I heard t his " t hum p" behind m e. I pulled m y horse around, and t here was m y friend lying on t he gr ound, half a dozen yards before t he t rees. " Are you OK?" I asked. He was kind of em barrassed and said, " Yeah, I 'm alright ." " What happened?" I asked. " The st upid horse was going t o m n int o a t ree, so I had t o j um p off," he replied. Now here is som eone who has obviously m ist aken horses for cars. The conscious m ind is like t he rider. I t evaluat es t he direct ion t he horse is going. I f t he horse, or t he unconscious, is not going where we want it t o go, it doesn't m ean t hat it 's bad, or not following inst ruct ions, or about t o m n int o a t ree. I t m eans t hat t he unconscious has it s own program s and is m nning t hem t he best it can based on all it s hist ory and habit s- j ust like t hat horse had t he habit of knocking people off and going back t o t he st able. Wit h NLP, you can direct your conscious m ind t o not ice when you're not where you want t o be. What 's m ore im port ant , you can use NLP t echniques t o effect ively int roduce new pat t erns int o your unconscious m ind t o bring about t he changes you desire, inst ead of com plaining or m aking up any one of a t housand reasons why you aren't where you want t o be in your life. = = = = We t alked earlier about t aking t he t im e t o exam ine your goals- t o m ake sure t hat t hey are indeed t he goals you want and if t hey're not , changing t he direct ion of your effort s accordingly. Assum ing a person has done t hat , do you have any advice on how t o best t ransform t hose goals int o a realit y? = = = = I can best answer t hat quest ion by relat ing t he experience of Gary Faris, an NLP t rainer and colleague. Gary's st udy of t his very quest ion grew out of a com pelling personal experience. Gary is an avid m nner. Several years ago, while running down a farm road in California, he was hit by a pick- up t ruck. His inj uries wer e so severe t hat t he em er gency room doct ors weren't sure he would even live. When he sur vived aft er t he first t wo of t he six operat ions he would event ually undergo, t he doct ors said t hat t he only reason he had m ade it was because he was in such good physical condit ion. They t old him t hat he would never walk norm ally, and cert ainly never run again. Over t he next t wo years, Gary was in sport s r ehabilit at ion. He rebuilt his body, overcom ing t he pain. Today, he r uns regularly and is t he fit t est t rainer working for NLP Com prehensive [ one of t he first and forem ost NLP t raining organizat ions] . Needless t o say, t he doct ors were ast ounded. However, t hey were m aking t heir assessm ent based on t he st at ist ical evidence of sim ilar cases. They didn't realize t hat Gary Faris had m ade him self int o an except ional pat ient . Right aft er his accident , Gary began st udying sport s inj ury rehabilit at ion. He searched for t he core charact erist ics of t hose at hlet es who had gone t hrough successful rehabilit at ion. He exam ined t heir m ent al at t it udes. He found t hat six basic m ent al pat t erns charact erized all t hese people. First , t hese at hlet es used bot h m ot ivat ing direct ions. I n ot her words, t hey were bot h m oving t oward and away from consequences. I n t his way, t hese athlet es were ut ilizing t heir m axim um m ot ivat ion. Second, t hese at hlet es w ere absolut ely dedicat ed t o regaining full st rengt h and healt h. This. st andard becam e t heir guiding goal. Anyt hing less was unaccept able. I n fact , m any of t hem not only want ed t o regain full st rengt h and healt h, but t hey st rived t o get in even bet t er shape t han t hey were before t heir inj uries. They knew t heir capabilit ies and wouldn't accept any t hing less. These at hlet es knew t hey would succeed. The t hird key elem ent t hat t hese at hlet es had in com m on was t hat t hey approached t heir rehabilit at ion one st ep at a t im e. I f you cont em plat e achieving a m aj or proj ect , such as overcom ing a t errible inj ury, it 's int im idat ing t o t hink of t he ent ire t ask all at once. However, if you can t ake it in chunks, or individual st eps, you'll com plet e it . Each st ep becom es a new goal. For Gary, he had t o survive before he could walk; he had t o walk before he could m n. Gary and t he ot her at hlet es he st udied derived great sat isfact ion from com plet ing each st ep. Thus, t hey experienced succeeding at each of t he m ilest ones along t he way t o a m aj or goal of full st rengt h and healt h. The fourt h key elem ent relat ed t o t he way in which t hese recover ing at hlet es perceived t im e. They were in t he m om ent . I n ot her words, t hey succeeded because t hey focused on t he present . I f, inst ead, t hey had focused t oo far int o t he fut ure, it would have been easier t o fall int o a negat ive orient at ion by quest ioning whet her t hey would achieve t heir ult im at e obj ect ive. The fift h elem ent of t heir posit ive m ent al at t it ude was involvem ent . The m ore t he at hlet e helped him selfeven doing som et hing as sim ple as placing ice on an inflam ed ar ea- t he m ore com plet e and fast er t he recovery. When you part icipat e, you feel you can influence what 's going on, and t hat m akes you m ore det erm ined and aggressive. The sixt h and final key elem ent was relat ed t o how t he at hlet es j udged t heir individual perform ance and progress. People have a nat ural t endency t o com pare t hem selves and t heir act ions wit h ot hers. This t ype of t hinking begins at an early age and becom es m ore ingrained as we becom e adult s. I t is crit ical t hat recovering at hlet es not fall int o t his m ent al habit . Because of t heir inj uries, t hey would com pare poorly and would likely becom e discouraged. The successful at hlet es looked solely at t heir own progress. They m ade self- t o- self com parisons. They asked t hem selves quest ions like, " How far have I progressed since last week, or last m ont h?" I ncident ally, t eaching kids t o m ake self- t o- self com parisons is one of t he gr eat est gift s parent s can give t hem . Let t hem know t hat in any endeavor t hey engage in, t here will always be som e people who are bet t er and ot hers who are worse. What is im port ant is our own progress. By adopt ing t his m ent al at t it ude, it 's possible t o look at ot her people's accom plishm ent s as inspirat ion and m odels of excellence as opposed t o t arget s of envy.

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164 When t hese six elem ent s are com bined, t hey creat e a com pulsion t o succeed. I n subsequent research, I found t hat t hese six core charact erist ics provided t he basis of any posit ive m ent al at t it ude. Whet her I looked at at hlet es, ent repr eneurs, or execut ives, t he m ore confident t heir m ent al at t it ude, t he m ore t hey used t hese sam e six elem ent s. = = = = You have becom e heavily involved in bot h NLP and t rading. Do you see any sim ilarit ies bet ween t hese t wo endeavors? = = = = Trading and NLP are like m irrors of each ot her. Trading is concerned w it h m arket pat t erns, and NLP is concerned wit h t he pat t er ns of t he m ind. Bot h deal wit h t angible, not t heoret ical, result s. Traders are j udged by t heir result s- t he m oney in t heir t rading account s- not t he beaut y or int ricacy of t heir m arket t heories. NLP pract it ioners are j udged by t heir result s- client s quickly achieving t he changes t hey ar e seeking in t heir livesnot t he originalit y or insight s of NLP t heories about how t he brain works. NLP seeks t o m odel hum an excellence, and t rading is an act ivit y in w hich excellence is required for success, since only a sm all m inorit y can win. I have been dr awn t o NLP and t rading because I like t he em phasis t hey bot h place on real- world result s and excellence. Does NLP work? My personal view on t his quest ion m at t ers lit t le because it would represent only a sam ple of one. Ther e is cert ainly a t rem endous am ount of anecdot al evidence support ing t he efficacy of NLP t echniques. However, rigorous, double- blind scient ific t est s are in short supply. No doubt t he paucit y of hard scient ific experim ent al evidence is due t o t he ext rem e difficult y of m easuring t he result s of NLP, which deal largely wit h feelings and beliefs. However, one of t he hallm arks of NLP is t hat it virt ually guarant ees quick result s. Therefore, if you t ry NLP in one of it s form s ( books, t apes, sem inars, or one- on- one sessions) , you should be able t o m ake a fairly quick det erm inat ion of whet her t he approach has any validit y for you. The broader quest ions of NLP's m erit s aside, I did find cert ain aspect s of Faulkner's m essage com pelling. First , I found t he concept of m ission a highly useful m ent al const ruct for focusing goals and int ensifying m ot ivat ion. My list ening t o Faulkner's t apes coincided wit h a surge in m y personal effort s t o furt her a com m odit y t rading advisory vent ure and significant progress in t hat regar d. I also t hink t here is a great deal of m erit t o Faulkner's list of t he six key st eps in achievem ent : 1. Use bot h Toward and Away From m ot ivat ion. 2. Have a goal of full capabilit y plus, wit h anyt hing less being unaccept able. 3. Break dow n pot ent ially overwhelm ing goals int o chunks, wit h sat isfact ion garnered from t he com plet ion of each individual st ep. 4. Fully concent rat e on t he present m om ent of t im e- t hat is, t he single t ask at hand rat her t han t he longt erm goal. 5. Personally involve yourself in achieving goals ( as opposed t o depending on ot hers) . 6. Make self- t o- self com parisons t o m easure progr ess. The above elem ent s have im port ant im plicat ions and applicat ions t o t rading. As one exam ple, t he st ress on self- involvem ent would im ply t hat it is unlikely for people t o succeed at t rading by com plet ely relying on som eone else's syst em . As anot her, t he focus on self- t o- self com parisons im plies t hat t raders should j udge t heir progress based on t heir own past perform ance, not t he perform ance of ot her t raders. The im age t hat Faulkner paint s of a successful t rader is in st ark cont rast t o popular percept ions. Most people probably t hink of great t raders as t he Evil Knievels of t he financial world- individuals willing t o t ake great risks, drawn t o t heir calling by t he adrenalin- charged excit em ent . According t o Faulkner, not hing could be furt her from t he t rut h. Successful t raders have learned t o avoid risk, not seek it . Moreover, very few of t hem t rade for excit em ent . On t he cont rary, based on Faulkner's observat ions, one of t he hallm arks of successful t raders is t heir abilit y t o m aint ain a calm , det ached em ot ional st at e while t rading. They m ay get excit em ent in t heir lives, but it 's not from t rading. Many of Faulkner's com m ent s have relevance t o m ore t han j ust t rading. Most people could probably benefit from t he advice given by Faulkner and NLP t o explore what success m eans for t hem . The one com m ent I found part icularly st riking concerned his conversat ions wit h hundreds of elderly pat ient s: " Not one of t hese people said t hey t ruly regret t ed anyt hing t hey had act ually done. What t hey regret t ed was what t hey hadn't done."

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165 Robert Krausz: The Role of the Subconscious I first learned of Robert Krausz t hrough a let t er in Club 3000- a publicat ion t hat consist s largely of let t ers writ t en by subscribers who share an int erest in t rading. The t rader who wrot e t he let t er described how a set of sublim inal t apes he had purchased from Robert Krausz, a m em ber of t he Brit ish Hypnot ist Exam iners Council, had im proved his t rading im m ensely. I was int rigued. There is alm ost a Dickensian qualit y t o Robert Krausz's life st ory. His early childhood years were spent in a ghet t o in Hungary during World War I I . At t he age of eight , he and a friend escaped from a forced m ar ch t o a deat h cam p, bolt ing for t he woods in opposit e direct ions during a m om ent in which t he guards were dist ract ed. Having no place else t o go, he m ade his way back t o t he ghet t o, where he st ayed unt il t he end of t he war. Krausz spent t he years aft er t he war in a succession of orphanages, finally ending up in an orphanage in Sout h Africa. There he m et a diam ond m agnat e who t ook a liking t o him . The wealt hy indust rialist began com ing t o t he or phanage on Sundays t o t ake Rober t out on ex cursions- st art ing a relat ionship t hat ended in adopt ion. I n t his way, t he orphan who had survived t he horrors of war found a new life as a son of one of Sout h Africa's wealt hiest m en. Krausz's wart im e experience m ade him an avid support er of I srael. As he gr ew older, he becam e m ore and m ore com m it t ed t o I srael's sur vival. Troubled by t he im plied hypocrisy of convincing ot her young Sout h African Jews t o em igrat e and j oin t he I sraeli arm ed forces while st aying put him self, he event ually followed his own advice. Despit e t he prot est s of his fat her, whom he loved and respect ed, he j oined t he I sraeli arm ed forces, serving as a parat rooper during t he 1956 war wit h Egypt . The socialist undert one of t he I sraeli econom y t roubled Krausz, however, and he event ually em igrat ed t o Great Brit ain. I n London, Krausz's art ist ic inclinat ions led t o a career as a dress designer. He event ually developed his own line of clot hes during t he heyday of Cam aby St reet and t he Beat les era. Krausz's business subsequent ly expanded t o include t he design of fabric pat t erns and clot hes for overseas m anufact urers and t he im port at ion of t he finished product s back int o t he Unit ed Kingdom . I n connect ion wit h t his business, Krausz t raveled very ext ensively t hroughout t he Far Bast over a num ber of years. Alt hough t he business prospered, Kr ausz's increasing fascinat ion wit h t rading led t o anot her m aj or career change. I n early 1988, he gave up his business and em igrat ed t o t he Unit ed St at es t o begin a new endeavor as a full- t im e t rader. Krausz declined t o com m ent on his specific result s as a t rader ot her t han t o say t hat he has done well enough t o " earn a very com fort able living." When he discusses t rading as a career, Kr ausz becom es anim at ed. " This is t he best business in t he world! " he em phat ically proclaim s. " There is no ot her profession t hat is so black and whit e; you're eit her right or wrong." ( As he says t his, I am st ruck by what he is wearing- black slacks and a whit e shirt .) " Trading also appeals t o m e because you're t ot ally dependent on your own t alent s and abilit ies." I m et Krausz at his Fort Lauderdale hom e. He is an openly friendly m an. He insist ed on personally picking m e up at t he airport and ent husiast ically invit ed m e t o spend t he night at t he guest cot t age adj oining his house. My conversat ions wit h Krausz progressed t hrough v arious st ages t hroughout t he day. Krausz speaks wit h a dist inct Sout h African accent ( which, t o t he unt rained Am erican ear, would com m only be m ist aken for a Brit ish accent ) , a fact or t hat adds furt her color t o his ret elling of past exper iences. We began our t alks sit t ing on t he pat io, looking out ont o t he wat er way and t ropical forest preserve t hat borders t he r ear of his propert ya m ost ext raordinary backyard. The chill of a seasonally cool Florida wint er day event ually drove us inside, and we cont inued t he int erview in Krausz's office. The office, which Krausz shares wit h his wife, a well- known financial ast rologer, runs t he widt h of t he house, wit h t he windows on one side facing t he ocean and t he windows on t he ot her side overlooking t he wat erway and pr eser ve; t he Krauszes divide t he office along t he lines of t heir preferred views. One can see t hat Krausz is a serious chart ist , as a draft ing t able in his office is covered wit h t hree- by- t wofoot chart s t hat Krausz m anually m aint ains. Unlike convent ional chart s, which use vert ical bars t o represent each day or t im e int erval, Krausz's chart s use price bars of varying widt hs as part of a m et hodology called Sym m et ries, which is based on t he assum ed sym m et ry of price and t im e and was invent ed by Joe Rondinone, one of W. D. Gann's first st udent s. The int erview was t em porarily halt ed for a lengt hy dinner break. I f Krausz is as good a t rader as he is a Hungarian cook, he will becom e a very wealt hy m an. = = = = You have m ent ioned t hat you consider being a t rader an essent ial qualificat ion as a hypnot herapist specializing in helping t raders. Which cam e first * t he t rading or t he t raining in hypnosis? = = = = The t rading was t he cat alyst t hat led m e t o hypnosis. My first exposure t o t r ading cam e during t he recordset t ing 1979- 80 bull m arket in gold. At t he t im e, I t hought t hat I was t rading. Of course, it was not t rading; it was j ust childish nonsense. = = = = How did you first get involved in t rading? = = = = During t hat 1979 bull m arket , every t wo or t hree days t he Financial Tim es carried anot her art icle bearing t he banner " New Highs in Gold" or som e ot her very sim ilar headline. These r epeat ed st ories m ade an im pression on m e. I also had a friend who was involved in t he gold m arket and m aking a great deal of m oney t rading. We went out for dinner one evening, and he t alked t o m e at lengt h about t he gold m arket . He considered him self a great expert . Of course, I lat er found out t hat he knew absolut ely not hing about t rading. He said t o m e, " Robert , y ou're a fool. You work from 7 A- M. t o 7 P. M. every day, six days a week. I 'm m aking

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166 m ore m oney working only a few hours a day. Who's bet t er off?" He gave m e t he nam e of his broker, and I opened up an account . Then t he great est t ragedy happened: My first t rade was an absolut e winner. My second t r ade was also a winner. My t hird t rade was breakev en. My fourt h t rade was anot her winner. On m y fift h t rade, I gave it all back. Then on m y sixt h t rade, I lost m ore m oney t han I had m ade in all m y previous winning t rades put t oget her. The m arket had t urned, and I lost a considerable am ount of m oney- m uch m ore t han t he account - st art ing equit y. = = = = I n ot her words, you were m eet ing m argin calls along t he way. = = = = Exact ly. I kept put t ing m ore and m ore m oney int o t he account . I kept on t hinking, " The m arket is going t o t urn. The m arket is going t o t urn." Of course, it never t urned. = = = = When did you finally give up t he ship? = = = = I had a specific cut off point . I was a 50 percent shareholder in a garm ent business, and I want ed t o be absolut ely cert ain t hat m y losses would not endanger t he business. When I r eached m y m axim um loss point , I got out . The experience proved t o be a subst ant ial financial loss, but even m ore im port ant , it was a t rem endous inflict ion of pain t o m y ego. I was a reasonably successful businessm an who up t o t hat point had never failed in any vent ure. I couldn't believe how st upid I had been. = = = = While you were t rading, were you m aking your own decisions, or was your broker giving you advice? ==== Oh, m y broker was very " helpful" in advising m e on t he t rades. I lat er found out t hat he knew less t han I did. But I 've always t aken responsibilit y for m y act ions, and t his experience was no except ion. = = = = What ult im at ely happened t o your friend who ent iced you t o t rade t he gold m arket ? = = = = He never gave up t he belief. The m an event ually went t ot ally broke. = = = = Did you cont inue t o agonize over your m ist ake aft er you were out of t he m arket ? = = = = I found out a long t im e ago t hat one of t he m ost dam aging t hings a per son can do is t o harp on past m ist akes. I f you're const ant ly repeat ing t o yourself, " I shouldn't have done t hat ," it 's like a cart wheel going over t he sam e t racks. Event ually, t he negat ive m essage get s so em bedded in your psyche t hat it becom es very difficult t o change your course of act ion. At t hat point , I decided t hat eit her I was going t o figure out what m akes t he m arket t ick, or I was going t o wipe m y m out h, sm ile, walk away, and never t rade anot her cont ract for as long as I lived. Since I 'm not t he t ype of person t o walk away from a challenge, I chose t he form er course of act ion. At t he t im e, m y business required m e t o t ravel ext ensively t o rem ot e r egions in t he Far East . Since t here were few diversions in t hese ar eas, I had lot s of fr ee t im e. I used t his t im e t o do a gr eat deal of reading on t he m arket s. I also began t o follow t he gold m ar ket on a daily basis. I went so far as t o have m y part ner t elex m e t he daily open, high, low, and close in gold. My library grew and grew, as I was wolfing down every new book t hat cam e out on t echnical analysis. One of t he books I read was alluringly t it led How To Make Money in t he Com m odit y Market s- and Lot s of I t ! by Charles Drum m ond. I found t hat Drum - m ond t raveled down a different t rack from everyone else. The book espoused a unique m et hodology called point - and- line chart ing. I t m ade sense t o m e, and I purchased Drum m ond's second book, which delved m ore deeply int o t he subj ect . I t hen began t rading again, using t his point - and- line m et hodology. However, I found t hat I was hesit at ing in t aking t rades. The fear of loss had arrived. By t his t im e, I had st art ed com m unicat ing wit h Drum m ond, init ially wit h quest ions regarding his t echniques. He alw ays graciously responded t o m y inquiries. I n one of m y t elexes t o Drum m ond, I m ent ioned m y dilem m a of being unable t o m ake t rades. Drum m ond t elexed back, " You're experiencing what is known as t he 'freeze,' which is purely a psychological problem ." Around t his t im e, I had a chance m eet ing wit h an acquaint ance who ran a large public com pany. He seem ed t o be very depr essed, and I asked him what was wrong. He t old m e t hat he was get t ing a divorce and his business was doing very poor ly. Three weeks lat er, I bum ped int o t his sam e individual at a local rest aurant . He was t alking, laughing, and alt oget her quit e j ovial. I was quit e curious about his sudden t ransform at ion. The next day over lunch, he t old m e how he had gone t o a hypnot herapist and his life was now back on t rack. I got t he num ber of t his hypnot herapist and went t o see him wit h t he specific int ent of seeking help wit h m y t rading problem . For m y first session, I brought along a copy of Drum m ond's book. He flipped t hrough it and exclaim ed, " My god, it 's Japanese! " That was his idea of a j oke. Of course, he had no concept of t rading. = = = = Did his lack of fam iliarit y wit h t rading act as an im pedim ent , or did t he hypnosis help anyway? = = = = Yes, it helped. My t rading quickly went t o breakeven, which for m e was quit e an accom plishm ent . I was st ill experiencing som e slight hesit at ion in t aking t rades, but t he " freeze" was gone. I was so im pressed by hypnot herapy t hat I sought out inform at ion on get t ing t rained as a hypnot ist m yself. I found t here was a group called t he Brit ish Hypnot ist Exam iners Council [ BHEC] t hat offered courses, which t aught t he t echniques. I t ook t he beginner's course. = = = = How long was t his course? = = = = I t was given over t wo weekends. = = = = And t hat 's all it t akes t o becom e a qualified pract it ioner? = = = = No, of course not . The course t eaches y ou only t he basic t echniques, which are act ually quit e sim ple. Over t he next year, I spent about one day a week observing one of t he inst ruct ors, John Cross, in his pract ice. Aft er a while, John allowed m e t o work wit h som e of his client s under his observat ion. I t hen t ook an advanced course, given by BHEC. At t he end of all of t his, I t ook t he BHEC qualificat ion exam .

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167 = = = = Tell m e about your first client . = = = = He was a st udent who cam e t o m e for help in im proving his grades. I was quit e nervous, but , fort unat ely, he was an easily hypnot izable subj ect . = = = = What percent age of t he populat ion is hypnot izable? = = = = About 85 percent . Cont rary t o popular belief, int elligent and creat ive people are t he m ost easy t o hypnot ize. = = = = Are you saying t hat as m uch as 85 percent of t he populat ion can be influenced under hypnosis t o change t heir beliefs and behavior? = = = = Yes, providing you don't ask t hem t o do anyt hing t hat t hey wouldn't do in a norm al waking st at e. = = = = How t hen do night club hypnot ist s get people t o m ake fools of t hem selves on st age? = = = = The t rick is t hat people who volunt eer t o go of individuals who like t o perform in public. pie who want t o show off- closet showbiz calling. Hypnosis m erely brings out t hese bypassing t he behavioral cont rols enforced I t 's virt ually im possible t o get a nat urally shy on st age. up on st age are t he t ype Typically, t hey are peo- t ypes who m issed t heir nat ural inclinat ions by by t he conscious m ind. person t o do silly t hings = = = = How can you t eli whet her a person is really hypnot ized or m erely following inst ruct ions t o please t he hypnot ist ? = = = = There are a num ber of st andard t echniques. For ex am ple, one m et hod involves t elling t he subj ect t hat his or her arm is a rigid piece of st eel, and t hen inst ruct ing t he person t o ex t end t he ar m horizont ally. I f t he person is really hypnot ized, you won't be able t o push t he arm down, regardless of t he force applied- even if t he subj ect is a physically weak person. = = = = Was t here anyt hing m em orable about your first t rading client ? = = = = I would like t o say t hat t he procedur e was im m ensely successful, but t he t rut h is t hat t he person didn't experience any overnight t ransform at ion. I t t ook m any years before I realized why hypnosis was very effect ive wit h som e t raders but not ot hers. = = = = What is t he reason? = = = = Som e t rader s have a valid m et hodology t hat t hey have adequat ely back- t est ed and t hat t heir conscious m ind is happy wit h. These are t he t raders who can usually be helped t hrough hypnosis. The only t hing hypnosis can do is t o inform t he subconscious m ind t hat t he person now has a valid m et hodology t hat t he conscious m ind has already accept ed. = = = = But you m ust first be at t hat point . = = = = Absolut ely. For a novice t rader t o t ry t o becom e an expert t rader t hrough hy pnosis is like a novice chess player seeking t o becom e a m ast er t hrough hypnosis. The point is t hat a cert ain proficiency level is necessary before hypnosis can help. = = = = Besides aiding in your t ransform at ion from losing t rader t o winning t rader, how else did t he exposure t o hypnosis affect you? = = = = I t 's no exaggerat ion t o say t hat hypnosis changed m y percept ion of realit y. = = = = I n what way? = = = = I discovered t hat t here was anot her world t hat I was t ot ally unaware of: t he subconscious. I realized t hat t he subconscious m ind had t he power t o overcom e t he conscious m ind. Today, of course, I no longer t hink in t hose t erm s. I now underst and t hat t he subconscious and conscious m inds have t o be in har m ony. The m ore closely t he conscious m ind is aligned wit h t he subconscious, t he easier it is t o generat e winnings. To keep t hose winnings, however, your subconscious m ind m ust believe only one t hing: t hat you deserve your winnings. = = = = I s t he absence of t hat belief t he reason why people lose in t he m arket s? = = = = YES! YES! YES! = = = = How can you be so cert ain? = = = = Because I 've seen t he process t im e and t im e and t im e again. = = = = Could you give m e an anonym ous case hist ory? = = = = A few years ago, I worked wit h a m an who had t raded very successfully for over t hirt y years. All of a sudden, he st art ed losing six- figure am ount s m ont hly. He had been losing t his am ount for about five consecut ive m ont hs when he cam e t o m e for help. I t t urned out t hat t he onset of his losing st reak coincided wit h his being left by his wife, who was a m uch younger wom an. As soon as I helped him realize t hat t he breakup of his m arriage was not his own fault and t hat his wife's affect ions went only as deep as his pocket book, his t rading began t o change dram at ically. Wit hin t hree days, he was breaking even, and wit hin anot her t hree days, he was m aking m oney. Once he had begun winning again, I quest ioned him under hypnosis. " Have you changed your m et hod?" I asked. " No," he replied. " Are you feeling m ore confident ?" I asked. " Yes," he answered. " What has m ade t he big difference?" I inquired. He replied, " Robert , I feel I deserve m y winnings again." = = = = Why did he feel he didn't deserve his winnings? = = = = That was exact ly m y next quest ion. Apparent ly, he believed t hat t he breakup of his m arriage was due t o

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168 his inabilit y t o perform sexually at t he sam e level he had as a younger m an. Because at t he subconscious level he felt t hat he had failed his wife, he was punishing him self by losing in t he m arket s. He felt he didn't deserve t o win anym ore because of his inadequacy. = = = = I s t he im plicat ion t hat people always lose because t hey feel t hat t hey don't deserv e t o win? = = = = No. Som e people lose because t hey feel t hey don't deserve t o win, but m ore people lose because t hey never perfor m t he basic t asks necessary t o becom e a winning t rader. = = = = What are t hose t asks? = = = = 1. Develop a com pet ent analyt ical m et hodology. 2. Ext ract a reasonable t rading plan from t his m et hodology. 3. Form ulat e rules for t his plan t hat incorporat e m oney m anagem ent t echniques. 4. Back- t est t he plan over a sufficient ly long period. 5. Exercise self- m anagem ent so t hat you adhere t o t he plan. The best plan in t he world cannot work if you don't act on it . = = = = Typically, how do you work wit h som eone who com es t o you for help in im proving his or her t rading? ==== The first t hing I do is go t hough a series of about t hirt y quest ions t hat have only one purpose: finding out if t he person has a m et hodology. = = = = What do you do if you det erm ine t hat t he person doesn't have an effect ive m et hodology? = = = = I t ell t hem , "Go hom e; find yourself a m et hodology; and t hen see m e if you st ill need t o." Hypnosis is not a crut ch. I f you don't have a m et hodology and t rading plan, all t he hypnosis in t he world won't help you. = = = = Does t hat happen frequent ly? = = = = I t 's not uncom m on, but t he t ypical person who seeks m e out is serious about t rading and already has a t rading plan. The problem , however, is t hat in t he past , t his person m ay have suffered so m any losses and so m uch pain using anot her m et hodology t hat t he new t rading plan is not perm it t ed t o seep t hrough t he subconscious m ind as a new realit y. I n ot her words, t he belief syst em has t o be alt ered. = = = = Are you im plying t hat t he subconscious sabot ages t he t rading? = = = = Exact ly. Every t im e you have a losing t rading plan, t he m em ory is et ched in your subconscious. The m ore losses, t he deeper t he im pression and t he deeper t he pain. Let 's say you st art t rading w it h Met hodology A and t ake m any losses. You t hen st op t rading for one or t wo years. Aft er m uch research and careful t est ing, you develop Met hodology B, which your conscious m ind is convinced is valid. However, t he losses from your previous Met hodology A are so ingrained in your subconscious t hat whenever you cont em plat e m aking a t rade, t he adrenaline st art s t o flow, and t he fear of execut ing a t rade ar ises. Som e t raders are lit erally im m obilized by t his fear at t he m om ent when t hey need t o act . This is t he 'freeze" t hat I encount ered when I ret urned t o t rading years aft er m y first painful experience. I f you have t ruly back- t est ed a m et hodology and are em ploying an effect ive t rading plan, your conscious m ind is already aware of it s validit y. I t 's your subconscious m ind t hat prevent s you from t aking correct act ion in t he m arket . The problem will persist unt il you convince t he subconscious in a very direct m anner t hat t he new m et hodology is valid and t hat it has t o forget about t he old m et hodology. = = = = How is t his t ransform at ion achieved? = = = = We m ust erase t he previous pict ures of im pending financial disast er and paint new pict ures in beaut iful colors, showing a happy, confident , and successful t rader. Thr ough deep- r elaxat ion t echniques, achieved t hrough hypnosis, we can bypass t he crit ical facult y of t he conscious m ind and est ablish a direct connect ion t o t he subconscious m ind. Deep r elaxat ion or hypnosis is a st at e of m ind, not a st at e of sleep. Because t he subconscious m ind is nonj udgm ent al, it will accept new input as fact s. By inform ing t he subconscious m ind t hat t he old fears are no longer valid and t hat t he t rader now has a w ell- t est ed and confident plan, t he subconscious m ind will begin t o accept t his new realit y. One cannot t ruly be a winner unt il t h- e subconscious m ind is fully in t une wit h what t he conscious m ind has set out t o achieve. = = = = Do you ever have people com e t o you saying t hat t hey want t o be t raders, but when you put t hem in a hypnot ic st at e you find t hat t hey really don't want t o be t rader s aft er all? = = = = Absolut ely. This sit uat ion arises wit h alarm m g regularit y. Som e people t ry t o punish t hem selves t hrough t he m arket . Of course, t his all occurs on a subconscious level. There ar e people who feel t hey have t o m ake ret ribut ion for som e real or im agined wrong t hey have done t o anot her person. For som e people, t he channel is suicide; for som e people, it 's doing t heir j ob poorly on purpose; and for som e people, it 's losing m oney in t he m arket s- even t hough t hey m ay know bet t er. Quit e sim ply, t here are som e people w ho j ust shouldn't be t rading. By put t ing t hem under hypnosis you find t hat t hese people are not really com fort able t rading; it 's not t heir calling. When I find people who fall int o t his cat egory, I bring t hem t o and inform t hem as t o what t ranspired during hypnosis. I t ell t hem , " Here's your m oney; I can't help you. Do yourself and your fam ily a great favor and forget t rading." = = = = I s t here a t ypical react ion when you present t his t ype of person wit h t he advice t o give up t rading? ==== Tot al horror. I 've even been t hreat ened wit h physical violence. " I 'll bash your f- ing head in! " one person shout ed at m e aft er I gave him t his advice. = = = = Can you describe a specific sit uat ion in which you advised a client t o give up t rading? = = = = One person hat ed his wife but didn't have t he courage t o divorce her. I ronically, it was his wife who had sent him t o m e. He was a successful professional m an who had been t rading for t wo years and losing m oney

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169 st eadily. Under hypnosis, it cam e out t hat t he only way he saw out of his dilem m a was t o m ake him self church- m ouse poor so t hat his wife would walk out on him . The st rat egy was t o m ake his financial losses look legit im at e. He couldn't m ake him self look bad t hrough his own profession, because he w as so good at it . So every m ont h in which he m ade X t housand dollars in his profession, he would give back X t housand plus in t he com m odit y m arket s. = = = = Did he adm it all of t his under hypnosis? Or was t his your analyt ical int erpret at ion? = = = = I asked him st raight out under hypnosis, "Are you get t ing back at your wife? Do you feel t hat if you lose enough m oney in t he m arket s, she'll walk out on you?" He exclaim ed, " That 's t he idea! " = = = = That was his subconscious t alking? = = = = Absolut ely. I n his conscious m ind t his m an would never adm it t o t his m ot ivat ion. = = = = Was t his a person who believed he want ed t o t rade? = = = = Not only did he want t o t rade, he felt he had t o t rade. He em phat ically t old m e, " 1 love t o t rade t he m arket s. I prefer t rading t o m y profession." = = = = Any ot her unusual case hist ories com e t o m ind? = = = = There was one rat her hum orous sit uat ion t hat occur red while I was st ill in London. One day t his m an cam e t o m e and said, " Mr. Krausz, I 've heard good t hings about you. I don't know whet her y ou can help m e, but do you ever work wit h t raders' wives?" " I t would be a first ," I adm it t ed, " but I suppose it could be done. What seem s t o be t he pr oblem ?" I asked. He said, " Every day, m y broker sends m e m y runs, but I never receive t hem . My wife pinches t hem ." " What do you m ean she pinches t hem ?" I asked. " She hides t hem from m e," he answered. " She m eet s t he m ailm an and int ercept s m y st at em ent s befor e I ever get t hem . At first I didn't realize what was happening. I called up m y br oker and asked him why I wasn't get t ing m y st at em ent s. However, he insist ed m at m y daily runs were being sent out r egularly. I am now convinced m y wife is pinching t hem ." I said, " This is ridiculous. Can't you go out and m eet t he m ailm an first ?" " I can't go! " he exclaim ed. " The m ailm an com es in t he m iddle of t he t rading day; I 'm busy wat ching t he quot e screen. We've got t o find out why she's hiding m y st at em ent s." " Why don't you sim ply ask her?" I suggest ed. " She denies it ," he answered. " Go on and get her on t he phone yourself. You'll see t hat she'll deny everyt hing." I called his wife and said, " I have your husband in m y office. Exact ly what is t he problem wit h t he m issing st at em ent s?" She replied, " Mr. Krausz, I prom ise you t hat I never t ouch his m ail." So 1 asked her, " What t hen do you t hink happens t o his st at em ent s?" " He hides t hem him self," she answered. " He never opens t hem ." I t hought t o m yself. That 's very int erest ing. I t hanked her, hung up t he phone, and said t o her husband, " Why don't w e j ust have a short hypnot herapy session right now; no charge. Maybe I can help you in figuring out how t o handle your wife wit h t his problem ." " Good idea," he ent husiast ically replied. There are various levels of hypnosis. Aft er about half an hour, I had him at t he level I want ed. I asked him , " What is happening t o your brokerage st at em ent s?" " Why, I hide t hem , of course," he answered. " Do you open t hem ?" I asked. " Nooooooo," he said, slowly drawing out t he word, " I don't want t o see m y m ist akes." " How t hen do you know when you're losing m oney?" I asked. " My broker phones m e and t ells m e t hat I have t o put up anot her few t housand pounds on m argin." " And do you send t he m oney in?" I queried. " Oh yes," he replied. " I have t o. Ot herwise, I would have t o st op t rading- wouldn't I ? My broker would j ust close t he account ." I asked, " Would you like him t o close t he account ?" " Oh no, I love t rading! " he t rum pet ed. " Well, do you know t hat you're losing m oney?" I asked. " Cert ainly, I 'm not a fool," he said aut horit at ively. " Where do y ou hide your st at em ent s?" I inquired. " Oh, I can't t ell you t hat ," he whispered. " You'll j ust t ell m y wife." " I prom ise t hat I won't t ell her," I assured him . "But , t ell m e, what would happen if she found out ?" " She'd be ver y cross," he said. " She'd t hrow m e out of t he house." " Why would she do t hat ?" I asked. " Because I 'm losing m oney t hat I should be giving her t o buy new dresses." I t hought t o m yself. The best favor I can do for t his chap is t o st op him from t rading. I brought him out of hypnosis and m ade an appoint m ent t o see him again t he following week. Before he left , he t urned t o m e and asked, " Do you t hink you can get m y wife t o t ell us where she's hiding t he st at em ent s?" I said, " We'll t alk about t hat next t im e." " Why don't I bring her along wit h m e," he suggest ed. " You know what ," I said, "t hat 's a good idea."

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170 The following week t hey bot h showed up at t he appoint ed t im e. I asked him , " Are we going t o solve t his problem ?" He answered, " Cert ainly we're going t o solve t his problem - as long as you can st op her from t aking m y m ail." I put him under hypnosis, and I t old his wife exact ly what had happened. She nonchalant ly replied, " Oh, I know he's hiding his st at em ent s. I even know where he's hiding t hem , but I dare not say anyt hing, because it will dest roy him ." She was obviously a very clever wom an. Under hypnosis I t old him , " Your wife has agreed t o t urn over t o you all your back st at em ent s. Moreov er, she has prom ised t hat she will never st op t he m ailm an again, as long as you t ake responsibilit y for your own act ions and st op playing t he fool." " Are you sure?" he asked. " I 'm sure," I replied. " I n fact , I 'm going t o bring you out of hypnosis now, and your wife is going t o put t his agreem ent in w rit ing." He t hanked m e energet ically, and I brought him out of hypnosis. Three days lat er, his wife called t o t ell m e he had closed his account . = = = = What had been his m ot ivat ion for t rading? = = = = Just t hrills. He was leading a very boring life. He held a civil service posit ion and t his was j ust his way of seeking som e excit em ent . [ His j ob only required a m inim al num ber of hours of at t endance in a consult ing capacit y; hence he was able t o t rade during t he day.] = = = = What m ot ivat ed him t o st op t rading? = = = = When he was confront ed wit h t he piece of paper st at ing t hat his wife would t urn over all his past st at em ent s, he knew t hat she knew w here he had been hiding t hem because t hat was t he only way t hat she could give him t he m ail t hat she had supposedly int ercept ed. At t his point , his conscious m ind realized what had been happening. His wife t old m e t hat , t he next day, he pulled out t he hidden st at em ent s, put t hem on t he dining room t able, and said, " Aha! I see t hat you have finally decided t o give m e all t he m ail." She said, " Yes dear; here it is; t ake it ." The next day , he phoned his broker and closed t he account . = = = = What is t he m ost surprising t hing you have discovered about hum an behavior or hum an nat ure since you st art ed doing hypnosis? = = = = How ready we are t o fool ourselves. I learned t hat people's percept ions of realit y and t rue realit y are not t he sam e t hm g. I t 's a person's belief syst em , not realit y, t hat really count s. The m o- re I worked wit h hypnosis, t he m ore I realized how oft en our lives are warped and m isdirect ed by invalid beliefs t hat have t heir origins in childhood. These beliefs frequent ly cause people t o live t heir lives wit h a dist ort ed view of realit y. = = = = Can you give m e an exam ple? = = = = A young boy of five wat ches his fat her fixing t he fam ily aut om obile in t he garage. Wishing t o help, he picks up one of his fat her's t ools. The fat her, afraid t hat t he boy will get hurt , shout s at him t o put t he t ool down. This t ype of experience only has t o happen a couple of t im es before t he subconscious m ind files it int o perm anent m em ory. Fast forward t he scene t o when t he boy Ls t welve. Now t he fat her t hinks his son is ready t o learn how t o use t ools, and he asks his son t o help him fix t he car. Wit hout knowing why, as soon as he picks up one of t he t ools, t he boy feels uncom fort able. What ever he t ries, he does poorly. Event ually his fat her t ells him not t o bot her, saying he's. j ust clum sy wit h t ools. That boy is now convinced for life t hat he's useless wit h t ools. What has happened m t his exam ple? The first experience at t he age of five is filed away in t he subconscious m ind as, " I f I t ouch t hese t ools, m y fat her will shout at m e. Ther efore it 's bad." Then, when t he boy is t welve and t he fat her asks for help, t he subconscious m ind is reinforced at t he conscious level by t he belief t hat he's also clum sy. Unless a way is found t o eradicat e t hese false prem ises, t hey'll rem ain wit h t he boy t he rest of his life. = = = = Can you give m e a t rading analogy? = = = = We discussed one earlier. Based on past experiences, a person m ay believe he's a poor t rader on a subconscious level, even aft er he has developed an effect ive t rading m et hodology. The result m ay be fear based on beliefs t hat are no longer relevant . = = = = Why do m ost t raders lose? = = = = Recent ly I conduct ed a t wo- day workshop wit h a group of t hirt y part - t im e t raders. At one point , I present ed t hem wit h a quest ionnaire. The key quest ion asked t he st udent s t o rank t he following list in order of im port ance as t o what t hey t hought were t heir great est weak nesses in t he m arket s: 1. Execut ion ( pulling t he t rigger) 2. Analysis 3. Lack of knowledge 4. Lack of confidence 5. No t rading plan 6. Personal problem s 7. Fear of loss 8. Not devot ing enough t im e [ Not e t o reader: You m ay wish t o answer t his quest ion yourself, before cont inuing on.] Am azingly, 90 percent of t his group picked t he exact sam e four it em s for t he t op of t heir list , alt hough t he

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171 order varied: 1. Lack of confidence 2. No t rading plan 3. Execut ion 4. Fear of loss What single elem ent is t he root of t he ot her t hree? What causes lack of confidence? What causes fear of loss? What causes poor execut ion? NO TRADI NG PLAN! This is t he basic feat ure t hat separat es losing t raders from whining t raders. Lack of confidence disappear s in direct relat ion t o t he validit y of a back- t est ed t rading plan. = = = = What are t he key charact erist ics of a winning t rader? = = = = Persist ence, pat ience, and a willingness t o t ake risks. = = = = How has hypnosis changed your life? = = = = I learned t hr ough t he use of creat ive visualizat ion t hat I could set goals and achieve t hem - providing, of course, t hat t he goals were realist ic. I ncident ally, t raders who do not set goals or t arget s find it m uch m ore difficult t o achieve high ret urns t han t raders who set such goals. = = = = What do you m ean by " creat ive visualizat ion" ? = = = = Using t rading as an exam ple, in a deep- relaxat ion st at e you see yourself applying your m et hodology, and you t hen see t his m et hodology succeeding. By m ent ally playing t hrough t hese im ages, you can alt er t he negat ive beliefs in your subconscious and in t he process enhance your chance of success. This is t he sam e m et hodology em ployed by m any t op at hlet es. = = = = As a hypnot ist , you've cert ainly been exposed t o t he gam ut of hum an em ot ions. I assum e t hat t hose people who want t o succeed as t raders want t o do so because t hey believe it will m ake t hem happy. Let 's deal wit h a m ore fundam ent al quest ion: I n your experience, what do you believe is t he essent ial elem ent in achieving happiness? = = = = I believe t he single m ost im port ant fact or is having cont rol of your own life. Everyt hing else is secondary. According t o Krausz, t he m aj or fact ors t rader s cit e as ( he reasons for why t hey lose- lack of confidence, fear of loss, and poor ex ecut ion- are all a consequence of not having a t rading plan. Clearly, based on t his prem ise, t he absolut ely essent ial first st ep for a t rader is t o develop a t rading plan. Once such a plan has been const ruct ed, t he t rader m ust adequat ely back- t est t he m et hod t o gain t he necessary confidence in t he validit y of t he approach. Thus far, t he advice is sound but hardly unconvent ional. Krausz offers a m ore unique view in his discussion of t he role of t he subconscious as an im pedim ent t o t rading success. Krausz explains t hat subconscious beliefs will dict at e a person's act ions. The point is t hat if t he subconscious believes t hat a person is a losing t rader based on prior experiences, it will cont inue t o hold t hat view even aft er t he t rader has developed an effect ive m et hodology. These beliefs, predicat ed on past experiences, can cause a person t o feel fears t hat m ay no longer be appropriat e. These fears can lead t o what Krausz's m ent or, Charles Drum m ond, called t he " freeze." Thus, Krausz believes t hat once an effect ive t rading plan is developed, it is crit ical t o convince t he subconscious m ind of t he new realit y. The great er t he harm ony bet ween t he conscious and subconscious m inds, t he bet t er t he chance for success. The t echniques for achieving such harm ony include hypnosis or deep relaxat ion and visualizat ion. Krausz's unst at ed m ot t o m ight be: We becom e w hat we believe. I f you accept t his pr em ise, t hen it becom es quit e clear why psychology plays such an im port ant role in t rading success or failure.

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172 PART VIII Closing Bell

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173 Market Wiz(ar)dom By now it should be clear t hat t he m et hods em ployed by except ional t raders are ext raordinarily diverse. Som e are pure fundam ent al ist s; ot hers em ploy only t echnical analysis: and st ill ot hers com bine t he t wo m et hodologies. Som e t raders consider t wo days t o be long t erm , while ot hers consider t wo m ont hs t o be short t erm . Yet despit e t he wide gam ut of st yles, I have found t hat cert ain principles hold t m e for a broad spect rum of t raders. Aft er a score of years of analyzing and t rading t he m arket s and t wo books of int erviews wit h great t raders, I have com e down t o t he following list of fort y- t wo observat ions regarding success in t rading: 1 . FI RST TH I N GS FI RST _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 3 2 . EXAM I N E YOUR M OTI VES _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 3 . M ATCH TH E TRAD I N G M ETH OD TO YOUR PERSON ALI TY _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 4 . I T I S ABSOLUTELY N ECESSARY TO H AVE AN ED GE_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 5 . D ERI VE A M ETH OD _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 6 . D EVELOPI N G A M ETH OD I S H ARD W ORK _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 7 . SKI LL VERSUS H ARD W ORK _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 4 8 . GOOD TRAD I N G SH OULD BE EFFORTLESS _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 9 . M ON EY M AN AGEM EN T AN D RI SK CON TROL _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 1 0 . TH E TRAD I N G PLAN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 1 1 . D I SCI PLI N E _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 1 2 . UN D ERSTAN D TH AT YOU ARE RESPON SI BLE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 1 3 . TH E N EED FOR I N DEPEN D EN CE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 5 1 4 . CON FI DEN CE_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 6 1 5 . LOSI N G I S PART OF TH E GAM E _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 6 1 6 . LACK OF CON FI D EN CE AN D TI M E- OUTS _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 6 1 7 . TH E URGE TO SEEK AD VI CE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 6 1 8 . TH E VI RTUE OF PATI EN CE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 6 1 9 . TH E I M PORTAN CE OF SI TTI N G _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 0 . D EVELOPI N G A LOW - RI SK I D EA _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 1 . TH E I M PORTAN CE OF VARYI N G BET SI ZE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 2 . SCALI N G I N AN D OUT OF TRAD ES _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 3 . BEI N G RI GH T I S M ORE I M PORTAN T TH AN BEI N G A GEN I US _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 4 . D ON 'T W ORRY ABOUT LOOKI N G STUPI D _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 7 2 5 . SOM ETI M ES ACTI ON I S M ORE I M PORTAN T TH AN PRUDEN CE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 2 6 . CATCH I N G PART OF TH E M OVE I S JUST FI N E _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 2 7 . M AXI M I ZE GAI N S, N OT TH E N UM BER OF W I N S _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 2 8 . LEARN TO BE D I SLOYAL _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 2 9 . PULL OUT PARTI AL PROFI TS _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 3 0 . H OPE I S A FOUR- LETTER W ORD _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 3 1 . D ON 'T D O TH E COM FORTABLE TH I N G _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 8 3 2 . YOU CAN 'T W I N I F YOU H AVE TO W I N _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 3 . TH I N K TW I CE W H EN TH E M ARKET LETS YOU OFF TH E H OOK EASI LY _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 4 . A M I N D I S A TERRI BLE TH I N G TO CLOSE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 5 . TH E M ARKETS ARE AN EXPEN SI VE PLACE TOLOOKFOR EXCI TEM EN T _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 6 . TH E CALM STATE OF A TRAD ER _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 7 . I D EN TI FY AN D ELI M I N ATE STRESS _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 8 . PAY ATTEN TI ON TO I N TUI TI ON _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 9 3 9 . LI FE'S M I SSI ON AN D LOVE OF TH E EN DEAVOR _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 0 4 0 . TH E ELEM EN TS OF ACH I EVEM EN T _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 0 4 1 . PRI CES ARE N ON RAN D OM = TH E M ARKETS CAN BE BEAT _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 0 4 2 . KEEP TRADI N G I N PERSPECTI VE _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 8 0

1. FI RST THI NGS FI RST First , be sure t hat you really want t o t rade. As bot h Krausz and Faulkner confirm ed, based on t heir

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174 experience in working wit h t raders, it is com m on t hat t hey really don't .

for people who t hink t hey want t o t rade t o discover

2. EXAMI NE YOUR MOTI VES Think about why you really want t o t rade. I f you want t o t rade for t he excit em ent , you m ight be bet t er off riding a roller coast er or t aking up hang gliding. I n m y own case, I found t hat t he underlying m ot ive for t rading was serenit y or peace of m ind- hardly t he em ot ional st at e t ypical of t rading. Anot her personal m ot ive for t rading was t hat I loved puzzle solving- and t he m arket s provided t he ult im at e puzzle. However, while I enj oyed t he cerebral aspect s of m arket analysis, I didn't part icularly like t he visceral charact erist ics of t rading it self. The cont rast bet w een m y m ot ives and t he act ivit y result ed in very obvious conflict s. You need t o exam ine your own m ot ives very carefully for any such conflict s. The m arket is a st em m ast er. You need t o do alm ost everyt hing right t o win. I f part s of you are pulling in opposit e direct ions, t he gam e is lost before you st art . How did I resolve m y own conflict ? I decided t o focus com plet ely on m echanical t rading approaches in order t o elim inat e t he em ot ionalit y in t rading. Equally im port ant , focusing on t he design of m echanical syst em s direct ed m y energies t o t he part of t rading I did enj oy- t he puzzle- solving aspect s. Alt hough I had devot ed som e ener gy t o m echanical syst em s for t hese reasons for a num ber of years, I event ually cam e t o t he realizat ion t hat I want ed t o m ove in t his direct ion exclusively. ( This is not int ended as an advocacy for m echanical syst em s over hum an- decision- orient ed approaches. I am only providing a per sonal exam ple. The appropriat e answer for anot her t rader could well be very different .) 3. MATCH THE TRADI NG METHOD TO YOUR PERSONALI TY I t is crit ical t o choose a m et hod t hat is consist ent w it h your own personalit y and com fort level. I f you can't st and t o give back significant profit s, t hen a long- t erm t rend- following approach- even a very good one- will be a disast er, because you will never be able t o follow it . I f you don't want t o wat ch t he quot e screen all day ( or can't ) , don't t ry a day- t rading m et hod. I f you can't st and t he em ot ional st rain of m aking t rading decisions, t hen t ry t o develop a m echanical syst em for t rading t he m arket s. The approach you use m ust be right for you; it m ust feel com fort able. The im port ance of t his cannot be overem phasized. Rem em ber Randy McKay's assert ion: " Virt ually every successful t rader I know ult im at ely ended up wit h a t rading st yle suit ed t o his personalit y." I ncident ally, t he m ism at ch of t rading st yle and personalit y is one of t he key reasons why purchased t rading syst em s rarely m ake profit s for t hose who buy t hem , even if t he syst em is a good one. While t he odds of get t ing a winning syst em are sm all- cert ainly less t han 50/ 50- t he odds of get t ing a syst em t hat fit s your personalit y are sm aller st ill. I 'U leave it t o your im aginat ion t o decide on t he odds of buying a profit able/ m oderat e risk syst em and using it effect ively. 4. I T I S ABSOLUTELY NECESSARY TO HAVE AN EDGE You can't win wit hout an edge, even wit h t he world's great est discipline and m oney m anagem ent skills. I f you could, t hen it would be possible t o win at roulet t e ( over t he long run) using perfect discipline and risk cont rol. Of course, t hat is an im possible t ask because of t he law s of probabilit y. I f you don't have an edge, all t hat m oney m anagem ent and discipline will do for you is t o guarant ee t hat you will gradually bleed t o deat h. I ncident ally, if you don't know what your edge is, you don't have one. 5. DERI VE A METHOD To have an edge, you m ust have a m et hod. The t ype of m et hod is irrelevant . Som e of t he supert rader s are pure fundam ent alist s; som e are pure t echnicians; and som e are hybrids. Even wit hin each group, t here are t rem endous variat ions. For exam ple, wit hin t he group of t echnicians, t here are t ape readers ( or t heir m odem - day equivalent - screen wat chers) , chart ist s, m echanical syst em t raders, EI liot t Wave analyst s, Gann analyst s, and so on. The t ype of m et hod is not im port ant , but having one is crit ical- and, of course, t he m et hod m ust have an edge. 6. DEVELOPI NG A METHOD I S HARD WORK Short cut s rarely lead t o t rading success. Developing your own approach requires resear ch, observat ion, and t hought . Expect t he process t o t ak e lot s of t im e and hard work. Expect m any dead ends and m ult iple failures before you find a successful t rading approach t hat is right for you. Rem em ber t hat you are playing against t ens of t housands of professionals. Why should you be any bet t er? I f it were t hat easy, t here would be a lot m ore m illionaire t raders. 7. SKI LL VERSUS HARD WORK I s t rading success dependent on innat e skills? Or is hard work sufficient ? There is no quest ion in m y m m d t hat m any of t he supert raders have a special t alent for t rading. Marat hon running provides an appropriat e analogy. Virt ually anyone can run a m arat hon, given sufficient com m it m ent and hard work. Yet , regar dless of t he effort and desire, only a sm all fract ion of t he populat ion will ever be able t o run a 2: 12 m arat hon. Sim ilarly, anyone can learn t o play a m usical inst rum ent . But again, regardless of work and dedicat ion, only a handful of individuals possess t he nat ural t alent t o becom e concert soloist s. The general rule is t hat except ional perform ance requires bot h nat ural t alent and hard w ork t o realize it s pot ent ial. I f t he innat e skill is lacking, hard work m ay provide proficiency, but not excellence.

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175 I n m y opinion, t he sam e principles apply t o t rading. Virt ually anyone can becom e a net profit able t rader, but only a few have t he inborn t alent t o becom e supert raders. For t his reason, it m ay be possible t o t each t rading success, but only up t o a point . Be realist ic in your goals. 8. GOOD TRADI NG SHOULD BE EFFORTLESS Wait a m inut e. Didn't I j ust list hard work as an ingredient t o successful t rading? How can good t rading require hard work and yet be effort less? There is no cont radict ion. Hard work refers t o t he preparat or y process- t he research and observat ion necessary t o becom e a good t rader - not t o t he t rading it self. I n t his respect , hard work is associat ed wit h such qualit ies as vision, creat ivit y, persist ence, drive, desire, and com m it m ent . Hard work cert ainly does not m ean t hat t he process of t rading it self should be filled wit h exert ion. I t cert ainly does not im ply st ruggling wit h or fight ing against t he m arket s. On t he cont rary, t he m ore effort less and nat ural t he t rading process, t he bet t er t he chances for success. As t he anonym ous t rader in Zen and t he Art of Trading put it , "I n t rading, j ust as in archery, whenever t here is effort , force, st raining, st ruggling, or t rying, it 's wrong. You're out of sync; you're out of harm ony wit h t he m arket . The perfect t rade is one t hat requires no effort ." Visualize a world- class dist ance runner , clicking off m ile aft er m ile at a five- m inut e pace. Now pict ure an out - of- shape, 250- pound couch pot at o t rying t o run a m ile at a t en- m inut e pace. The professional runner glides along gracefully- alm ost effort lessly- despit e t he long dist ance and fast pace. The out - of- shape runner, however, is likely t o st ruggle, huffing and puffing like a Yugo going up a 1 percent grade. Who is put t ing in m ore work and effort ? Who is m ore successful? Of course, t he world- class runner put s in his hard work during t raining, and t his prior effort and com m it m ent are essent ial t o his success. 9. MONEY MANAGEMENT AND RI SK CONTROL Alm ost every person I int erviewed felt t hat m oney m anagem ent was even m ore im port ant t han t he t rading m et hod. Many pot ent ially successful syst em s or t rading approaches have led t o disast er because t he t rader applying t he st rat egy lacked a m et hod of cont rolling risk. You don't have t o be a m at hem at ician or underst and port folio t heory t o m anage risk. Risk cont rol can be as easy as t he following t hree- st ep appr oach: 1. Never risk m ore t han 1 t o 2 percent of your capit al on any t rade. ( Depending on your approach, a m odest ly higher num ber m ight st ill be reasonable. However, I would st rongly advise against anyt hing over 5 percent .) 2. Predet erm ine your exit point before you get int o a t rade. Many of t he t raders I int erviewed cit ed exact ly t his rule. 3. I f you lose a cer t ain predet erm ined am ount of your st art ing capit al ( e.g., 10 percent t o 20 percent ) , t ake a breat her, analyze what went wrong, and wait unt il you feel confident and have a high- probabilit y idea before you begin t rading again. For t raders wit h large account s, t rading very sm all is a reasonable alt ernat ive t o a com plet e t rading hiat us. The st rat egy of cut t ing t rading size down sharply during losing st reaks is one m ent ioned by m any of t he t raders int erviewed. 10. THE TRADI NG PLAN Trying t o win in t he m arket s wit hout a t rading plan is like t rying t o build a house wit hout blueprint s- cost ly ( and avoidable) m ist akes are virt ually inevit able. A t rading plan sim ply requires com bining a per sonal t rading m et hod wit h specific m oney m anagem ent and t rade ent ry rules. Krausz considers t he absence of a t rading plan t he root of all t he principal difficult ies t rader s encount er in t he m arket s. Driehaus st resses t hat a t rading plan should reflect a personal core philosophy. He explains t hat wit hout a core philosophy, you are not going t o be able t o hold on t o your posit ions or st ick wit h your t rading plan during really difficult t im es. 11. DI SCI PLI NE Discipline was probably t he m ost frequent word used by t he except ional t raders t hat I int erviewed. Oft en, it was m ent ioned in an alm ost apologet ic t one: " I know you've heard t his a m illion t im es before, but believe m e, it 's really im port ant ." There are t wo basic reasons w hy discipline is crit ical. First , it is a prerequisit e for m aint aining effect ive risk cont rol. Second, you need discipline t o apply your m et hod wit hout second- guessing and choosing which t rades t o t ak e. I guarant ee t hat you will alm ost always pick t he wrong ones. Why? Because you will t end t o pick t he com fort able t rades, and as Eckhardt explained, " What feels good is oft en t he wrong t hing t o do." As a final word on t his subj ect , rem em ber t hat you are never im m une t o bad t rading habit s- t he best you can do is t o keep t hem lat ent . As soon as you get lazy or sloppy, t hey will ret urn. 12. UNDERSTAND THAT YOU ARE RESPONSI BLE Whet her you win or lose, you are responsible for your own result s. Even if you lost on your broker's t ip, an advisory service recom m endat ion, or a bad signal from t he syst em you bought , you are responsible because you m ade t he decision t o list en and act . I have never m et a successful t rader who blam ed ot hers for his losses. 13. THE NEED FOR I NDEPENDENCE You need t o do your own t hinking. Don't get caught up in m ass hyst eria. As Ed Seykot a point ed out , by t he t im e a st ory is m aking t he cover of t he nat ional periodicals, t he t rend is probably near an end.

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176 I ndependence also m eans m aking your own t rading decisions. Never list en t o ot her opinions. Even if it occasionally helps on a t rade or t wo, list ening t o ot hers invariably seem s t o end up cost ing you m oney- not t o m ent ion confusing your own m arket view. As Michael Marcus st at ed in Market Wizards, " You need t o follow your own light . I f you com bine t wo t raders, you will get t he worst of each." A relat ed personal anecdot e concerns anot her t rader I int erviewed in Market Wizards. Alt hough he could t rade bet t er t han I if he were blindfolded and placed in a t runk at t he bot t om of a pool, he st ill was int erest ed in m y view of t he m arket s. One day he called and asked, " What do you t hink of t he yen?" The yen was one of t he few m arket s about which I had a st rong opinion at t he t im e. I t had form ed a part icular chart pat t ern t hat m ade m e very bearish. " I t hink t he yen is going st raight down, and I 'm short ," I replied. He preceded t o give m e fift y- one reasons why t he yen was oversold and due for a rally. Aft er he hung up, I t hought : " I 'm leaving on a business t rip t om orrow. My t rading has not been going very well during t he last few weeks. The short yen t rade is one of t he only posit ions in m y account . Do I really want t o fade one of t he world's best t raders given t hese considerat ions?" I decided t o close out t he t rade. By t he t im e I ret urned from m y t rip several days lat er, t he yen had fallen 150 point s. As luck would have it , t hat aft ernoon t he sam e t rader called. When t he conversat ion rolled around t o t he yen, I couldn't resist asking, "By t he way, are you st ill long t he yen?" " Oh no," he replied, " I 'm short ." The point is not t hat t his t rader was t rying t o m islead m e. On t he cont rary, he firm ly believed each m arket opinion at t he t im e he expressed it . However, his t im ing was good enough so t hat he probably m ade m oney on bot h sides of t he t rade. I n cont rast , I ended up wit h not hing, even t hough I had t he original m ove pegged exact ly right . The m oral is t hat even advice from a m uch bet t er t rader can lead t o det rim ent al result s. 14. CONFI DENCE An unwavering confidence in t heir abilit y t o cont inue t o win in t he m ar ket s was a nearly universal charact erist ic am ong t he t raders I int erviewed. Dr. Van Tharp, a psychologist who has done a great deal of research on t raders and was int erviewed in Market Wizards, claim s t hat one of t he basic t rait s of winning t raders is t hat t hey believe " t hey've won t he gam e before t he st art ." 15. LOSI NG I S PART OF THE GAME The great t r aders fully realize t hat losing is an int rinsic elem ent in t he gam e of t rading. This at t it ude seem s linked t o confidence. Because except ional t raders are confident t hat t hey will win over t he long run, individual losing t rades no longer seem horrible; t hey sim ply appear inevit able- which is w hat t hey ar e. As Linda Raschk e explained, " I t never bot hered m e t o lose, because I always knew t hat I would m ake it right back." There is no m ore cert ain recipe for losing t han having a fear of losing. I f you can't st and t aking losses, you will eit her end up t aking large losses or m issing great t rading opport unit ies- eit her flaw is sufficient t o sink any chance for success. 16. LACK OF CONFI DENCE AND TI ME- OUTS Trade only when you feel confident and opt im ist ic. I have oft en heard t rader s say: " I j ust can't seem t o do anyt hing right ." Or, " I bet I get st opped out right near t he low again." I f you find yourself t hinking in such negat ive t erm s, it is a sure sign t hat it is t im e t o t ake a break from t rading. Get back int o t rading slowly. Think of t rading as a cold ocean. Test t he wat er before plunging in. 17. THE URGE TO SEEK ADVI CE The urge t o seek advice bet rays a lack of confidence. As Linda Raschke said, " I f you ever find yourself t em pt ed t o seek out som eone else's opinion on a t rade, t hat 's usually a sure sign t hat you should get out of your posit ion." 18. THE VI RTUE OF PATI ENCE Wait ing for t he right opport unit y increases t he pr obabilit y of success. You don't always have t o be in t he m arket . As Edwin Lefevre put it in his classic Rem iniscences of a St ock Operat or, " There is t he plain fool who does t he wrong t hing at all t im es anywhere, but t here is t he Wall St reet fool who t hinks he m ust t rade all t he t im e." One of t he m ore colorful descript ions of pat ience in t rading was offered by Jim Rogers in Market Wizards: " I j ust wait unt il t here is m oney lying in t he com er, and all I have t o do is go over t here and pick it up." I n ot her words, unt il he is so sure of a t rade t hat it seem s as easy as picking m oney off t he floor, he does not hing. Mark Weinst ein ( also int erview ed in Market Wizar ds) provided t he following apt analogy: " Alt hough t he cheet ah is t he fast est anim al in t he w orld and can cat ch any anim al on t he plains, it will w ait unt il it is absolut ely sure it can cat ch it s prey. I t m ay hide in t he bush for a week, wait ing for Just t he right m om ent . I t will wait for a baby ant elope, and not Just any baby ant elope, but preferably one t hat is also sick or lam e. Only t hen, when t here is no chance it can lose it s prey, does it at t ack. That , t o m e, is t he epit om e of professional t rading." As a final bit of advice on t he subj ect of pat ience, guard part icularly against being overeager t o t rade in order t o win back prior losses. Vengeance t rading is a sure recipe for failure.

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177 19. THE I MPORTANCE OF SI TTI NG Pat ience is im port ant not only in wait ing for t he right t rades, but also in st aying wit h t rades t hat are working. The failure t o adequat ely profit from correct t rades is a key profit - lim it ing fact or. Quot ing again from Lefevre in Rem iniscences, " I t never was m y t hinking t hat m ade big m oney for m e. I t was always m y sit t ing. Got t hat ? My sit t ing t ight ! " Also, recall Eckhardt 's com m ent on t he subj ect : " One com m on adage ... t hat is com plet ely wrongheaded is: You can't go broke t aking profit s. That 's precisely how m any t rader s do go broke. While am at eurs go broke by t aking large losses, professionals go broke by t aking sm all profit s." 20. DEVELOPI NG A LOW- RI SK I DEA One of t he exercises Dr. Van Tharp uses in his sem inars is having t he part icipant s t ake t he t im e t o w rit e down t heir ideas on low- risk t rades. The m erit of a low- risk idea is t hat it com bines t wo essent ial elem ent s: pat ience ( because only a sm all port ion of ideas will qualify) and risk cont rol ( inherent in t he definit ion) . Taking t he t im e t o t hink t hrough low- risk st rat egies is a useful exercise for all t raders. The specific ideas will vary great ly from t rader t o t rader, depending on t he m arket s t raded and m et hodologies used. At t he sem inar I at t ended, t he part icipant s cam e up w it h a long list of descript ions of low- risk ideas. As one exam ple: a t rade in which t he m arket m ovem ent required t o provide convincing proof t hat you are wrong is sm all. Alt hough it had not hing t o do wit h t rading, m y personal favorit e of t he low- risk ideas m ent ioned was: " Open a doughnut shop next door t o a police st at ion." 21. THE I MPORTANCE OF VARYI NG BET SI ZE All t raders who win consist ent ly over t he long m n have an edge. However, t hat edge m ay vary significant ly from t rade t o t rade. I t can be m at hem at ically dem onst rat ed t hat in any wager gam e wit h varying probabilit ies, winnings are m axim ized by adj ust ing t he bet size in accordance wit h t he perceived chance for a successful out com e. Opt im al blackj ack bet t ing st rat egy provides a perfect illust rat ion of t his concept ( see Hull chapt er) . I f t he t rader has som e idea as t o which t rades have a great er edge- say, for exam ple, based on a higher confidence level ( assum ing t hat is a reliable indicat or) - t hen it m akes sense t o be m ore aggressive in t hese sit uat ions. As Druckenm iller expresses it , " The way t o build [ superior] long- t erm ret urns is t hrough preservat ion of capit al and hom e runs.... When you have t rem endous convict ion on a t rade, you have t o go for t he j ugular. I t t akes courage t o be a pig." For a num ber of Market Wizards, keen j udgm ent as t o when t o really st ep on t he accelerat or and t he courage t o do so have been inst rum ent al t o t heir achieving except ional ( as opposed t o m erely good) ret urns. Som e of t he t raders int erviewed m ent ioned t hat t hey varied t heir t rading size in accordance wit h how t hey were doing. For exam ple, McKay indicat ed t hat it was not uncom m on for him t o vary his posit ion size by as m uch as a fact or of one hundred t o one. He finds t his approach helps him reduce risk during losing periods while enhancing profit s during t he winning periods. 22. SCALI NG I N AND OUT OF TRADES You don't have t o get in or out of a posit ion all at once. Scaling in and out of posit ions provides t he flexibilit y of fine- t uning t rades and broadens t he set of alt ernat ive choices. Most t raders sacrifice t his flexibilit y wit hout a second t hought because of t he innat e hum an desire t o be com plet ely right . ( By definit ion, a scaling approach m eans t hat som e port ions of a t rade w ill be ent ered or exit ed at w orse prices t han ot her port ions.) As one exam ple of t he pot ent ial benefit s of scaling, Lip- schut z not ed t hat it has enabled him t o st ay wit h long- t erm winners m uch longer t han he has seen m ost t raders st ay wit h t heir posit ions. 23. BEI NG RI GHT I S MORE I MPORTANT THAN BEI NG A GENI US I t hink one reason why so m any people t ry t o pick t ops and bot t om s is t hat t hey want t o prove t o t he world how sm art t hey ar e. Think about winning rat her t han being a hero. Forget t rying t o j udge t rading success by how close you can com e t o picking m aj or t ops and bot t om s, but rat her by how well you can pick individual t rades wit h m erit based on favorable risk/ ret urn sit uat ions and a good per cent age of winners. Go for consist ency on a t rade- t o- t rade basis, not perfect t rades. 24. DON'T WORRY ABOUT LOOKI NG STUPI D Last week you t old everyone at t he office, " My analysis has j ust given m e a great buy signal in t he S&P. The m arket is going t o a new high." Now as you exam ine t he m arket act ion since t hen, som et hing appears t o be wrong. I nst ead of rallying, t he m arket is breaking down. Your gut t ells you t hat t he m arket is vulnerable. Whet her you realize it or not , your announced pr ognost icat ions are going t o color your obj ect ivit y. Why? Because you don't want t o look st upid aft er t elling t he world t hat t he m arket was going t o a new high. Consequent ly, you are likely t o view t he m arket 's act ion in t he m ost favorable light possible. " The m arket isn't breaking down, it 's j ust a pullback t o knock out t he weak longs." As a result of t his t ype of rat ionalizat ion, you end up holding a losing posit ion far t oo long. There is an easy solut ion t o t his problem : Don't t alk about your posit ion. What if your j ob requires t alking about your m arket opinions ( as m ine does) ? Here t he rule is: Whenev er you st art worrying about cont radict ing your previous opinion, view t hat concern as reinforcem ent t o reverse your m arket st ance. As a personal exam ple, m early 1991 I cam e t o t he conclusion t hat t he dollar had form ed a m aj or bot t om . I specifically rem em ber one t alk in which an audience m em ber asked m e about m y

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178 out look for currencies. I responded by boldly predict ing t hat t he dollar would head higher for years. Several m ont hs lat er, when t he dollar surrender ed t he ent ire gain it had realized following t he new s of t he August 1991 Soviet coup before t he coup's failure was confirm ed, I sensed t hat som et hing was wrong. I recalled m y m any predict ions over t he preceding m ont hs in which I had st at ed t hat t he dollar would go up for years. The discom fort and em barrassm ent I felt about t hese prev ious forecast s t old m e it was t im e t o change m y opinion. I n m y earlier years in t he business, I invariably t ried t o rat ionalize m y original m arket opinion in such sit uat ions. I was burned enough t im es t hat I event ually learned a lesson. I n t he above exam ple, t he abandonm ent of m y original proj ect ion was fort unat e, because t he dollar collapsed in t he ensuing m ont hs. 25. SOMETI MES ACTI ON I S MORE I MPORTANT THAN PRUDENCE Wait ing for a price correct ion t o ent er t he m arket m ay sound prudent , but it is oft en t he wrong t hing t o do. When your analysis, m et hodology, or gut t ells you t o get int o a t rade at t he m arket inst ead of wait ing for a correct ion- do so. Caut ion against t he influence of knowing t hat you could have got t en in at a bet t er price in recent sessions, part icularly in t hose sit uat ions when t he m arket wit nesses a sudden, large m ove ( oft en due t o an im port ant surprise new s it em ) . I f you don't feel t he m arket is going t o correct , t hat consider at ion is irrelevant . These t y pes of t rades oft en work because t hey are so hard t o do. As a perfect exam ple, recall t he willingness of t he t rader in Lipschut z's group t o aggressively sell t he dollar int o a collapsing m arket following t he G- 7 m eet ing. Anot her exam ple of t his principle is Driehaus's willingness t o buy a st ock heavily aft er it is already up very sharply on a bullish earnings report if he feels t he new inform at ion im plies t he st ock will go st ill higher. 26. CATCHI NG PART OF THE MOVE I S JUST FI NE Just because you m issed t he first m aj or port ion of a new t rend, don't let t hat keep you fr om t rading wit h t hat t rend ( as long as you can define a reasonable st op- loss point ) . Recall McKay's observat ion t hat t he easiest part of a t rend is t he m iddle port ion, which im plies always m issing part of t he t rend prior t o ent ry. 27. MAXI MI ZE GAI NS, NOT THE NUMBER OF WI NS Eckhardt explains t hat hum an nat ure does not operat e t o m axim ize gain but rat her t he chance of a gain. The problem w it h t his is t hat it im plies a lack of focus on t he m agnit udes of gains ( and losses) - a flaw t hat leads t o nonopt im al perform ance result s. Eckhardt blunt ly concludes: " The success rat e of t rades is t he least im port ant perform ance st at ist ic and m ay even be inversely relat ed t o perform ance." Yass echoes a sim ilar t hem e: " The basic concept t hat applies t o bot h poker and opt ion t rading is t hat t he pr im ary obj ect is not winning t he m ost hands, but rat her m axim izing your gains." 28. LEARN TO BE DI SLOYAL Loyalt y m ay be a virt ue in fam ily, friends, and pet s, but it is a fat al flaw for a t rader. Never have loyalt y t o a posit ion. The novice t rader will have lot s of loyalt y t o his original posit ion. He will ignore signs t hat he is on t he wrong side of t he m arket , riding his t rade int o a large loss while hoping for t he best . The m ore experienced t rader, having learned t he im port ance of m oney m anagem ent , will exit quickly once it is apparent he has m ade a bad t r ade. How ever, t he t ruly skilled t rader w ill be able t o do a I SO- degr ee t urn, reversing his posit ion at a loss if m arket behavior point s t o such a course of act ion. Recall Dm ckenm iller's illt im ed reversal from short t o long on t he very day before t he Oct ober 19, 1987 crash. His abilit y t o quickly recognize his error and, m ore im port ant , t o unhesit at ingly act on t hat realizat ion by reversing back t o short at a large loss helped t ransform a pot ent ially disast rous m ont h int o a net profit able one. 29. PULL OUT PARTI AL PROFI TS Pull a port ion of w innings out of t he m arket t o prevent t r ading discipline from det eriorat ing int o com placency. I t is far t oo easy t o rat ionalize overt rading and procrast inat ion in liquidat ing losing t rades by saying, " I t 's only profit s." Profit s wit hdrawn from an account are m uch m ore likely t o be viewed as real m oney. 30. HOPE I S A FOUR- LETTER WORD Hope is a dirt y word for a t rader, not only in regards t o procrast inat ing in a losing posit ion, hoping t he m arket will com e back, but also in t erm s of hoping for a react ion t hat will allow for a bet t er ent ry in a m issed t rade. I f such t rades ar e good, t he hoped- for r eact ion will not m at erialize unt il it is t oo lat e. Oft en t he only way t o ent er such t rades is t o do so as soon as a reasonable st op- loss point can be ident ified. 31. DON'T DO THE COMFORTABLE THI NG Eckhardt offers t he rat her provocat ive proposit ion t hat t he hum an t endency t o select com fort able choices will lead m ost people t o experience worse t han random result s. I n effect , he is saying t hat nat ural hum an t rait s lead t o such poor t rading decisions t hat m ost people would be bet t er off flipping coins or t hrowing dart s. Som e of t he exam ples Eckhardt cit es of t he com fort able choices people t end t o m ake t hat run count er t o sound t rading principles include: gam bling wit h losses, locking in sure winners, selling on st rengt h and buying on weakness, and designing ( or buying) t rading syst em s t hat hav e been overfit t ed t o past price behav ior. The im plied m essage t o t he t rader is: Do what is right , not what feels com fort able.

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179 32. YOU CAN'T WI N I F YOU HAVE TO WI N There is an old Wall St reet adage: " Scared m oney never wins." The reason is quit e sim ple: I f you are risking m oney you can't afford t o lose, all t he em ot ional pit falls of t rading will be m agnified. Druckenm iller's " bet t ing t he ranch" on one t rade, in a last - dit ch effort t o save his firm , is a perfect exam ple of t he above aphorism . Even t hough he cam e wit hin one week of picking t he absolut e bot t om in t he T- bill m arket , he st ill lost all his m oney. The need t o win fost ers t rading errors ( e.g., excessive leverage and a lack of planning in t he exam ple j ust cit ed) . The m arket seldom t olerat es t he carelessness associat ed wit h t rades bom of desperat ion. 33. THI NK TWI CE WHEN THE MARKET LETS YOU OFF THE HOOK EASI LY Don't be t oo eager t o get out of a posit ion you have been worried at > out if t he m arket allows you t o exit at a m uch bet t er price t han ant icipat ed. I f you had been worried about an adverse over night ( or over- t heweekend) price m ove because of a news event or a t echnical price failure on t he previous close, it is likely t hat m any ot her t raders shared t his concern. The fact t hat t he m arket does not follow t hrough m uch on t hese fears st rongly suggest s t hat t here m ust be som e very powerful underlying forces in favor of t he direct ion of t he original posit ion. This concept , which was first proposed by Mart y Schwart z in Market Wizards, was illust rat ed in t his volum e by t he m anner in which Lipschut z exit ed t he one t rade he adm it t ed had scared him . I n t hat inst ance, he held an enorm ous short dollar posit ion in t he m idst of a st rongly rallying m arket and had t o wait for t he Tokyo opening t o find sufficient liquidit y t o exit his posit ion. When t he dollar opened weaker t han expect ed in Tokyo, he didn't j ust dum p his posit ion m relief; rat her, his t rader's inst inct s t old him t o delay liquidat ion- a decision t hat result ed in a far bet t er exit price. 34. A MI ND I S A TERRI BLE THI NG TO CLOSE Open- m indedness seem s t o be a com m on t rait am ong t hose who excel at t rading. For exam ple, Blake's ent ry int o t rading was act ually an at t em pt t o dem onst rat e t o a friend t hat prices were random . When he realized he was wrong, he becam e a t rader. Driehaus says t hat t he m ind is like a parachut e; it 's good only when it 's open. 35. THE MARKETS ARE AN EXPENSI VE PLACE TOLOOKFOR EXCI TEMENT Excit em ent has a lot t o do wit h t he im age of t rading but not hing t o do wit h success in t rading ( except in an inverse sense) . I n Market Wizards, Larry Hit e described his conversat ion wit h a friend who couldn't underst and his absolut e adherence t o a com put erized t rading syst em . His friend asked, " Larry, how can you t rade t he way you do. I sn't it bor ing?" Larry replied, " I don't t rade for excit em ent ; I t rade t o win." This passage cam e t o m ind when Faulkner described t he t rader who blew out because he found it t oo boring t o be t rading in t he way t hat produced profit s. 36. THE CALM STATE OF A TRADER I f t here is an em ot ional st at e associat ed wit h successful t rading, it is t he ant it hesis of excit em ent . Based on his observat ions, Faulkner st at ed t hat except ional t raders are able t o rem ain calm and det ached regardless of what t he m arket s are doing. He describes Pet er St eidlm ayer's response t o a posit ion t hat is going against him as being t ypified by t he t hought , " Hm m m , look at t hat ." Basso also t alks direct ly about t he benefit s of a det ached per spect ive in t rading: " I f inst ead of saying, 'I 'm going t o do t his t rade,' you say, 'I 'm going t o wat ch m yself do t his t rade,' alt of a sudden you find t hat t he process is a lot easier." 37. I DENTI FY AND ELI MI NATE STRESS St ress in t rading is a sign t hat som et hing is w rong. I f you feel st ress, t hink about t he cause, and t hen act t o elim inat e t he problem . For exam ple, let 's say you det erm ine t hat t he gr eat est source of st ress is indecision in get t ing out of a losing posit ion. One way t o solve t his problem is sim ply t o ent er a prot ect ive st op order every t im e you put on a posit ion. I will give you a personal exam ple. One of t he elem ent s of m y j ob is providing t rading recom m endat ions t o brokers in m y com pany. This t ask is very sim ilar t o t rading, and, having done bot h, I believe it 's act ually m ore difficult t han t rading. At one point , aft er years of net profit able recom m endat ions, I hit a bad st reak. I j ust couldn't do anyt hing right . When I was right about t he direct ion of t he m arket , m y buy recom m endat ion was j ust a bit t oo low ( or m y sell price t oo high) . When I got in and t he direct ion was right , I got st opped out - frequent ly wit hin a few t icks of t he ext rem e of t he react ion. I responded by developing a range of com put erized t rading pr ogram s and t echnical indicat ors, t hereby widely diversifying t he t rading advice I provided t o t he firm . I st ill m ade m y day- t o- day subj ect ive calls on t he m arket , but everyt hing was no longer riding on t he accuracy of t hese recom m endat ions. By widely diversifying t he t rading- relat ed advice and inform at ion, and t ransferring m uch of t his load t o m echanical approaches, I was able t o great ly dim inish a source of per sona] siress- and im prove t he qualit y of t he research product in t he process. 38. PAY ATTENTI ON TO I NTUI TI ON As I see it , int uit ion is sim ply experience t hat resides in t he subconscious m ind. The obj ect ivit y of t he m arket analysis done by t he conscious m ind can be com prom ised by all sort s of ext raneous consider at ions ( e.g., one's current m arket posit ion, a resist ance t o change a pr evious forecast ) . The subconscious, however, is not inhibit ed by such const raint s. Unfort unat ely, we can't readily t ap int o our subconscious t hought s.

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180 However, when t hey com e t hrough as int uit ion, t he t rader needs t o pay at t ent ion. As t he anonym ous t rader in Zen and t he Art of Trading expressed it , " The t rick is t o different iat e bet ween what you want t o happen and what you know will happen." 39. LI FE'S MI SSI ON AND LOVE OF THE ENDEAVOR I n t alking t o t he t raders int erviewed in t his book, I had t he definit e sense t hat m any of t hem felt t hat t rading was what t hey were m eant t o do- in essence, t heir m ission in life. Recall Charles Faulkner's quot e of John Grinder's descript ion of m ission: " What do you love so m uch t hat you would pay t o do it ?" Throughout m y int erviews, I was st ruck by t he exuberance and love t he Market Wizards had for t rading. Many used gam elike analogies t o describe t rading. This t ype of love for t he endeavor m ay indeed be an essent ial elem ent for success. 40. THE ELEMENTS OF ACHI EVEMENT Faulkner's list of t he six key st eps t o achievem ent based on Gary Faris's st udy of successfully rehabilit at ed at hlet es appears t o apply equally well t o t he goal of achieving t rading success. These st r at egies include t he following: 1. using bot h 'Toward" and " Away From " m ot ivat ion; 2. having a goal of full capabilit y plus, wit h anyt hing less being unaccept able; 3. breaking down pot ent ially overwhelm ing goals int o chunks, wit h sat isfact ion garnered from t he com plet ion of each individual st ep; 4. keeping full concent rat ion on t he present m om ent - t hat is, t he single t ask at hand rat her t han t he longt erm goal; 5. being personally involved in achieving goals ( as opposed t o depending on ot hers) ; and 6. m aking self- t o- self com parisons t o m easure progress. 41. PRI CES ARE NONRANDOM = THE MARKETS CAN BE BEAT I n reference t o academ icians who believe m arket prices are random , Trout says, 'That 's probably why t hey're professors and w hy I 'm m aking m oney doing what I 'm doing." The debat e over whet her prices ar e random is not yet over. However, m y experience wit h t he int erviews conduct ed for t his book and it s predecessor leaves m e wit h lit t le doubt t hat t he random walk t heory is wrong. I t is not t he m agnit ude of t he winnings regist ered by t he Market Wizards but t he consist ency of t hese winnings in som e cases t hat underpin m y belief. As a part icularly com pelling exam ple, consider Blake's 25: 1 rat io of winning t o losing m ont hs and his average annual ret urn of 45 percent com par ed wit h a worst drawdown of only 5 percent . I t is hard t o im agine t hat result s t his lopsided could occur purely by chance- perhaps in a universe filled wit h t raders, but not in t heir m ore finit e num bers. Cert ainly, winning at t he m ar ket s is not easy- and, m fact , it is get t ing m ore difficult as professionals account for a const ant ly growing proport ion of t he act ivit y- but it can be done! 42. KEEP TRADI NG I N PERSPECTI VE There is m ore t o life t han t rading.

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181 A Personal Reflection I am frequent ly asked whet her writ ing t his volum e and t he first Market Wizards helped m e becom e a bet t er t rader . The answer is yes, but not in t he way people expect when t hey ask t he quest ion. No t rader revealed t o m e any great m arket secret s or m ast er plan unlocking t he grand design of t he m arket s. ( I f t his is what you seek, don't despair, t he answer is readily available- j ust check t he ads in any financial periodical.) For m e, t he single m ost im port ant lesson provided by t he int erviews is t hat it is absolut ely necessary t o adopt a t rading approach pr ecisely suit ed t o one's own personalit y. Over t he year s, I have com e t o clearly realize m at what I really like about t his business is t rying t o solve t his m ast er puzzle: How do you win in t he m arket s? You have all t hese pieces, and you can put t hem t oget her in a lim it less num ber of ways, bounded only by your creat ivit y. Moreover, t o k eep t he gam e int erest ing, t here are lot s of pit falls t o lead you ast ray, and som e of t he rules keep changing in subt le w ays. There is even a group of very int elligent people t elling you t hat t he gam e can't be won at all. The really fascinat ing t hing is t hat , as com plex as t his puzzle is, t here are a m ult it ude of t ot ally different solut ions, and t here are always bet t er solut ions. Trying t o solve t his wonderful puzzle is what I enj oy. On t he ot her hand, I hav e also com e t o realize t hat I do not like t he t rading aspect at all. I do not enj oy t he em ot ionalit y of m aking int raday t rading decisions. When I am losing, I am upset , and when I am on a hot st reak, I am anxious because I know I can't keep it up. I n short , it is not m y st yle. I n cont rast , t here are people who t hrive on and excel at t he act ual t rading. One person who in m y m ind epit om izes t his t ype of approach is Paul Tudor Jones, whom I int erviewed in Market Wizards. When you wat ch Paul t rade, you can see he's really charged by t he act ivit y. He bubbles over wit h energy, t aking in inform at ion from a hundred different direct ions and m aking inst ant aneo- us t rading decisions. He seem s t o love it , as if it were som e challenging sport . And loving it is probably why he is so good at it . For m any years, I part icipat ed in bot h descr et ionary t rading and syst em t rading. I t is, perhaps, no coincidence t hat in t he course of working on t his book, I cam e t o t he conclusion t hat it " was syst em t rading t hat suit ed m y personalit y. Once I increased m y effort s and com m it m ent t o syst em t rading, m y progress accelerat ed and I felt t hat t he approach fit like a glove. I t t ook m e over a decade t o figure out m y nat ural direct ion. I 'd suggest t hat y ou t ake t he t im e t o seriously ponder whet her t he pat h you are on is t he one you want t o be on. Per haps your j ourney will t hen be short ened.

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182 Appendix: Options - Understanding the

Basics

There are t w o basic t ypes of opt ions: calls and put s. The purchase of a call opt ion provides t he buyer wit h t he right - but not t he obligat ion- t o purchase t he underlying it em at a specified price, called t he st rike price or exercise price, at any t im e up t o and including t he expirat ion dat e. A put opt ion pr ovides t he buyer wit h t he right - but not t he obligat ion- t o sell t he underlying it em at t he st rike price at any t im e prior t o expirat ion. ( Not e, t herefore, t hat buying a put is a bearish t rade, w hereas selling a put is a bullish t rade.) The price of an opt ion is called a prem ium . As an exam ple of an opt ion, an I BM April 130 call gives t he purchaser t he right t o buy 100 shar es of I BM at $130 per shar e at any t im e during t he life of t he opt ion. The buyer of a call seeks t o profit from an ant icipat ed price rise by locking in a specified purchase price. The call buyer's m axim um possible loss w ill be equal t o t he dollar am ount of t he prem ium paid for t he opt ion. This m axim um loss would occur on an opt ion held unt il expirat ion if t he st rike price were above t he prevailing m arket price. For exam ple, if I BM were t rading at $125 when t he 130 opt ion expired, t he opt ion would expire wort hless. I f at expirat ion t he price of t he underlying m arket was above t he st rike price, t he opt ion w ould have som e value and would hence be ex er cised. However, if t he difference bet ween t he m arket price and t he st rike price wer e less t han t he prem ium paid for t he opt ion, t he net result of t he t rade would st ill be a loss. I n order for a call buyer t o realize a net profit , t he difference bet ween t he m arket price and t he st rike price would have t o exceed t he prem ium paid when t he call was purchased ( aft er adj ust ing for com m ission cost ) . The higher t he m arket price, t he great er t he result ing profit . The buyer of a put seeks t o profit from an ant icipat ed price decline by locking in a sales price. Like t he call buyer, his m axim um possible loss is lim it ed t o t he dollar am ount of t he prem ium paid for ( he opt ion. I n t he case of a put held unt il expirat ion, t he t rade would show a net profit if t he st rike price exceeded t he m arket price by an am ount great er t han t he prem ium of t he put at purchase ( aft er adj ust ing for com m ission cost ) . Whereas t he buyer of a call or put has lim it ed risk and unlim it ed pot ent ial gain, t he reverse is t rue for t he seller. The opt ion seller ( oft en called t he w rit er) receives t he dollar value of t he prem ium in ret urn for undert aking t he obligat ion t o assum e an opposit e posit ion at t he st rike price if an opt ion is exercised. For exam ple, if a call is exercised, t he seller m ust assum e a short posit ion in t he underlying m arket at t he st rike price ( because, by exercising t he call, t he buyer assum es a long posit ion at t hat price) . The seller of a call seeks t o profit from an ant icipat ed sideway s t o m odest ly declining m arket . I n such a sit uat ion, t he prem ium earned by selling a call provides t he m ost at t ract ive t rading opport unit y. However, if t he t rader ex pect ed a large price decline, he would usually be bet t er off going short t he underlying m arket or buying a put - t rades w it h open- ended profit pot ent ial. I n a sim ilar fashion, t he seller of a put seeks t o profit from an ant icipat ed sideways t o m odest ly rising m arket . Som e novices have t rouble underst anding why a t rader would not always prefer t he buy side of t he opt ion ( call or put , depending on m arket opinion) , since such a t rade has unlim it ed pot ent ial and lim it ed risk. Such confusion reflect s t he failure t o t ake probabilit y int o account . Alt hough t he opt ipn seller's t heoret ical risk is unlim it ed, t he price levels t hat have t he great est pr obabilit y of occurrence ( i.e., prices in t he vicinit y of t he m arket price when t he opt ion t rade occurs) would result in a net gain t o t he opt ion seller. Roughly speaking, t he opt ion buyer accept s a large probabilit y of a sm all loss in ret urn for a sm all probabilit y of a large gain, w hereas t he opt ion seller accept s a sm all probabilit y of a large loss in exchange for a large probabilit y of a sm all gain. I n an efficient m arket , neit her t he consist ent opt ion buyer nor t he consist ent opt ion seller should have any significant advant age over t he long m n. The opt ion prem ium consist s of t wo com ponent s: int rinsic value plus t im e value. The int rinsic value of a call opt ion is t he am ount by w hich t he current m arket price is above t he st rike price. ( The int rinsic value of a put opt ion is t he am ount by which t he current m arket price is below t he st rike price.) I n effect , t he int rinsic value is t hat part of t he prem ium t hat could be realized if t he opt ion were exercised at t he cur rent m arket price. The int rinsic value serves as a floor price for an opt ion. Why? Because if t he prem ium were less t han t he int rinsic value, a t rader could buy and exercise t he opt ion and im m ediat ely offset t he result ing m arket posit ion, t hereby realizing a net gain ( assum ing t hat t he t rader covers at least t ransact ion cost s) . Opt ions t hat have int rinsic value ( i.e., calls wit h st rike prices below t he m ark et price and put s wit h st rike prices above t he m arket price) are said t o be in t he m oney. Opt ions t hat have no int rinsic value are called out - of- t he- m oney opt ions. Opt ions wit h a st rike price closest t o t he m arket price are called at - t he- m oney opt ions. An out - of- t he- m oney opt ion, which by definit ion has an int rinsic value equal t o zero, will st ill have som e value because of t he possibilit y t hat t he m arket price will m ove beyond t he st r ike price prior t o t he expirat ion dat e. An in- t he- m oney opt ion will have a value great er t han t he int rinsic value because a posit ion in t he opt ion will be preferred t o a posit ion in t he underlying m arket . Why? Because bot h t he opt ion and t he m arket posit ion will gain equally in t he event of a favorable price m ovem ent , but t he opt ion's m axim um loss is lim it ed. The port ion of t he prem ium t hat exceeds t he int rinsic value is called t he t im e value. The t hree m ost im port ant fact ors t hat influence an opt ion's t im e value are t he following: 1. Relat ionship bet ween t he st rike price and m arket price- Deeply out - of- t he- m oney opt ions will have lit t le t im e value since it is unlikely t hat t he m arket price will m ove t o t he st rike price- or beyond- prior t o expirat ion. Deeply in- t he- m oney opt ions have lit t le t im e value because t hese opt ions offer posit ions very sim ilar t o t he underlying m arket - bot h w ill gain and lose equivalent am ount s for all but an ext rem ely adverse price m ove. I n ot her words, for a deeply in- t he- m oney opt ion, risk being lim it ed is not wort h very m uch because t he st rike price is so far from t he prevailing m arket price. 2. Tim e rem aining unt il expirat ion- The m ore t im e r em aining unt il expirat ion, t he gr eat er t he value of t he

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183 opt ion. This is t rue because a longer life span increases t he probabilit y of t he int rinsic value increasing by any specified am ount prior t o expirat ion. 3. Volat ilit y- Tim e value will vary direct ly wit h t he est im at ed volat ilit y ( a m easure of t he degr ee of price variabilit y) of t he underlying m arket for t he rem aining life span of t he opt ion. This relat ionship result s because gr eat er volat ilit y raises t he pr obabilit y of t he int rinsic value increasing by any specified am ount prior t o expirat ion. I n ot her words, t he great er t he volat ilit y, t he great er t he probable price range of t he m arket . Alt hough volat ilit y is an ext rem ely im port ant fact or in t he det erm inat ion of opt ion prem ium values, it should be st ressed t hat t he fut ure volat ilit y of a m arket is never precisely known unt il aft er t he fact . ( I n cont rast , t he t im e rem aining unt il expirat ion and t he relat ionship bet ween t he current m arket price and t he st rike price can be exact ly specified at any j unct ure.) Thus, volat ilit y m ust always be est im at ed on t he basis of hist orical volat ilit y dat a. The fut ure volat ilit y est im at e im plied by m arket prices ( i.e., opt ion prem ium s) , which m ay be higher or lower t han t he hist orical volat ilit y, is called t he im plied volat ilit y. / / * * Not e: * * / / / / This Appendix was adapt ed from Jack D. Schwager, A Com plet e Guide lo t he Fut ures Market ( New York: John Wiley & Sons, 1984) ./ /

183

184 Glossary = = = = Advance/ decline line = = = = The cum ulat ive t ot al of t he daily difference bet w een t he num ber of New York St ock Exchange st ocks advancing and t he num ber declining. Divergences bet ween t he advance/ decline line and t he m arket averages, such as t he Dow Jones I ndust rial Average ( DJI A) , can som et im es be viewed as a m arket signal. For exam ple, if aft er a decline t he DJI A rebounds t o a new high but t he advance/ decline line fails t o follow suit , such price act ion m ay be reflect ive of int ernal m arket weakness. = = = = Arbit rage = = = = The im plem ent at ion of purchases in one m arket against equivalent sales in a closely relat ed m arket based on t he price relat ionship bet ween t he t wo being viewed as out of line. = = = = Arbit rageurs = = = = Traders who specialize in arbit rage. Arbit rageurs seek t o m ake sm all profit s from t em porar y dist ort ions in t he price relat ionships bet ween relat ed m arket s, as opposed t o at t em pt ing t o profit from correct proj ect ions of m arket direct ion. = = = = Averaging losers ( averaging down) = = = = Adding t o a losing posit ion aft er an adverse price m ove. = = = = Bear = = = = Som eone who believes t hat prices will decline. = = = = Bear m arket = = = = A m arket charact erized by declining prices. = = = = Boiler room operat ion = = = = An illegal or quasilegal phone sales operat ion in w hich high- pressure t act ics are used t o sell financial inst rum ent s or com m odit ies at excessive prices or inflat ed com m issions t o unsophist icat ed invest ors. For exam ple, cont ract s for precious m et als ( or opt ions on precious m et als) m ight be sold at prices far above levels prevailing at organized exchanges. I n som e cases, such operat ions are com plet e frauds, as t he cont ract s sold are purely fict it ious. = = = = Breakout = = = = A price m ovem ent beyond a previous high ( or low) or out side t he boundaries of a preceding price consolidat ion. = = = = Bull = = = = Som eone who believes t hat prices will rise. = = = = Bull m arket = = = = A m arket charact erized by rising prices. = = = = Call opt ion = = = = A cont ract t hat gives t he buyer t he right - but not t he obligat ion- t o purchase t he underlying financial inst rum ent or com m odit y at a specified price for a given period of t im e. = = = = Chart = = = = A graph t hat depict s t he price m ovem ent of a given m arket . The m ost com m on t ype of chart is t he daily bar chart , which denot es each day's high, low, and close for a given m arket wit h a single bar. = = = = Chart analysis = = = = The st udy of price chart s in an effort t o find pat t erns t hat in t he past preceded price advances or declines. The basic concept is t hat t he developm ent of sim ilar pat t erns in a current m arket can signal a probable m arket m ove in t he sam e direct ion. Pract it ioners of chart analysis are oft en referred t o as chart ist s or t echnicians. = = = = Congest ion = = = = See Consolidat ion. = = = = Consolidat ion = = = =

184

185 A

price

pat t ern

charact erized

by

ext ended

sideways m ovem ent . ( Also known as Congest ion.)

= = = = Cont ract = = = = I n fut ures m arket s, a st andardized t raded inst rum ent t hat specifies t he quant it y and qualit y of a com m odit y ( or financial asset ) for delivery ( or cash set t lem ent ) at a specified fut ure dat e. = = = = Cont rarian = = = = One who t rades on cont rary opinion ( see next it em ) . = = = = Cont rary opinion = = = = The general t heory t hat one can profit by doing t he opposit e of t he m aj orit y of t raders. The basic concept is t hat if a large m aj orit y of t raders ar e bullish, it im plies t hat m ost m arket part icipant s w ho believe prices are going higher are already long, and hence t he pat h of least resist ance is down. An analogous line of reasoning would apply when m ost t raders are bear ish. Cont rary opinion num bers are provided by various services t hat survey t rader s, m arket let t ers, or t rading advisors. = = = = Cover = = = = To liquidat e an exist ing posit ion ( i.e., sell if one is long; buy if one is short ) . = = = = Day t rade = = = = A t rade t hat is liquidat ed on t he sam e day it is init iat ed. = = = = Discret ionary t rader = = = = I n a general sense, a t r ader who has t he pow er of at t orney t o execut e t rades for cust om er account s wit hout prior approval. However, t he t erm is oft en used in a m ore specific sense t o indicat e a t rader who m akes decisions based on his own int erpret at ion of t he m arket , rat her t han in response t o signals generat ed by a com put erized syst em . = = = = Divergence = = = = The failure of a m arket or indicat or t o follow suit when a relat ed m arket or indicat or set s a new high or low. Som e analyst s look for divergences as signals of im pending m arket t ops and bot t om s. Diversificat ion. Trading m any different m arket s in an effort t o reduce risk. = = = = Downt rend = = = = A general t endency for declining prices in a given m arket . = = = = Drawdown = = = = The equit y reduct ion in an account . The m axim um drawdown is t he largest difference bet ween a relat ive equit y peak and any subsequent equit y low. Low drawdowns are a desirable perfor m ance feat ure for a t rader or a t rading syst em . = = = = Earnings per share ( EPS) = = = = A com pany's t ot al aft er- t ax profit s divided by t he num ber of com m on shares out st anding. = = = = Elliot t Wave analysis = = = = A m et hod of m arket analysis based on t he t heories of Ralph Nelson Elliot t . Alt hough relat ively com plex, t he basic t heory is based on t he concept t hat m arket s m ove in waves, form ing a general pat t ern of five waves ( or m arket legs) in t he direct ion of t he m ain t rend, followed by t hree correct ive waves in t he opposit e direct ion. One aspect of t he t heory is t hat each of t hese waves can be broken down int o five or t hree sm aller waves and is it self a segm ent of a st ill larger wave. Equit y. The t ot al dollar value of an account . = = = = Fade = = = = To t rade in t he opposit e direct ion of a m arket signal ( or analyst ) . For exam ple, a t rader who goes short aft er prices penet rat e t he upside of a prior consolidat ion- a price developm ent t hat m ost t echnically orient ed t raders would int erpret as a signal t o buy or st ay long- can be said t o be fading t he price br eakout . = = = = False breakout = = = = A short - lived price m ove t hat penet rat es a prior high or low before succum bing t o a pronounced price m ove in t he opposit e direct ion. For exam ple, if t he price of a st ock t hat has t raded bet w een $18 and $20 for six m ont hs rises t o $21 and t hen quickly falls below $18, t he m ove t o $21 can be t erm ed a false breakout . = = = = Federal Reserve Board ( Fed) = = = = The governing arm of t he Feder al Reserve Syst em , which seeks t o regulat e t he econom y t hrough t he im plem ent at ion of m onet ary policy.

185

186 = = = = Fibonacci ret racem ent s = = = = The concept t hat ret racem ent s of prior t rends will oft en approxim at e 38.2 percent and 61.8 percent - num bers derived from t he Fibonacci sequence ( see next it em ) . = = = = Fibonacci sequence = = = = A sequence of num bers t hat begins wit h 1,1 and pr ogresses t o infinit y, wit h each num ber in t he sequence equal t o t he sum of t he preceding t wo num bers. Thus, t he init ial num bers in t he sequence would be 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, et c. The rat io of consecut ive num bers in t he sequence converges t o 0.618 as t he num bers get larger. The rat io of alt ernat e num ber s in t he sequence ( for exam ple, 21 and 55) converges t o 0.382 as t he num bers get larger. These t wo r at ios- 0.618 and 0.382- are com m only used t o proj ect ret racem ent s of prior price swings. = = = = Floor t rader = = = = A m em ber of t he exchange who t rades on t he floor for personal profit . = = = = Front running = = = = The unet hical- and in som e cases illegal- pract ice of a broker placing his own order in front of a cust om er order t hat he ant icipat es will m ove t he m arket . = = = = Fundam ent al analysis = = = = The use of econom ic dat a t o forecast prices. For exam ple, fundam ent al analysis of a currency m ight focus on such it em s as relat ive inflat ion rat es, relat ive int erest rat es, relat ive econom ic growt h rat es, and polit ical fact ors. = = = = Fut ures = = = = See " Fut ures- Underst anding t he Basics." = = = = Gann analysis = = = = Market analysis based on a variet y of t echnical concept s developed by William Gann, a fam ous st ock and com m odit y t rader during t he first half of t he t went iet h cent ury. = = = = Gap = = = = A price zone at which no t rades occur . For exam ple, if a m arket t hat has pr eviously t raded at a high of $20 opens at $22 on t he following day and m oves st eadily higher, t he price zone bet ween $20 and $22 is referred t o as a gap. = = = = Hedge = = = = A posit ion ( or t he im plem ent at ion of a posit ion) used t o offset invent ory risk or risk relat ed t o an ant icipat ed fut ure purchase or sale. An exam ple of a hedge t rade is a corn farm er who, during t he growing season, sells corn fut ures wit h a delivery dat e subsequent t o his ant icipat ed harvest . I n t his illust rat ion, t he sale of fut ures effect ively locks in an approxim at e fut ure sales price, t hereby lim it ing risk exposure t o subsequent price fluct uat ions. = = = = Hedger = = = = A m arket part icipant who im plem ent s a posit ion t o reduce price risk. The nedger's risk posit ion is exact ly opposit e t hat of t he speculat or, who accept s risk in im plem ent ing posit ions t o profit from ant icipat ed price m oves. = = = = I m plied volat ilit y = = = = The m arket 's expect at ion of fut ure price volat ilit y as im plied by prevailing opt ion prices. = = = = Leverage = = = = The abilit y t o cont rol a dollar am ount of a com m odit y or financial inst m m ent great er t han t he am ount of capit al em ployed. The great er t he leverage of t he posit ion, t he great er t he pot ent ial profit or loss. = = = = Lim it posit ion = = = = A m axim um posit ion size ( i.e., num ber of cont r act s) t hat a speculat or m ay hold. For m any fut ures cont ract s, governm ent regulat ions specify t his lim it . = = = = Lim it price m ove = = = = For m any fut ures cont ract s, t he exchanges specify a m axim um am ount by w hich t he price can change on a single day. A m arket t hat increases in price by t his specified m axim um is said t o be lim it - up, while a m arket t hat declines by t he m axim um is said t o be lim it - down. I n cases in which free m arket forces would norm ally

186

187 seek an equilibrium price out side t he range of boundaries im plied by t he lim it , t he m arket w ill sim ply m ove t o t he lim it and virt ually cease t o t rade. For an advancing m arket , such a sit uat ion is referred t o as locked lim it - up or lim it - bid; for a declining m arket , t he analogous t erm s are locked lim it - down or lim it offered. = = = = Liquidit y = = = = The degree t o which a given m arket is liquid. = = = = Liquid m arket = = = = A m arket in which t here is a sufficient ly large num ber of t rades daily so t hat m ost reasonably sized buy and sell orders can be ex ecut ed wit hout significant ly m oving prices. I n ot her words, a liquid m arket allows t he t rader relat ive ease of ent ry and exit . = = = = Local = = = = A synonym for Floor t rader, t ypically used t o connot e an exchange m em ber who t rades for his or her own account . = = = = Long = = = = A posit ion est ablished w it h a buy order, which profit s in a rising price m arket . The t erm is also used t o refer t o t he person or ent it y holding such a posit ion. = = = = Lot = = = = I n fut ures m arket s, anot her nam e for cont ract . = = = = Mark t o t he m arket = = = = The valuat ion of open posit ions at prevailing set t lem ent prices. I n ot her words, if a posit ion is m arked t o t he m arket , t here is no dist inct ion bet ween realized and unrealized losses ( or gains) . = = = = Mechanical syst em = = = = A t rading syst em ( usually com put erized) t hat generat es buy and sell signals. A m echanical syst em t rader follows t he signals of such a syst em wit hout regard t o personal m arket assessm ent s. = = = = Money m anagem ent = = = = The us.e of various m et hods of risk cont rol in t rading. = = = = Moving average = = = = A m et hod of sm oot hing prices t o m ore easily discern m arket t rends. A sim ple m oving average is t he average price during t he m ost recent fixed num ber of days.. Crossovers ( one series m oving from below t o above anot her, or vice versa) of price and a m oving average- or of t wo different m oving averages- ar e used as buy and sell signals in som e sim ple t rend- following syst em s. = = = = Naked opt ion = = = = A short opt ion posit ion by a t rader who does not own t he underlying com m odit y or financial inst rum ent . = = = = Open int erest = = = = I n fut ures m arket s, t he t ot al num ber of open long and short posit ions are always equal. This t ot al ( long or short ) is called t he open int erest - By definit ion, when a cont ract m ont h first begins t rading, t he open int erest is zero. The open int erest t hen builds t o a peak and declines as posit ions are liquidat ed approaching it s expirat ion dat e. = = = = Opt ions = = = = See t he Appendix. = = = = Out right posit ion = = = = A net long or short posit ion ( as opposed t o spreads and arbit rage t rades, in which posit ions are count erbalanced by opposit e posit ions in relat ed inst rum ent s) . = = = = Overbought / oversold indicat or = = = = A t echnical indicat or t hat at t em pt s t o define when prices have risen ( declined) t oo far, t oo fast , and hence are vulnerable t o a react ion in t he opposit e direct ion. The concept of overbought / oversold is also oft en used in associat ion w it h cont rary opinion t o describe w hen a large m aj orit y of t raders are bullish or bearish. = = = = PandL = = = =

187

188 Short hand for profit / loss = = = = Pat t ern recognit ion = = = = A price- forecast ing m et hod t hat uses hist orical chart pat t erns t o draw analogies t o current sit uat ions.

= = = = Pit = = = = The area where a fut ures cont ract is t raded on t he exchange floor. Also som et im es called t he Ring. = = = = Posit ion lim it = = = = See Lim it posit ion. = = = = Price/ earnings ( P/ E) rat io = = = = The price of a st ock divided by t he com pany's annual earnings. = = = = Put / call rat io = = = = The volum e of put opt ions divided by t he volum e of call opt ions. A put / call rat io is one exam ple of a cont rary opinion or overbought / oversold m easure. The basic prem ise is t hat a high rat io, which reflect s m or e put s being purchased t han calls, im plies t hat t oo m any t raders are bearish and t he rat io is hence considered bullish. Analogously, a low put / call rat io w ould be considered bearish. = = = = Put opt ion = = = = A cont ract t hat provides t he buyer wit h t he right - but not t he obligat ion- t o sell t he underlying financial inst rum ent or com m odit y at a specific price for a fixed period of t im e. = = = = Pyram iding = = = = Using unrealized profit s on an exist ing posit ion as m ar gin t o increase t he size of t he posit ion. By increasing t he leverage in a t rade, pyram iding increases t he profit pot ent ial as well as t he risk. = = = = React ion = = = = A price m ovem ent in t he opposit e direct ion of t he predom inant t rend. = = = = Relat ive st rengt h = = = = I n t he st ock m arket , a m easure of a given st ock's price st rengt h relat ive t o a broad index of st ocks. The t erm can also be used in a m ore gener al sense t o refer t o an overbought / over sold t ype of indicat or. = = = = Resist ance = = = = hi t echnical analysis, a price area at which a rising m arket is expect ed t o encount er increased selling pressure sufficient t o st all or reverse t he advance. = = = = Ret racem ent = = = = A price m ovem ent count er t o a preceding t rend. For exam ple, in a rising m arket , a 60 percent ret racem ent would indicat e a price decline equal t o 60 percent of t he prior advance. = = = = Reversal day = = = = A day on which t he m arket reaches a new high ( low) and t hen reverses direct ion, closing below ( above) one or m ore im m ediat ely preceding daily closes. Reversal days are considered m ore significant ( " key" ) if accom panied by high volum e and a par t icularly wide price range. = = = = Ring = = = = A synonym for Pit . = = = = Risk cont rol = = = = The use of t rading rules t o lim it losses. = = = = Risk/ reward rat io = = = = The rat io of t he est im at ed pot ent ial loss of a t rade t o t he est im at ed pot ent ial gain. Alt hough, t heoret ically, t he probabilit y of a gain or loss should also be incorporat ed in any calculat ion, t he rat io is frequent ly based naively on t he m agnit udes of t he est im at ed gain or loss alone. = = = = Scalper = = = = A floor broker who t rades for his own account and seeks t o profit from very sm all price fluct uat ions. Typically, t he scalper at t em pt s t o profit from t he edge available in selling at t he bid price and buying at t he

188

189 offered price- a t rading approach t hat also provides

liquidit y t o t he m arket .

= = = = Seat = = = = A m em bership on an exchange. = = = = Sent im ent indicat or = = = = A m easure of t he balance bet ween bullish and bearish opinions. Sent im ent indicat ors are used for cont rary opinion t rading. The put / call rat io is one exam ple of a sent im ent indicat or. = = = = Short = = = = A posit ion im plem ent ed w it h a sale, which profit s from a declining price m ar ket . The t er m also refers t o t he t rader or ent it y holding such a posit ion. = = = = Slippage = = = = See Skid. = = = = Skid. The difference bet ween a t heoret ical execut ion price on a t rade ( for exam ple, t he m idpoint of t he opening range) and t he act ual fill price. = = = = Speculat or = = = = A person who willingly accept s risk by buying and selling financial inst rum ent s or com m odit ies in t he hopes of profit ing from ant icipat ed price m ovem ent s. = = = = Spike = = = = A price high ( low) t hat is sharply above ( below) t he highs ( lows) of m e preceding and succeeding days. Spikes represent at least a t em porary clim ax in buying ( selling) pressur e and m ay som et im es prove t o be m aj or t ops or bot t om s. = = = = Spread = = = = The com bined purchase of a fut ures cont ract ( or opt ion) and sale of anot her cont ract ( or opt ion) in t he sam e or a closely relat ed m arket . Som e exam ples of spreads include long June T- bonds/ short Sept em ber Tbonds, long Deut sche m arks/ short Swiss francs, and long I BM 130 call/ short I BM 140 call. = = = = St op order = = = = A buy order placed abov e t he m arket ( or sell order placed below t he m arket ) t hat becom es a m arket or der when t he specified price is reached. Alt hough st op orders are som et im es used t o im plem ent new posit ions, t hey are m ost frequent ly used t o lim it losses. I n t his lat t er applicat ion. They are frequent ly called st op- loss orders. = = = = Support = = = = I n t echnical analysis, a price area at which a falling m arket is expect ed t o encount er increased buying support sufficient t o st all or reverse t he decline. = = = = Syst em = = = = A specific set of rules used t o generat e buy and sell signals for a given m arket or set of m arket s. = = = = Syst em s t rader = = = = A t rader who ut ilizes syst em s t o det erm ine t he t im ing of purchases and sales, rat her t han rely on a personal assessm ent of m arket condit ions. = = = = Tape reader = = = = A t rader who at t em pt s t o predict im pending m ar ket direct ion by m onit oring closely a st ream of price quot es and accom panying volum e figures. = = = = Technical analysis = = = = Price forecast ing m et hods based on a st udy of price it self ( and som et im es volum e and open int erest ) as opposed t o t he underlying fundam ent al ( i.e., econom ic) m arket fact ors. Technical analysis is oft en cont rast ed wit h fundam ent al analysis. = = = = Tick = = = = The m inim um possible price m ovem ent , up or down, in a m arket . = = = = Trading range = = = =

189

190 A sideways price band t hat encom passes all range im plies a direct ionless m arket .

price act ivit y during a specified per iod. A t rading

= = = = Trend = = = = The t endency of prices t o m ove in a given general direct ion ( up or down) . = = = = Trend- following syst em = = = = A syst em t hat generat es buy and sell signals in t he direct ion of a newly defined t rend, based on t he assum pt ion t hat a t rend, once est ablished, will t end t o cont inue. = = = = Upt ick rule = = = = A st ock m arket regulat ion t hat short sales can be im plem ent ed only at a price above t he preceding t ransact ion. = = = = Upt rend = = = = A general t endency for rising prices in a given m arket . = = = = Volat ilit y = = = = A m easure of price variabilit y in a m arket . A volat ile m arket is a m arket t hat is subj ect t o wide price fluct uat ions. = = = = Volum e = = = = The t ot al num ber of shares or cont ract s t raded dur ing a given period. = = = = Whipsaw = = = = A price pat t ern charact erized by repeat ed, abrupt r eversals in t rend. The t er m is oft en used t o described losses result ing from t he applicat ion of a t rend- following syst em t o a choppy or t rendless m arket . I n such m arket s, t rend- following syst em s will t end t o generat e buy signals j ust before downside price reversals and sell signals j ust before upside price reversals.

190