WIZARD LESSONS
There is no single true path for succeeding in the markets. The methods employed by great traders are extraordinarily diverse. Some are pure fundamentalists; others use only technical analysis; and still others combine the two methodologies. Some traders consider two days to be long term, while others consider two months to be short-term. Some are highly quantitative, while others rely primarily on qualitative market decisions.
Although the traders interviewed differed dramatically in terms of their methods, backgrounds, and personalities, there were numerous traits common to many of them. One trait that was shared by all the traders is discipline.
Successful trading is essentially a two-stage process:
· Develop an effective trading strategy and an accompanying trading plan that addresses all contingencies.
· Follow the plan without exception. (By definition, any valid reason for an exception—for example, correcting an oversight—would become part of the plan.) No matter how sound the trading strategy, its success will depend on this execution phase, which requires absolute discipline.
Cohen emphasizes that it is critical to adopt a trading style that matches your personality. There is no single right way to trade the markets; you have to know who you are. For example, don't try to be both an investor and a day trader. Choose an approach that is comfortable for you. Minervini offers similar advice: "Concentrate on mastering one style that suits your personality, which is a lifetime process."
Successful traders invariably gravitate to an approach that fits their personality. For example, Cook is happy to take a small profit on a trade but hates to take even a small loss. Given this predisposition, the methodologies he has developed, which accept a low return/risk ratio on each trade in exchange for a high probability of winning, are right for him. These same methods, however, could be a mismatch for others. Trading is not a one-size-fits-all proposition; each trader must tailor an individual approach.
Although some of the traders in this book were successful from the start, the early market experiences of others were marked by complete failure. Mark Cook not only lost his entire trading stake several times, but on one of these occasions he also ended up several hundred thousand dollars in debt and a hair away from personal bankruptcy. Stuart Walton wiped out once with money borrowed from his father and several years later came close to losing not only all his trading capital, but also the money he borrowed on a home equity loan. Mark Minervini lost not only all his own money in the markets, but some borrowed money as well.
Despite their horrendous beginnings, these traders ultimately went on to spectacular success. How were they able to achieve such a complete metamorphosis? Of course, part of the answer is that they had the inner strength not to be defeated by defeat. But tenacity without flexibility is no virtue. Had they continued to do what they had been doing before, they would have experienced the same results. The key is that they completely changed what they were doing.
Even great traders sometimes have completely wrongheaded ideas when they start. They ultimately succeed, however, because they have the flexibility to change their approach. Benjamin Franklin said, "One of the greatest tragedies of life is the murder of a beautiful theory by a gang of brutal facts." Great traders are able to face such "tragedies" and choose reality over their preconceptions.
Walton, for example, started out by selling powerhouse stocks and buying bargain stocks. When his empirical observations of what actually worked in the market contradicted this original inclination, he was flexible enough to completely reverse his approach. As another example, when Minervini was a novice trader he favored buying low-priced stocks that were making new lows, an approach that was almost precisely the opposite of the methodology he ended up using.
Markets are dynamic. Approaches that work in one period may cease to work in another. Success in the markets requires the ability to adapt to changing conditions and altered realities. Some examples:
· Walton adjusts his strategy to fit his perception of the prevailing market environment. As a result, he might be a buyer of momentum stocks in one year and a buyer of value stocks in another. "My philosophy" he says, "is to float like a jellyfish, and let the market push me where it wants to go."
· Even though Lescarbeau has developed systems whose performance almost defy belief, he continues his research to develop their replacements so that he is prepared when market conditions change.
· Fletcher's primary current strategy evolved in several stages from a much simpler earlier strategy. As competitors increase in the current approaches he is utilizing, Fletcher is busy developing new strategies.
· Cohen says, "I'm always learning, which keeps it exciting and new. I'm not doing the same thing that I was doing ten years ago. I have evolved, and will continue to evolve."
Experience is a minimum requirement for success in trading, just as it is in any other profession, and experience can be acquired only in real time. As Cook says, "You can't expect to become a doctor or an attorney overnight, and trading is no different."
Although the process of gaining experience can't be rushed, it can be made much more efficient by writing down market observations instead of depending on memory. Keeping a daily diary in which he recorded the recurrent patterns he noticed in the market was instrumental to Cook's transition from failure to great success. All of the many trading strategies he uses grew out of these notes. Masters jots down observations on the backs of his business cards. A compilation of these notes provided the basis for his trading model.
Develop a specific trading philosophy—an integration of market concepts and trading methods—that is based on your market experience and is consistent with your personality (item 3). Developing a trading philosophy is a dynamic process—as you gather more experience and' knowledge, the existing philosophy should be revised accordingly.
Unless you can answer this question clearly and decisively, you are not ready to trade. Every trader in this book has a specific edge. Here are a few examples:
· Masters has developed a catalyst-based model that identifies high probability trades.
· Lauer employs a specific six-step selection process that identifies stocks with extremely favorable return/risk prospects.
· Cook has identified price patterns that correctly predict the short term direction of the market approximately 85 percent of the time.
· Cohen combines the information flow provided by the select group of traders and analysts he has assembled with his innate timing skills as a trader.
· A tremendous investment in research and very low transactions costs have made it possible for Shaw's firm to identify and profit from small market inefficiencies.
· By combining carefully structured financing deals with hedging techniques, Fletcher and Guazzoni implement transactions that have a very high probability of being profitable in virtually any scenario.
· Watson's extensive communication-based research allows him to identify overlooked stocks that are likely to advance sharply well before those opportunities become well recognized on Wall Street.
One of the most strikingly evident traits among all the Market Wizards is their high level of confidence. This leads to the question: Are they confident because they have done so well, or is their success a consequence of their confidence? Of course, it would hardly be surprising that anyone who has done as extraordinarily well as the traders in this book would be confident. But the more interviews f do with Market Wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, and is as much a contributing factor to their success as a consequence of it. To cite only a few of the many possible examples:
· When Watson was asked what gave him the confidence to pursue a career in money management when he had no prior success picking stocks, he replied, "Once I decide 1 am going to do something, I become determined to succeed, regardless of the obstacles. If I didn't have that attitude, I never would have made it.'
· Masters, who launched his fund when he was an unemployed stockbroker with virtually no track record gave this response to a similar question. "I realized that if somebody could make money trading, so could I. Also, the fact that I had competed successfully at the highest levels of swimming gave me confidence that I could excel in this business as well."
· Lauer was almost apologetic about his confidence when he decided to switch careers from analyst to money manager: "I hesitate to say this because 1 don't, want to sound arrogant—one of the things that gave me confidence in going out on my own was that the fund managers were my clients when 1 was an analyst, and 1 thought they would not be particularly difficult to compete against".
· Lescarbeau's confidence seemed to border on the irrational. When asked why he didn't delay a split with his partner, who was the money manager of the team, until he had developed his own approach, Lescarbeau replied, "I knew I would come up with something. There was absolutely no doubt in my mind. I had never failed to succeed at anything that I put my mind to, and this was no different."
An honest self-appraisal in respect to confidence may be one of the best predictors of a trader's prospects for success in the markets. At the very least, those who consider changing careers to become traders or risking a sizable portion of their assets in the market should ask themselves whether they have absolute confidence in their ultimate success. Any hesitation in the answer should be viewed as a cautionary flag.
The irony is that so many people are drawn to the markets because it seems like an easy way to make a lot of money, yet those who excel tend to be extraordinarily hard workers—almost to a fault. Consider just some of the examples in this book:
· As if running a huge trading company were not enough, Shaw has also founded a number of successful technology companies, provided venture capital funding and support to two computational chemistry software firms, and chaired a presidential advisory committee. Even when he is on a rare vacation, he acknowledges, "I need a few hours of work each day just to keep myself sane."
· Lescarbeau continues to spend long hours doing computer research even though his systems, which require very little time to run, are performing spectacularly well. He continues to work as if these systems were about to become ineffective tomorrow. He never misses a market day, to the point of hobbling across his house in pain on the day of his knee surgery so that he could check on the markets.
· Minervini works six-day workweeks, fourteen-hour trading days, and claims not to have missed a market day in ten years, even when he had pneumonia.
· Cook continues to do regular farmwork in addition to spending fifty to sixty hours a week at trading. Moreover, for years after the disastrous trade that brought him to the brink of bankruptcy, Cook worked the equivalent of two full-time jobs.
· Bender not only spends a full day trading in the U.S. markets, but then is up half the night trading the Japanese stock market.
There is often a fine line between hard work and obsession, a line that is frequently crossed by the Market Wizards. Certainly some of the examples just cited contain elements of obsession. It may well be that a tendency toward obsessiveness in respect to the markets, and often other endeavors as well, is simply a trait associated with success.
To list a few examples:
· When Fletcher started his first job, he was given a desk and told to "figure it out." He never stopped. Fletcher has made a career of thinking up and implementing innovative market strategies.
· Bender not only developed his own style of trading options but also created an approach that sought to profit by betting against conventional option models.
· Shaw's entire life has been defined by innovation: the software company he launched as a graduate student; his pioneering work in designing the architecture of supercomputers; the various companies he founded; and his central role in developing the unique complex mathematical trading model used by D. E. Shaw.
· By compiling detailed daily diaries of his market observations for over a decade, Cook was able to develop a slew of original, high-reliability trading strategies.
· Minervini uncovered his own menagerie of chart patterns rather than using the patterns popularized in market books.
· By jotting down all his market observations, Masters was able to design his own catalyst-based trading model.
· Although he was secretive about the details, based on their incredible performance alone, it is quite clear that Lescarbeau's systems are unique.
In Watson's words, "You can't be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money."
Minervini believes that one of the common mistakes made by novices is that they "spend too much time trying to discover great entry strategies and not enough time on money management." "Containing your losses," he says, "is 90 percent of the battle, regardless of the strategy." Cohen explains the importance of limiting losses as follows: "Most traders make money only in the 50 to 55 percent range. My best trader makes money only 63 percent of the time. That means you're going to be wrong a lot. If that's the case, you better make sure your losses are as small as they can be."
Risk-control methods used by the traders interviewed included the following:
Stop-loss points. Both Minervini and Cook predetermine where they will get out of a trade that goes against them. This approach allows them to limit the potential loss on any position to a well-defined risk level (barring a huge overnight price move). Both Minervini and Cook indicated that the stop point for any trade depends on the expected gain—that is, trades with greater profit potential will use wider stops (accept more risk).
Reducing the position. Cook has a sheet taped to his computer reading: GET SMALLER. "The first thing I do when I'm losing," he says, "is to stop the bleeding." Cohen expresses the virtually identical sentiment: "If you think you're wrong, or if the market is moving against you and you don't know why, take in half. You can always put it on again. If you do that twice, you've taken in three-quarters of your position. Then what's left is no longer a big deal."
Selecting low-risk positions. Some traders rely on very restrictive stock selection conditions to control risk as an alternative to stop-loss liquidation or position reduction (detailed in item 17).
Limiting the initial position size. Cohen cautions, "A common mistake traders make ... is that they take on too big of a position relative to their portfolio. Then when the stock moves against them, the pain becomes too great to handle, and they end up panicking or freezing." On a similar note, Fletcher quotes his mentor, Elliot Wolk, "Never make a bet you can't afford to lose."
Diversification. The more diversified the holdings, the lower the risk. Diversification by itself, however, is not a sufficient risk-control measure, because of the significant correlation of most stocks to the broader market and hence to one another. Also, as discussed in item 53, too much diversification can have significant drawbacks.
Short selling. Although the common perception is that short selling is risky, it can actually be an effective tool for reducing portfolio risk (see item 5 9).
Hedged Strategies. Some traders (Fletcher, Guazzoni, Shaw, and Bender) use methodologies in which positions are hedged from the onset. For these traders, risk control is a matter of restricting leverage, since even a low-risk strategy can become a high-risk trade if the leverage is excessive. (See, for example, discussion of LTCM in the Shaw interview.)
Risk control should not be confused with fear of risk. A willingness to accept risk is probably an essential personality trait for a trader. As Watson states, "You have to be willing to accept a certain level of risk, or else you will never pull the trigger." When asked what he looks for when he hires new traders, Cohen replies, "I'm looking for people who are not afraid to take risks."
A number of the traders interviewed restrict their stock selection to the universe of undervalued securities. Watson focuses on the stocks with relatively low price/earnings ratios (8 to 12). Lauer will look for stocks that have witnessed market-adjusted declines of at least 50 percent. Okumus buys stocks that have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value.
One reason all these traders focus on buying stocks that meet their definition of value is that by doing so they limit the downside. As Lauer explains when talking about using a large price decline as a selection screen, "Right now, I'm only focusing on the question of how I make sure
I don't lose money. I'm not talking about making money yet." Another advantage of buying stocks that are trading at depressed levels is that the stocks in this group that do turn around will often have tremendous upside potential.
It should be stressed that although a number of traders considered undervaluation a necessary condition for purchasing a stock, none of them viewed it as a sufficient condition. There always had to be other compelling reasons for the trade, because a stock could be low priced and stay that way for years. Even if you don't lose much in buying a value stock that just sits there, it could represent a serious investment blunder by tying up capital that can be used much more effectively elsewhere.
Lauer has six selection criteria, but five are defensive in nature, aimed at capital preservation. All five of these factors can be in place and he would not consider purchasing a stock without the sixth—a catalyst. "The key question," he says, is "what is going to make the stock go up?"
Watson's stock selection process contains two essential steps. First, the identification of stocks that fulfill his value criteria, which is the easy part of the process and merely defines the universe of stocks in which he prospects for buy candidates. Second, the search for catalysts (recent or impending) that will identify which of these value stocks have a compelling reason to move higher over the near term. To discover these catalysts, he conducts extensive communication with companies, as well as their competitors, distributors, and consumers. By definition, every trade requires a catalyst.
Masters has developed an entire trading model based primarily on catalysts. Through years of research and observation, he has been able to find scores of patterns in how stocks respond to catalysts. Although most of these patterns may provide only a small edge by themselves, when grouped together, they help identify high-probability trades.
When to get out of a position is as important as when to get in. Any market strategy that ignores trade liquidation is by definition incomplete. A liquidation strategy can include one or more of the following elements:
Stop-loss points. Detailed in item 15.
Profit objective. A number of traders interviewed (e.g., Okumus, Cook) will liquidate a stock (or index) if the market reaches their predetermined profit target.
Time stop. A stock (or index) is liquidated if it failsto reach a target within a specified time frame. Both Masters and Cook cited time stops as a helpful trading strategy.
Violation of trade premise....
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