The Complete TurtleTrader

by Michael W Covel

  Dennis asked Eckhardt calmly, “What should we do?” Eckhardt panicked and froze at the controls. Dennis shorted silver and seconds later it was limit down, too (a big winner). Eckhardt enthused, “In my book that was Rich’s best trade ever because he did it under maximum duress. If he hadn’t done it, we both would have been bankrupted by the subsequent slide in gold.”16

  One Turtle gushed in awe that Dennis still had the “balls” to execute that trade “when they were dumb, deaf, and broke”: “They were going the wrong way and for Dennis to just totally cover and totally reverse was amazing. He was one of the few people who could pull the trigger on big numbers and pull the trigger intelligently. There are some people that just go nuts and they melt down. Especially when they’re on the wrong side of the trade and it’s going to send them to the poor house.”

  Many people can trade small amounts day in and day out and not worry about losing money. But as the size of their trading is increased, say by 100 percent, their trading decisions become more significant and problematic. They begin to think about how much they’re winning or losing, and it becomes harder to keep a level head about trading “big.” Emotions rise to the surface, and objectivity becomes harder and harder to maintain. Disassociating the dollars from the trading was a huge part of what was instilled in the Turtles.

  Robert Moss saw the qualities in Dennis that allowed that silver trade to happen: “There are some people who can trade one lot or two lots or a five lot and handle that position and perform not thinking about the money.” Moss had never seen anybody better. Tom R. Willis, the son of Tom Willis and close enough to Dennis to consider him an uncle, said that Dennis simply had a sense of proportion that was different from the rest of the world’s: “When he perceived that he had an edge, he would go all into a position with mammoth trading size.”

  Dennis may have been able to pull the trigger, but that disastrous first year came close to wiping him out. He lost $2 million that first day of November. It was touch-and-go for a while. The experience forced Dennis and Eckhardt to reevaluate everything they had learned about trading. They began to test by computer “every idea or piece of conventional wisdom that had ever passed their way. The successful trader is the one who codifies, the one who turns things into rules. Every idea that’s market-worthy must then be tested.”17

  Don’t discount this story by saying, “It was $2 million; this is a game for rich people, not me!” That is the dead wrong view. There will always be someone with more or less money than someone else. If you have $100 million and you lose $2 million, that is not a big deal. If you have $50,000 and you lose $1,000, that is not a big deal. Both losses are 2 percent.

  That is not to say losses are easy to accept, but Dennis and Eckhardt taught the Turtles not to consider their trading in terms of amounts of money. They wanted them to think of money as a variable, because in that way, regardless of account size, they could make the correct trading decisions at all times.

  However, first and foremost Dennis and Eckhardt wanted the Turtles to understand that their kind of speculation had virtually no external limits. It took place in a limitless environment. They could bet any amount on any potential market movement at any time, but if the Turtles entered this no-limit environment and didn’t protect their scarce capital, then sooner or later the probabilities would catch up with them.18

  The lessons they put forward in the classroom solved the dilemma of “speculation.” Since the markets are a zero-sum game, the Turtles learned that even a marginally profitable trader must win money from other market players. By definition, they must use different methods than everyone else in the game.19

  What this means is that only when “good” trades, not necessarily profitable trades, are consistently made over the long run, the chances of profitable results increase dramatically. A bad month, a bad quarter, or even a bad year does not mean much in the grand scheme. The Turtles learned that the most important thing was to have a sound trading approach tested in the real world.20

  Dennis and Eckhardt had that real world of making money figured out. Their philosophy and rules taught in the Turtle classroom were the equivalent of a two-week seminar on how to fly a plane without ever getting in the plane.21

  4

  The Philosophy

  “… when you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

  Sir Arthur Conan Doyle (Sherlock Holmes)

  Dennis and Eckhardt’s two weeks of training were heavy with the scientific method—the structural foundation of their trading style and the foundation on which they had based their arguments in high school. It was the same foundation relied upon by Hume and Locke.

  Simply put, the scientific method is a set of techniques for investigating phenomena and acquiring new knowledge, as well as for correcting and integrating previous knowledge. It is based on observable, empirical, measurable evidence, and subject to laws of reasoning.1 It involves seven steps:

  Define the question.

  Gather information and resources.

  Form hypothesis.

  Perform experiment and collect data.

  Analyze data.

  Interpret data and draw conclusions that serve as a starting point for new hypotheses.

  Publish results.2

  This is not the type of discussion you will hear on CNBC or have with your local broker when he calls with the daily hot tip. Such pragmatic thinking lacks the sizzle and punch of get-rich-quick advice. Dennis and Eckhardt were adamant that their students consider themselves scientists first and traders second—a testament to their belief in doing the “right thing.”

  The empiricist Dennis knew that plugging along without a solid philosophical foundation was perilous. He never wanted his research to be just numbers bouncing around in a computer. There had to be a theory, and then the numbers could be used to confirm it. He said, “I think you need the conceptual apparatus to be the first thing you start with and the last thing you look at.”3

  This thinking put Dennis way ahead of his time. Years later, the academic Daniel Kahneman would win a Nobel Prize for “prospect theory” (behavioral finance), a fancy name for what Dennis was actually doing for a living and teaching his Turtles. Avoiding the psychological voltage that routinely sank so many other traders was mandatory for the Turtles.

  The techniques that Dennis and Eckhardt taught the Turtles were different from Dennis’s seasonal spread techniques from his early floor days. The Turtles were trained to be trend-following traders. In a nutshell, that meant that they needed a “trend” to make money. Trend followers always wait for a market to move; then they follow it. Capturing the majority of a trend, up or down, for profit is the goal.4

  The Turtles were trained this way because by 1983, Dennis knew the things that worked best were “rules”: “The majority of the other things that didn’t work were judgments. It seemed that the better part of the whole thing was rules. You can’t wake up in the morning and say, ‘I want to have an intuition about a market.’ You’re going to have way too many judgments.”5

  While Dennis knew exactly where the sweet spot was for making big money, he often fumbled his own trading with too many discretionary judgments. Looking back, he blamed his pit experience, saying, “People trading in the pit are very bad systems traders generally. They learn different things. They react to the [price] ‘tick’ in your face.”6

  Dennis and Eckhardt did not invent trend following. From the 1950s into the 1970s, there was one preeminent trend trader with years of positive performance: Richard Donchian. Donchian was the undisputed father of trend following. He spoke and wrote profusely on the subject. He influenced Dennis and Eckhardt, and just about every other technically minded trader with a pulse.

  One of Donchian’s students, Barbara Dixon, described trend followers as making no attempt to forecast the extent of a price move. The trend follower “disciplines his thoughts into a strict set of conditions for entering and exiting the
market and acts on those rules or his system to the exclusion of all other market factors. This removes, hopefully, emotional judgmental influences from individual market decisions.”7

  Trend traders don’t expect to be right every time. In fact, on individual trades they admit when they are wrong, take their losses, and move on. However, they do expect to make money over the long run.8 In 1960, Donchian reduced this philosophy to what he called his “weekly trading rule.” The rule was brutally utilitarian: “When the price moves above the high of two previous calendar weeks (the optimum number of weeks varies by commodity), cover your short positions and buy. When the price breaks below the low of the two previous calendar weeks, liquidate your long position and sell short.”9

  Richard Dennis’s protégé Tom Willis had learned long ago from Dennis why price, the philosophical underpinning of Donchian’s rule, was the only true metric to trust. He said, “Everything known is reflected in the price. I could never hope to compete with Cargill [today the world’s second-largest private corporation, with $70 billion in revenues for 2005], who has soybean agents scouring the globe knowing everything there is to know about soybeans and funneling the information up to their trading headquarters.” Willis has had friends who made millions trading fundamentally, but they could never know as much as the big corporations with thousands of employees. And they always limited themselves to trading only one market. Willis added, “They don’t know anything about bonds. They don’t know anything about the currencies. I don’t either, but I’ve made a lot of money trading them. They’re just numbers. Corn is a little different than bonds, but not different enough that I’d have to trade them differently. Some of these guys I read about have a different system for each [market]. That’s absurd. We’re trading mob psychology. We’re not trading corn, soybeans, or S&P’s. We’re trading numbers.”10

  “Trading numbers” was just another Dennis convention to reinforce abstracting the world in order not to get emotionally distracted. Dennis made the Turtles understand price analysis. He did this because at first he “thought that intelligence was reality and price the appearance, but after a while I saw that price is the reality and intelligence is the appearance.”11

  He was not being purposefully oblique. Dennis’s working assumption was that soybean prices reflected soybean news faster than people could get and digest the news. Since his early twenties, he had known that looking at the news for decision-making cues was the wrong thing to do.

  If acting on news, stock tips, and economic reports were the real key to trading success, then everyone would be rich. Dennis was blunt: “Abstractions like crop size, unemployment, and inflation are mere metaphysics to the trader. They don’t help you predict prices, and they may not even explain past market action.”12

  The greatest trader in Chicago had been trading five years before he ever saw a soybean. He poked fun at the notion that if “something” was happening in the weather, his trading would somehow change: “If it’s raining on those soybeans, all that means to me is I should bring an umbrella.”13

  Turtles may have initially heard Dennis’s explanations and assumed he was just being cute or coy, but in reality he was telling them exactly how to think. He wanted the Turtles to know in their heart of hearts the downsides of fundamental analysis: “You don’t get any profit from fundamental analysis. You get profit from buying and selling. So why stick with the appearance when you can go right to the reality of price?”14

  How could the Turtles possibly know the balance sheets and assorted other financial metrics of all five hundred companies in the S&P 500 index? Or how could they know all the fundamentals about soybeans? They couldn’t. Even if they did, that knowledge would not have told them when to buy or sell along with how much to buy or sell.

  Dennis knew he had problems if watching TV allowed people to predict what would happen tomorrow—or predict anything for that matter. He said, “If the universe is structured like that, I’m in trouble.”15 Fundamental reporting from CNBC’s Maria Bartiromo would have been called “fluff” by the C&D Commodities teaching team.

  Michael Gibbons, a trend-following trader, put using “news” for trading decisions in perspective: “I stopped looking at news as something important in 1978. A good friend of mine was employed as a reporter by the largest commodity news service at the time. One day his major ‘story’ was about sugar and what it was going to do. After I read his piece, I asked, ‘how do you know all of this?’ I will never forget his answer; he said, ‘I made it up.’”

  However, trading a la Dennis was not all highs. Regular small losses were going to happen as the Turtles traded Dennis’s money. Dennis knew the role confidence would play. He said, “I suppose I didn’t like the idea that everyone thought I was all wrong, crazy, or going to fail, but it didn’t make any substantial difference because I had an idea what I wanted to do and how I wanted to do it.”16

  The Turtles’ core axioms were the same ones practiced by the great speculators from one hundred years earlier:

  “Do not let emotions fluctuate with the up and down of your capital.”

  “Be consistent and even-tempered.”

  “Judge yourself not by the outcome, but by your process.”

  “Know what you are going to do when the market does what it is going to do.”

  “Every now and then the impossible can and will happen.”

  “Know each day what your plan and your contingencies are for the next day.”

  “What can I win and what can I lose? What are probabilities of either happening?”

  However, there was precision behind the familiar-sounding euphemisms. From the first day of training, William Eckhardt outlined five questions that were relevant to what he called an optimal trade. The Turtles had to be able to answer these questions at all times:

  What is the state of the market?

  What is the volatility of the market?

  What is the equity being traded?

  What is the system or the trading orientation?

  What is the risk aversion of the trader or client?

  There was no messing around in Eckhardt’s tone, as he suggested that these were the only things that had any importance.17

  What is it the state of the market? The state of the market simply means. “What is the price that the market is trading at?” If Microsoft is trading at 40 a share today, then that is the state of that market.

  What is the volatility of the market? Eckhardt taught the Turtles that they had to know on a daily basis how much any market goes up and down. If Microsoft on an average trades at 50, but typically bounces up and down on any given day between 48 and 52, then Turtles were taught that the volatility of that market was four. They had their own jargon to describe daily volatilities. They would say that Microsoft had an “N” of four. More volatile markets generally carried more risk.

  What is the equity being traded? The Turtles had to know how much money they had at all times, because every rule they would learn adapted to their given account size at that moment.

  What is the system or the trading orientation? Eckhardt instructed the Turtles that in advance of the market opening, they had to have their battle plan set for buying and selling. They couldn’t say, “Okay, I’ve got $100,000; I’m going to randomly decide to trade $5,000 of it.” Eckhardt did not want them to wake up and say, “Do I buy if Google hits 500 or do I sell if Google hits 500?” They were taught precise rules that would tell them when to buy or sell any market at any time based on the movement of the price. The Turtles had two systems: System One (S1) and System Two (S2). These systems governed their entries and exits. S1 essentially said you would buy or sell short a market if it made a new twenty-day high or low.

  What is the risk aversion of the trader or client? Risk management was not a concept that the Turtles grasped immediately. For example, if they had $10,000 in their account, should they bet all $10,000 on Google stock? No. If Google all of a sudden dropped, they could lose all $10,000 fa
st. They had to bet a small amount of the $10,000, because they didn’t know whether or not a trade was going to go in their favor. Small betting (for example, 2 percent of $10,000 on initial bets) kept them in the game to play another day, all the while waiting for a big trend.

  Class Discussion

  Day after day, Eckhardt would emphasize comparisons. Once he told the Turtles to consider two traders who have the same equity, the same system (or trading orientation), and the same risk aversion and were both facing the same situation in the market. For both traders, the optimal course of action must be the same. “Whatever is optimal for one should be optimal for the other,” he would say.18

  Now this may sound simple, but human nature causes most people, when faced with a similar situation, to react differently. They tend to outthink the situation, figuring there must be some unique value that they alone can add to make it even better. Dennis and Eckhardt demanded that the Turtles respond the same or they were out of the program (and they did end up cutting people).

  In essence Eckhardt was saying, “You are not special. You are not smarter than the market. So follow the rules. Whoever you are and however much brains you have, it doesn’t make a hill of beans’ difference. Because if you’re facing the same issues and if you’ve got the same constraints, you must follow the rules.” Eckhardt said this in a far nicer, more professorial and academic way, but that was what he meant. He did not want his students to wake up and say, “I’m feeling smart today,” “I’m feeling lucky today,” or “I’m feeling dumb today.” He taught them to wake up and say, “I’ll do what my rules say to do today.”