Stock Market Wizards

by Jack D. Schwager

  How did you have enough money to cover your losses?

  Oh, I was a very good broker. I was the second from the top first-year broker nationwide for the firm. In 1981 I worked out a system for selling options when their premiums seemed too high and found someone to program the rules for me. Every week, the program would spit out a list of potential trades. Since I was selling options that were well out-of-the-money, they almost always expired worthless. Every Friday after the close, I would run the program, and every Monday morning, I would put on the trades. I was rolling along making several thousand dollars a month.

  By May 1982, I had built my account up to $115,000. I reached greater depths of greed. I thought that I’d perfected this and it was working great. I stepped up the trading in my account and my family’s accounts. That month I made an additional $50,000 using the same strategy.

  In June 1982, I decided to step up my trading even more. One week that month I ran my program, and the computer printed out a list of trades involving Cities Service. The stock was trading at $27 at the time, and the 35, 40, and 45 call options were selling for premiums far above the model-implied prices, with only about a week left before expiration. [Options with these strike prices would go to zero unless the stock price rose above these respective levels in the remaining week before their expiration.] I couldn’t believe the prices; I felt as if they were giving me the money. I sold hundreds of these options. I still remember that on June 16, 1982—one day before the day that will live in infamy for me—I tried to sell an additional hundred options at a specific price right before the close, but I didn’t get filled.

  The next day, they announced that Cities Service was going to be bought out for $20 more than my highest strike price option. They shut down trading in the stock and options for the rest of the week and didn’t resume trading until after the option expiration. Of course, the options got exercised [leaving Cook short one hundred shares for each option he had sold], and by the time the stock started trading again, I was down $500,000.

  Did that include your family’s accounts?

  No, that was just my account. I had gone from $165,000 at the start of June to a deficit of over $350,000. In addition, I had lost over $100,000 apiece in accounts I had for my mother, father, and aunt. I still have the trade slips right here in my desk drawer. It wasn’t until last year—seventeen years after this happened—that I was able to pull them out and look at them. I had a margin call in excess of one million dollars on my account, which is what I would have had to put up if I wanted to hold the short stock position instead of buying it back. Technically, you are supposed to have five days to meet the margin call, but the firm was on me to cover the position right away.

  That night I called my mother, which was the hardest phone call I ever had to make. I felt like a complete failure. I felt like I should be put in shackles and hauled away. “Mom,” I said, “I need to talk to you.”

  “What is it?” she asked.

  “I think you need to come over to the house tomorrow morning to discuss it.”

  “It’ll have to be pretty early,” she said, “because I have to get to the college.” [At the time, Cook’s mother, Martha, was chairman of the education department at Malone College in Canton, Ohio, where she still teaches a course in English grammar.]

  “That’s okay, Mom, the earlier, the better.” The next morning, around 6:30 A.M., I looked out my window and saw my mom dragging up the walk at a snail’s pace, which was very uncharacteristic for her.

  She came in and asked, “Mark, what is the problem?”

  “Sit down on the couch, Mom,” I said solemnly.

  She sat down and asked, “What’s wrong, Mark? Is it something serious?”

  “Yes, I’m afraid it is,” I answered. “Mom, I lost $100,000 of your money.”

  She didn’t flinch at all. She looked me straight in the eye and asked sympathetically, “How much did you lose, Mark?”

  “I lost half a million dollars,” I said.

  “But you don’t have half a million dollars.”

  “I know, Mom.”

  “What else?” she asked.

  “What do you mean, ‘what else’?” I asked.

  “Besides losing all this money, what else is wrong?”

  “That’s it, Mom,” I answered.

  “Oh, is that all! I thought you had cancer.”

  Did that ever put things in a different light. Her next sentence to me was unbelievable: “How long will it be until you make it back?” she asked.

  If she would have said anything else, I would have quit. But she had said just the right thing, at the right time. I straightened myself up a bit and said, “Five years,” picking a number out of the air because I had no clue how I would make the money back.

  “If you make the money back in ten years, that’s okay,” she said. “Now go ahead and do it.”

  From that point forward, I never again sold any naked options [option positions that have an open-ended loss if the market goes up or down sharply].

  What eventually happened to Cities Service after the brokerage firm liquidated your account?

  That’s the ironic thing. The deal fell through. If I had been able to meet the margin call, within a month, I would have made back all my money and even had a profit. The takeover offer was made just before expiration and then retracted afterward. There should have been an investigation, but there never was. On the positive side, though, if I had been filled on the last hundred options I was trying to sell the day before the takeover announcement, I would have been forced into bankruptcy.

  How were you able to cover the $350,000 deficit you had in your account?

  My parents gave me $200,000, and I borrowed the remaining $150,000, using my farm as collateral. There is nothing more debilitating than borrowing money to put into a brokerage account to bring it up to zero. I was only twenty-eight years old at the time, and I was determined to claw my way back. I worked fourteen-hour days. I would get up at 5:30 A.M., milk cows until 9 A.M., clean up, go into the office, and work as a broker until 5:30 P.M. When I came home, I changed clothes, went out into the barn to do the milking, and then came back in at 9 P.M. to eat dinner and go to bed. In essence, I was working two full-time jobs. I kept this routine up for five years until I sold the dairy operation.

  Did you maintain this grueling schedule because you were trying to make your money back as quickly as possible?

  I had to keep the farming operation going because I had borrowed against it. Also, remember that this was 1982, which was the virtual peak in the interest rate cycle. My monthly interest-rate payment alone was $8,800. My net worth was probably a negative $200,000. A number of people advised me to declare bankruptcy, but I wouldn’t do it. When I look back at it now, I realize that declaring bankruptcy would probably have been the right business decision. But I wouldn’t be the trader I am today if I had done it, because that would have been admitting defeat.

  Did you also feel that this self-imposed servitude was just punishment?

  I really did.

  How did your wife respond to this whole situation?

  She was actually quite supportive. When I started digging myself out of it, she said, “I’ve never seen anyone who can make money like you can when you’re backed into a corner.” She’s right. Even now, whenever I have a losing month, I just claw like a tiger to make it back. That’s when I work my hardest. When I work fifteen-hour days, my wife knows that my trading is not going well. Conversely, when I’m home early, she’ll say, “Your trading must really be floating along.”

  Most traders that I’ve talked to about losing periods say they ease up or even take a break during those times.

  I do just the opposite. Whenever I am down, the frequency of my trading steps up.

  But aren’t you afraid that you will aggravate your losses by doing that?

  I increase my activity, not my exposure. In fact, the first thing I do when I’m losing is to stop the bleeding. That’s why
I have this sign on my computer. [He points to a sheet that reads GET SMALLER.] I don’t get out of the trade that is hurting me completely; I just reduce the position size. Then the next trade that I do, I feel compelled to make money. It doesn’t matter how much. The point is to rebuild my confidence. Even if I only make a few hundred dollars on that trade, it shows that I can still make money. Once I have a winning trade, I’m ready to go again.

  What advice would you give to other traders about handling losing situations?

  Hope should never be in your vocabulary. It is the worst four-letter word I know. As soon as you say, “Boy, I hope this position comes back,” you should reduce your size.

  What about the flip side—winning streaks—any advice there?

  Never increase the size of your positions on a winning streak. Otherwise you guarantee that you will have your largest position on a losing trade.

  How long was it until you started trading again after the Cities Service disaster?

  Almost two years. The first trade I put on was in April 1984, right after the birth of my first daughter.

  Were you profitable when you resumed trading?

  I was approximately breakeven for 1984 and 1985. My first big profitable year was 1986.

  Did something change then?

  Yes, I had developed my cumulative tick indicator. In 1986, I began keeping a daily trading diary. Every day I wrote down recurrent patterns that I noticed in the market. One indicator that appeared to be useful was what is called the tick, which is the number of New York Stock Exchange stocks whose last trade was an uptick minus the number whose last trade was a downtick. When the market is going up, the tick will be positive, and when it’s going down, it will be negative. I noticed that whenever the tick became very negative, the market would tend to snap back on the upside. Conversely, strongly positive tick readings seemed to be followed by sell-offs.

  I asked a broker who had been in the business for thirty years what it meant when the tick got very positive or negative. He said, “A negative tick means the stock market is going down, and a positive tick means it is going up.”

  “Yeah, I know that,” I said, “but what do I do when the tick is very positive or negative?”

  “Well, if it’s a high plus, you buy, and if it’s a high minus, you sell,” he answered. I asked a number of other brokers the same question, and they gave me the same advice.

  Since this advice contradicted my observations, I did just the opposite: When the tick went above plus 400, I would sell, and when it went below minus 400, I would buy. I recorded the results in my diary and confirmed that this strategy was making money. I noticed, however, that the more minus the tick became, the more the market would snap back, and the more positive it became, the more the market would sell off. That’s how I got the idea of keeping a cumulative count on the tick, which evolved into my cumulative tick indicator. I have never had this indicator fail, but you need nerves of steel to trade with it because the market is always in a panic situation—usually because of an external news event—when the readings get extreme.

  I know your cumulative tick indicator is a proprietary measure, but what can you tell me about it?

  The calculation ignores periods when the tick is in a neutral band, which I define as a reading between-400 to +400. When the tick is beyond these thresholds, a reading is recorded at fixed time intervals and added to a running total. When this total gets below the historical 5th percentile, it signals an oversold situation [a buying opportunity], and when it gets above the 95th percentile it signals an overbought situation [a selling opportunity].

  How long did it take you to recover the $350,000 trading deficit that was left over from the Cities Service trade?

  Five years, measured from the Cities Service trade, which was three years after I resumed trading. The big year was 1987. When I say that, people automatically assume that I must have been short during the October crash, but I actually made most of the money during the bull market earlier that year.

  At that time I wasn’t day trading yet. In May 1987 I saw what I believed was a phenomenal buying opportunity in stock index call options. Two factors had converged: my cumulative tick indicator was giving extremely bullish readings, and the decline in volatility had made the option premiums very cheap. My grandfather used to tell me, “Buy things when people don’t want them, and sell things when people want them.” I put $55,000 into long-term, out-of-the-money stock index calls that were trading at ½ to 5/8. [In this type of option position, the trader can make multiples of the initial outlay if there is a huge price advance, but lose the entire investment in any other price scenario.] I bought well over a thousand options. During the next few months, stock prices exploded and the volatility shot up—a combination that caused the value of my options to soar.

  Ever since the Cities Service disaster in 1982, I had wanted to demonstrate to my parents that I wasn’t a failure. On August 7, 1987, I went over to see them. I told them, “I’m trading options again.”

  “Oh no!” exclaimed my dad. “What is the bad news this time?”

  “Well, Dad, that is why I’m here,” I answered.

  “Why do you trade those things, Mark? Didn’t you learn your lesson? Do you have a problem again?”

  “Yes, I have an income tax problem,” I answered. “The calls I bought are worth $750,000.”

  “How much did you invest?” my father asked.

  “Fifty-five thousand dollars,” I answered.

  “Gosh, take it!” he said.

  “No,” I said, “they are going up more tomorrow.” The next day I cashed out the position for a $1.4 million-dollar profit.

  What else do you base your trading decisions on besides the cumulative tick indicator?

  The cumulative tick indicator is an intermediate tool that only sets up about two to four times a year; the rest of the time, it’s in a neutral reading. I have a variety of different trades I use.

  Can you give me an example of some of them?

  One trade I do I call a “conjunction trade” because it requires two simultaneous conditions for a buy signal: the tick going below-400 and the tiki, which is a tick indicator based on the thirty Dow Jones stocks, going below-22. I give this trade only twenty-one minutes to work. Whenever I get a signal, I set my egg timer. [He winds up the egg timer on his desk, which ticks audibly as it unwinds during the ensuing conversation.] I picture the egg timer as a bomb, and I have to be out of the position before it goes off. I will liquidate the position when any of the following three things happen: I get my 3-point profit objective, my 6-point stop-loss is hit, or the twenty-one-minute time limit is running out.

  Why twenty-one minutes?

  Because of the trading diaries that I keep. I’ve recorded these trades time and time and time again. The best trades work the quickest. I found that you should make three points within the first ten minutes. After ten minutes, the trade could still work, but the odds are much lower. Once you get to fifteen minutes, the odds are so reduced that all you want to do is get out the best you can. The more time that goes by, the lower the probability that the objective will be reached.

  I note that you are using a risk point that is twice as large as your objective. That’s fairly unorthodox.

  It’s all a matter of probabilities. I like high-probability trades. This trade, as many of the other trades I do, works approximately seven out of eight times on average. If I make 3 points seven times and lose 6 points one time, I still come out ahead 15 points across eight trades.

  Another trade I do involves watching the ratio between the S&P and Nasdaq. I use this information to decide which market I will trade if I get a signal. If I get a buy signal on one of my other indicators, I will buy the index that is relatively stronger that day. And if I get a sell signal, I will sell the index that is relatively weaker.

  What would be an example of a signal?

  I have a trade that I called a “tick buy,” which means that if the tick gets to-100
0, I will buy because the market will tend to snap back after that point.

  In other words, if you get a tick buy signal, which implies a sharply declining market, you’ll buy the index—S&P or Nasdaq—that is less weak.

  That’s right.

  Can you give me any other examples of trades that you do?

  One trade I call a “catapult trade” because it’s just like a catapult, which gets bent back until it springs and then the projectile flies over a threshold. For example, if the S&P is trading back and forth in a range between 1350 and 1353, and each time it pulls back, it holds a little higher, then I’ll expect it to catapult above the top of the range by the width of the range, or to 1356. The reason the trade works is because stops tend to build up right above the catapult point.

  Another trade I do is the bond ratio trade. The bonds and S&P are like a couple. The bond market always leads, so it is the female, because the male always follows the female. When a couple first start to date, they don’t know each other yet, and they will be a bit out of harmony. On analogous markets days, when the bonds go up, the S&P may also go up, but it won’t follow very tightly. Then they get engaged, and the relationship becomes closer. Then they get married and go on a honeymoon. When they are on a honeymoon, everything they do is synchronous. On “honeymoon days” in the markets, when I see the bonds go up a few ticks, I know the S&P will immediately follow, and I will buy the S&P for a quick trade. After the honeymoon, when they settle into married life, the bonds will drag the S&P husband along, but they are not quite as joined as they once were. Then the couple gets estranged, or in market terms, whenever the bonds go up, the S&P will likely go down. Then comes the bitter divorce. On “divorce days” the bonds and S&P will move in exactly opposite directions. Every day, I make a determination of what type of day it is. Today, for example, the bonds were going up, and the S&P was selling off. The Street called it a “flight to quality,” but to me it was just a “divorce day.”