Stock Market Wizards

by Jack D. Schwager

  Did you ever manage money, or have you always traded just your own account?

  In 1989, I decided to get into money management. I asked people I knew in the business what I needed to do as an unknown in the middle of nowhere to attract investors. One person suggested that I enter the U.S. Investing Championship [a now defunct real money trading contest] to attract greater public visibility. That was the first time I had ever heard of this trading competition. Back in 1989, the contest was held for four-month intervals. I entered the options division category and finished second, making 89 percent for the four months. That gave me enough confidence to think that I could do this. I decided to give up my brokerage business and concentrate just on my own trading.

  Why couldn’t you continue to do both?

  It seemed to me that just about every time I was in a trade and had to do something quickly, a client would call and want to talk about utility stocks or something equally urgent.

  I opened a personal account with a clearing firm in New York that also did business with other money managers. After my account had been active for about three or four months, I received a call from compliance [the company department responsible for making sure that all accounts are traded in accordance with government and industry regulations]. My immediate thought was, “Oh no, what’s the problem now?”

  “I’ve been looking at your account,” the caller said, “and it appears that you only trade options.”

  “That’s right,” I answered warily.

  “It also looks like you only buy options,” he said.

  “That’s right,” I answered. “I don’t believe in selling options.”

  “Why not?” he asked.

  “Too much risk,” I said.

  “I reviewed all your trades since you opened your account with us,” he said.

  “Is there a problem?” I asked.

  “No, as a matter of fact, I have never seen anybody who can trade like you do.”

  “What exactly does that mean?” I asked.

  “Well, for starters, you are the shortest-term trader I have ever seen. In fact, it seems like you never hold a position for more than three days. Why is that?” he asked.

  “That’s because after years and years of trading experience, I have learned that if I hold positions for more than three days, it diminishes my return. When you buy an option, the premium steadily evaporates over time. It’s like holding an ice cube in your hand: the longer it’s there, the more it diminishes until finally it doesn’t exist at all. You are in the compliance department,” I said. “Is there a problem?”

  “We have been looking for someone like you for a long time. We are waiting for you to get a one-year track record before offering you as a money manager to our clients. I wasn’t supposed to contact you until this point because we thought it probably would change your trading pattern if you knew you were being watched.”

  “You don’t know me,” I said. “That’s not going to happen.”

  “We’ll see,” he said.

  Had he been tracking your account because he was looking for potential in-house money managers?

  Oh no, he started following me from a compliance standpoint to shut me down. I assume the fact that I was trading only options and turning over my trades very quickly must have sent up all sorts of red flags.

  He continued to monitor my account, and after the account reached the one-year mark, he called again. “You actually did better after you knew I was watching you,” he said.

  “I guess you gave me a bit of incentive,” I answered.

  “I can’t sell this, though,” he said.

  “Why not?” I asked.

  “You did too well. No one is going to believe these numbers. But don’t worry, I’m going to raise money for you anyway. I don’t have to show your track record. People will just invest with you based on my recommendation.”

  He pulled together a number of small accounts into a single million-dollar account, which I started trading at the beginning of 1991. If you recall, that was right at the brink of the United States’ launching an attack on Iraq, and the stock market had been selling off precipitously. The cumulative tick indicator was signaling that the market was heavily oversold. On January 4, I started buying S&P index calls [an option position that bets on a rising market]. I continued to add to the position over the next few days.

  Wait a minute. I thought you held positions only for a maximum of three days.

  That’s true for most of my trades. There is one major exception: if my cumulative tick indicator, which only sets up a few times a year, is still telling me to buy, then I will hold a position beyond three days. When the tick indicator sets up, the market sometimes responds immediately, but I’ve also seen it take as long as seven weeks. As long as the indicator is still providing a signal, I will only trade in the same direction. If it’s oversold, I will only buy calls, and if it’s overbought, I will only buy puts. [Puts are option positions that give the buyer the right to sell the stock or index at the strike price and will therefore make money in a declining market.] I still traded in and out of the market, but I kept a core position of long calls. This core position was down about 25 percent. Since for this account I used a money management plan that limited my total investment to one-third of the equity, I was down about 8 percent in terms of total equity.

  On January 7, for the first time, I received a call from the president of the company. I had only been trading the account for one week. “What do you think about the market? he asked.

  I knew what was happening. He was getting worried calls from the investors who were faceless people to me. “Well,” I said, “my cumulative tick indicator is very oversold.” I explained to him that whenever my index was deeply oversold, it signaled a major buying opportunity.

  “How soon until the market goes up?” he asked.

  “It can spring at any time,” I said. “We need a catalyst, but I can’t tell you exactly when that will be.”

  “Your indicators don’t work at all,” he said. “The market is going straight down.”

  “You can pull the plug,” I said, “but I want you to understand that if you do, the investors are going to know that you were the one who closed out the positions, not me.”

  My secretary had been sitting there, listening to my end of the conversation. When I hung up, she said, “Gosh, you were pretty rough with him.”

  “Don’t worry,” I said, “he is not going to close the account and take responsibility. He’s going to leave me out there to hang.”

  On the night of January 10, the United States began its air attack on Iraq, and the next day the market exploded on the upside. Not only did the market go up tremendously, but the sharp increase in volatility also caused option premiums to expand. On January 12, the president of the company called me back.

  Where was the account at this point?

  The option position I held had nearly quadrupled. [Since Cook had invested one-third of the equity, this implies that the account equity had nearly doubled.] By this time, I had already started to take profits on my position. Of course, he knew that I had started liquidating the position when he called.

  “What do you plan to do?” he asked.

  I plan to continue to scale out of the position,” I answered.

  “But it’s really going up now,” he said. “Do you think it will continue?”

  “Yes I do,” I answered, “because my cumulative tick indicator is still oversold.”

  “Then why don’t you hold the position?” he asked.

  “You don’t understand,” I said. “One reason the option premiums have gone up so much is because of the explosion in volatility. [Option prices depend on both the underlying market price and volatility.] Once the volatility starts to ease, option prices may not go up much even if the market continues to rise. Also, I realize now, which I didn’t before you called me last week, that your investors are pretty nervous, and they probably want money in their pockets. Isn�
�t that right?”

  “That’s true,” he answered.

  “Fine,” I said, “we’ll continue to liquidate the position and take it from there.”

  “Mark,” he said, “that’s why you are the trader you are.” Those were his exact words.

  “Thanks for telling me I’m a good trader,” I said for my secretary’s benefit, who had been listening to the conversation intently. “Now you realize that my indicators work—don’t you?”

  “Oh yes,” he answered, “your indicators work.”

  After I hung up the phone, my secretary said, “Wasn’t that nice of him to call and compliment you.”

  “Just watch,” I said. “He will jerk this money just as soon as he can.”

  “Why would he do that?” she asked in disbelief.

  “Because he can’t stand the volatility, and he can’t handle the clients. He also doesn’t understand what I am doing, which makes him a terrible intermediary. His involvement will only lead to doubt and skepticism among the clients. It would be different if I were talking to the clients directly and they could hear the confidence in my voice.” Ironically, I had chosen this type of structure because I wanted to be at arm’s length from the investors so that I wouldn’t be influenced by their emotions. Instead, I ended up with someone in the middle who was just aggravating the situation. “He’ll find some excuse to pull the account,” I told my secretary.

  “How could he find an excuse,” she asked, “when you have nearly doubled their money?”

  “I don’t know,” I said, “but he will find something.”

  By that point, the option premiums had expanded so far that it virtually eliminated any profit opportunities if you were only a buyer of options, as I was. Buying options then was like paying Rolls-Royce prices for a Yugo.

  Did you stop trading?

  Yes, I had to back off. I have to believe a trade has at least a 75 percent chance of being right or else I won’t put it on. I continued to trade very lightly over the next few months, and the account drifted sideways.

  At the end of April, the president of the company called again.

  “How come you’re not trading anymore?” he asked. “Are you afraid?” he sneered.

  “Yes, I’m afraid, but not of what you think. I’m afraid of the marketplace. I don’t see trades that will give me my 75 percent probability of winning, and I’m not going to do any coin-flip trades.”

  “Well, my investors are expecting you to trade,” he said. “Why can’t you do the same thing you did in January?”

  “Because the market is not the same,” I said. “We could do nothing for the rest of the year and still have a good year.”

  “Yeah, you’re still up 85 percent for the year,” he admitted.

  “And the investors aren’t happy with that?” I asked.

  “They saw you double their money in January, and they want you to really go for it. You better do some more trades, Mark,” he said.

  “What does he want now?” my secretary asked after I hung up the phone.

  “Now he wants to force me to trade. Isn’t that interesting. In January he wanted me to shut the account down, and now, when I shouldn’t be trading, he wants me to trade more.”

  What did you do?

  I thought I would put on one trade to keep him happy. Then if it didn’t work out, I could talk him out of pressuring me to trade. But as soon as I put on the trade, I thought to myself that this is stupid; I’m putting on a trade that I think may lose money to prove a point. Sure enough, the trade lost money—not much, maybe 5 percent of the equity. I backed off and stopped trading.

  How were you getting compensated for these accounts?

  I was supposed to get a percent of the profits.

  The standard 20 percent of profits?

  This will give you an idea of how naive I was at the time. They told me, “Don’t worry, we will make it right by you.” I had nothing in writing. I went along with that because I was mainly interested in getting a track record rather than earning anything on this account. I was so hungry to get started that I would’ve taken virtually any deal.

  At the end of May, the president called again. He told me that two of the accounts were pulling their money. “Oh, I guess they have some pressing financial needs,” I conjectured.

  “I’ll be honest with you, Mark,” he said, “there are more investors that are right at the cusp of closing their accounts.”

  “Why?” I asked.

  “Well, you haven’t done anything for us lately,” he answered.

  “Do you realize how much the account is up?” I asked. “If you had told these investors at the beginning of the year that they were going to make 80 percent on their money, don’t you think they would’ve been ecstatic?”

  “Yes, but you did more than that in the first month,” he replied. “During the past four months, you haven’t made anything.”

  “Wait a minute,” I said. “What expectations did these investors have?”

  “I showed them your track record for last year.”

  “You did what!” I exclaimed. “That track record was based on my own account, which trades up to 100 percent of the equity. My account will make three times as much as this account because of the leverage, but the drawdowns will also be three times as large, and I don’t think your investors could handle 40 percent drawdowns.”

  Ten minutes later he called back and said, “We’re shutting the account down.”

  I was so mad, I could have spit blood. I don’t know what he told the investors to make them all pull their money simultaneously. That was my first and last experience in managing any pooled money.

  Did they ever pay you anything on the profits you had made?

  Not a cent.

  As Samuel Goldwyn said, “A verbal contract isn’t worth the paper it’s written on.” What happened after they closed the account?

  I was basically flat for the rest of the year because the environment wasn’t conducive to buying options. In November 1991, I signed up for the 1992 U.S. Trading Championship, which by that time had expanded from a four-month to a one-year contest. In preparation, I researched all my past trades back to the 1970s to find out why I had made money and why I had lost money. I found that Tuesdays were my best day and Fridays my worst.

  Why is that?

  Because it takes me a little while to get warmed up. Mondays I am just getting back into gear, and by Tuesday I’m ready to roll. By the time I get to Friday, I’ve exhausted my energy, and if I have done well for the week, I just don’t have the drive and zeal. So what did I do in 1992? I didn’t trade on any Fridays, and I traded more aggressively on Tuesdays.

  Did your trading change forever because of this analysis?

  Oh yes, it was the best thing that I ever did. That’s when I became a very proficient trader.

  What advice do you have for people who want to follow in your footsteps and trade for a living?

  If you decide to trade for a living, you have to treat it just like any other business endeavor and go into it with a plan. If you want to start a business, and all you do is walk into a bank, smile pleasantly, and ask for a $200,000 loan, do you think you’ll get it? Are they going to say, “You have a really nice smile; here’s the money.” I don’t think so. You need to have a solid business plan. The trouble is that most people start trading without any definitive plan.

  What would a business plan for traders include?

  It should contain specific answers to all of the following questions:

  What markets are you going to trade? You need to select a market that fits your personality because a market is a reflection of the people who trade it. People who trade Internet stocks are definitely different from people who trade utility stocks.

  What is your trading capitalization? On the one hand, you should honestly be able to say, “If I lose all this money, it won’t change my lifestyle.” On the other hand, you need a large enough account so that making at least as much as
you do from your current job is a feasible goal. Otherwise, you will think that you are a failure because you will work harder as a trader than you do at the job you are in now.

  How will orders be entered? Will you scale into positions or put them on all at once? How will you exit losing trades? How will you exit winning trades?

  What type of drawdown will cause you to stop trading and reevaluate your approach? What type of drawdown will cause you to shut down trading?

  What are your profit goals, measured on as short a time frame as is feasible for your trading approach?

  What procedure will you use for analyzing your trades?

  What will you do if personal problems arise that could adversely impact your trading?

  How will you set up your working environment so that it is conducive to trading and maximizes your chances for success?

  How will you reward yourself for successful trading? Will you take a special vacation, buy yourself a new car, etcetera?

  How will you continue to improve yourself as a trader? What books will you read? What new research projects will you do?

  What other advice would you give to people who want to become traders?

  Approach trading as a vocation, not a hobby. I periodically give seminars for traders. I once had a tennis pro who attended my four-day seminar. On the third day, I asked people what they had learned so far and how they were going to apply it. When it was his turn, he said, “I’m not going to give up my tennis career. I give lessons on Tuesdays and Thursdays, so I’m going to trade on Mondays, Wednesdays, and Fridays.”

  “If you do that,” I told him, “I guarantee that Tuesdays and Thursdays will be the days when you will need to be watching the market. You’ll be making a hundred dollars giving a lesson and losing a thousand dollars in the market.”