Stock Market Wizards

by Jack D. Schwager

  “I’m not going to have that problem,” he said, “because I’m going to close out my positions every day.” Six months later, he gave up trading. He did two things wrong: First, his primary passion was tennis.

  Second, trading wasn’t a vocation to him; it was a hobby, and hobbies cost you money.

  What are some other reasons people fail as traders?

  People underestimate the time it takes to succeed as a trader. Some people come here and think they can sit with me for a week and become great traders. How many people when they went to college would’ve thought to walk up to the professor and say, “I know the course is for a semester, but I think a week should be enough for me to get it.” Gaining proficiency is the same in trading as in any other profession—it requires experience, and experience takes time.

  A man who attended one of my seminars a number of years ago asked me, “How long will it take me to become a professional trader so I can quit my job and support my family?”

  “Three to five years,” I said.

  “What! I’m going to do it in six months,” he answered.

  “Well, you’re probably a lot smarter than I am,” I said. “I didn’t make any money in my first five years.”

  It’s seven years later, and he’s still not profitable as a trader. You can’t expect to become a doctor or an attorney overnight, and trading is no different. It is a vocation that takes time, study, and experience.

  Wisdom is a product of knowledge and experience. If you have more knowledge, you can get away with less experience and vice versa. If you can get both, the learning curve is very steep.

  Why else do people fail as traders?

  Another common reason is undercapitalization. Sometimes I get people at my seminars who want to start trading with $10,000. I tell them that they should convert the $10,000 into hundred-dollar bills and then flush them down the toilet one at a time because if they try trading with $10,000, the result will be the same, but it will only prolong the agony. Ten thousand dollars is not enough money to trade.

  All the reasons for failure you have mentioned so far relate to the attitude with which people approach trading: a lack of commitment or funds going in. What flaws besides attitude cause people to fail as traders?

  It’s not a matter of intelligence, or even market knowledge. I’ve seen people with good trading skills fail, and those without any previous experience succeed. The main thing is that every trader has to be honest about his or her weakness and deal with it. If you can’t learn to do that, you will not survive as a trader.

  Several years ago, an option trader who had scheduled to come visit me at my office asked whether I would be willing to review his trades for the past year before he came. I agreed because I genuinely want to teach people how to trade.

  He said, “I had 84 percent winning trades last year.”

  “Good,” I said, “did you make any money?”

  “Well, no,” he answered, “I lost money for the year.”

  “Then the 16 percent is what we need to focus on,” I said.

  “That’s why I wanted to send you my trades.”

  He sent me his trades, and I found that out of about four hundred trades he did that year, five trades accounted for almost all his losses. At first I didn’t notice any common denominator. Then I checked the dates and discovered that four out of five of these trades had been done on expiration Fridays. I called him up and said, “I found your problem.”

  “Oh good,” he said. “What did you find?”

  “Four out of five of your big losing trades were done on an expiration Friday.”

  “Oh, I knew that,” he answered.

  “Well, there is a way to fix this problem,” I told him.

  “Good, good,” he said. “I knew you would have the answer.”

  “Don’t trade on expiration Fridays.”

  “Mark, what are you talking about? Those are the most exciting trading days.”

  “You have to decide whether you want excitement or you want to make money. Quit trading on expiration Fridays. Go out and do something else on those days.”

  “Oh no, I can’t do that,” he said. “I can’t give up the action on that day. I’ll figure out how to fix the problem.”

  “If you don’t fix this problem by quitting,” I told him, “it’s going to quit you.”

  Six months later, he was bankrupt. He knew indicators inside and out. He was a workaholic and very intelligent. He even knew how to take losses most of the time. But he just couldn’t stand aside on that one trading day. He had identified his problem, but he couldn’t fix it.

  Any other stories come to mind about traders you tried to help, but who ultimately failed?

  A few years ago, a man who attended one my seminars called me for advice. He told me that he wanted to become a full-time trader but had been unsuccessful so far. I gave him some advice about devising a business plan for his trading. He called a couple more times for additional advice. On one such call, his voice suddenly dropped. “I can hardly hear you,” I said. “We must have a bad connection.”

  “No,” he whispered, “my wife just walked into the room.”

  “She doesn’t know how much money you have lost, does she?” I asked.

  “No,” he admitted.

  “You have to tell her the truth. If she doesn’t support you, and you are fearful of her, nothing I teach you will help. If you keep trading secretly, one of two things will happen: you will lose all your money, or you will lose your marriage.” He didn’t listen to me, and he ended up losing both.

  What happened during September–December 1997? It was the only sustained losing period I saw in the statements you sent me and completely uncharacteristic in terms of your other trading. I believe you lost over $300,000 during a four-month period.

  I find that as the year progresses, I tend not to do as well. I just chalk it up to my getting tired or sloppy toward the end the year.

  But that doesn’t explain it. This period was so much worse than any other period, including the latter part of other years, that there must be some other explanation.

  [Cook rambles on further, trying to explain in general terms why he may have done poorly during that period. Then finally, a memory clicks.] Ah, you’re absolutely right! I had forgotten about it. In July 1997, I fell and severely tore the ACL in my knee [a ligament in the center of the knee]. I wore a brace and was on pain medication. I finally had an operation in December.

  Did the pain medication make you drowsy?

  It threw my focus off. I wasn’t as sharp. I felt as if I were moving in slow motion. I was also worried that I might never be able to play basketball with my kids again.

  It sounds like you were depressed during that period.

  Yes, I had gone from being physically active, both in sports and on the farm, to barely being able to walk. I put on over thirty pounds during those few months.

  If your operation was in December, then your trading seemed to recover immediately afterward.

  Yes it did. I felt so much better. I threw myself into rehabilitation, although I probably overdid it. I’m a gung ho type of guy. Two weeks after my operation, the physical therapist came over to me while I was on the weight machine and said, “We do lots of rehabilitation on ACL injuries. I will tell you just one thing, and maybe it will hit home: No one we had in here after ACL reconstructive surgery ever lifted as much weight as you are now. Do you get my point?” I backed off immediately.

  [About a week after the interview, I spoke to Cook on the phone, and he told me he had asked his assistant, Stacie, about her impression of him during this injury period. She told him, “You couldn’t walk. You even had trouble sitting because you were in such discomfort. You had pain in your face. You were just a shell of yourself, and it poured over into your trading. Once you had your operation, you were like a different person.”]

  Were there any other periods where personal turmoil interfered with your trading?

  In Se
ptember 1995, my father had a heart attack. He was in intensive care for eight days. During that period, I punished myself by doing every damaging trading mistake in the book.

  Why did you feel responsible for your dad’s heart attack?

  He worked so hard. On the day he had his heart attack, it was over ninety degrees, and he was baling hay. My mom told me that he felt a little sick during the middle of the day, came back in, and then went back out to work. He baled four hundred bales of hay on the day he had his heart attack. I thought, “He’s out there doing all that work for $700 or $800, and I’m sitting in an air-conditioned office, making $7,000 or $8,000.” It didn’t seem right to me, so I had to punish myself. When I look back on the trades I did during that period, it almost seems like temporary insanity.

  Then you weren’t doing your regular trades.

  Oh no, I was doing almost the exact opposite.

  Were you aware of what you were doing at the time?

  I didn’t care; I was totally despondent. I think I really wanted to lose money.

  For your style of trading, you have to watch the market closely all day long. Have you had any situations where interruptions cost you money?

  The trade that sticks in my mind most was in January 1987. It was my secretary’s birthday. I never leave the office during the day when I have a position on. But on that day, trying to be a nice guy, I took her out for lunch to celebrate her birthday. When I left the office, the option position I had on was up $30,000. When I came back after lunch, the position was down $40,000. I couldn’t believe the quotes. I always remember that trade. Now I give my secretary a card for her birthday [he chuckles].

  It sounds like a very expensive lunch. Are you sure you would have covered the position if you had stayed in the office?

  Absolutely. That’s one of my cardinal rules. I never let a profit turn into a loss.

  I’ve exhausted my questions. Any final words?

  I represent the average guy out here in rural America, in the U.S. Midwest. I sit in my great-grandfather’s farmhouse, staring at a computer screen, and I can make a living trading. That’s why I believe there is hope for people anywhere to do this. But you have to be willing to work hard and pay your tuition, which is the money you lose while you’re learning how to trade. People ask me all the time, “How long do you think it will take for me to succeed?” I tell them, “three to five years of twelve-hour days and losing money.” Very few people want to hear that.

  * * *

  It’s not over until you give up. Mark D. Cook didn’t just encounter initial failure, he failed repeatedly and spectacularly, losing his entire trading stake several times, and on one occasion, more than his entire net worth. Yet despite that inauspicious beginning and nearly a decade of false starts, Cook never gave up and ultimately triumphed, developing the methodology, business plan, and discipline that allowed him to extract triple-digit returns from the market with astounding consistency.

  In contrast to the conventional wisdom, which advises looking for trades that offer a profit potential several times as large as the risk, most of Cook’s trading strategies seek to make one dollar for every two dollars risked. This observation provides two important lessons, neither of which is that using a wider risk level than the profit objective is a generally attractive approach.

  First, looking at the probability of winning is every bit as essential as looking at the ratio of potential gain to risk. As Cook demonstrates, a strategy can lose more on losing trades than it gains on winning trades and still be a terrific approach if its probability of winning is high enough. Conversely, a strategy could make ten times as much on winning trades as it gives up on losing trades and still lead to financial ruin if the probabilities are low enough. Consider, for example, betting continuously on the number seven in roulette: when you win, you will win thirty-six times what you bet, but if you play long enough, you are guaranteed to lose all your money because your odds of success are only one in thirty-eight.

  Second, in choosing a trading approach, it is essential to select a method that fits your personality. Cook is happy to take a small profit on a trade but hates to take even a small loss. Given his 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. But these same methods could be very uncomfortable, and hence unprofitable, for others to trade. Trading is not a one-size-fits-all proposition; each trader must tailor an individual approach.

  Personal problems can decimate a trader’s performance. Consider, for example, Cook’s uncharacteristic large losses during his knee injury and his father’s heart attack. The moral is: If you are experiencing physical or emotional distress, either stop trading altogether, or reduce your trading activity to a level at which you can’t do much damage. If Cook himself is guilty of any serious trading sin during the past decade, it is failing to heed this advice—a mistake he is determined not to repeat.

  Most aspiring traders underestimate the time, work, and money required to become successful. Cook is adamant that to succeed as a trader requires a complete commitment. You must approach trading as a full-time business, not as a part-time interest. Just as in any entrepreneurial venture, you must have a solid business plan, adequate financing, and a willingness to work long hours. Those seeking shortcuts need not apply. And even if you do everything right, you should still expect to lose money during the first few years—losses that Cook views as tuition payments to the school of trading. These are cold, hard facts that many would-be traders prefer not to hear or believe, but ignoring them doesn’t change the reality.

  * * *

  Update on Mark D. Cook

  Cook has continued to roll along in his trading. Given his methodology, it makes no difference to him whether stocks are in a bull market or a bear market. For comparison, though, during the April 2000–September 2002 period when the S&P 500 declined by 45 percent and the Nasdaq by 75 percent, Cook’s trading account realized a cumulative 114 percent profit compounded (84 percent if measured as cumulative dollars profit divided by the average account equity level).

  In our first interview, we talked about the pattern of your trading showing dramatic deterioration in times when you faced personal stress. I know during the past two years you have had to deal with serious illness of a family member, but trading-wise you seem to have handled it better. Did you change what you do under such circumstances?

  The main thing I did was scale back on my size. I knew from past experience that I couldn’t be at 100 percent when I had personal problems. I realized that one of the reasons I traded poorly when I was under stress in my personal life was that if something went wrong when I was already in a weakened emotional state, it pushed me over the edge. I wasn’t rational anymore, and I always ended up giving back too much money. I thought that instead of not trading at all, I could just cut back my position size, and still keep my rationality.

  When everything is normal, and I’m not dealing with outside stress, I know what my appropriate position size should be, and I adjust it for market volatility. But when I have external problems gnawing at me, I’m not in the right mode to be trading that size. I never adjusted for that before, but in the past two years I have.

  I not only reduced my position size, but I also traded fewer days. I was going over my monthly summary sheets before you called, and I noticed that many months I traded on only eleven or twelve days instead of my normal eighteen to twenty days. By trading less, I was picking my best spots. If I didn’t get what I considered a concrete signal, I didn’t trade that day.

  Has your trading methodology changed at all during the past two years?

  Yes, it has. In the past, I used to let some trades get away from me, which would lead to a large drawdown. Now, I use what I call an “insurance stop” on my initial trade each day. It’s just like fire insurance on your house: You hope you never need it, but you need to have it just in case you do. The insurance stop is n
ot based on any technical point or any analysis; it is simply used to limit my maximum daily loss to a given dollar amount.

  When I wrote my business plan at the start of the year I arbitrarily picked a $25,000 maximum loss on my first trade of the day because I know I can get that back pretty easily. If I get hit on one of these insurance stops, the market is doing something that I don’t understand, and I shouldn’t be trading. For example, two weeks ago when the S&P 500 broke below the 900 level, my insurance stop was triggered. Initially, I felt sick about being hit with that loss, but then the market immediately went down another 30 or 40 full points, and I felt a lot better about it.

  How much would you have lost on that trade if you didn’t have the stop?

  It probably would have cost me $100,000.

  You only put your insurance stop in on the first trade of the day?

  Yes.

  But aren’t you then leaving yourself vulnerable to a large loss on a subsequent trade?

  No, because I actually give those trades a lot less latitude. The insurance stop is a much wider stop. It would be meaningless on trades later in the day because I become much more selective in my trades as the day goes on. After my first trade, I only put on what I consider very high probability trades, and I’m not willing to give those trades much room.

  I’m different from most people in this respect. For example, I’ve noticed that most people I train will tend to take more risk when they are playing with the market’s money. I’m just the opposite: Once I make a profit, I consider it my money, and I’m not about to let the market take it out of my pocket. So once I’m ahead on the day, I try to make sure I don’t give back much of it.

  One of the side benefits of having the insurance stop is that it has allowed me to go for bigger profits because I know I have a safety net if the trade turns around. It’s like the trapeze artist that might try a triple instead of double somersault when he knows he has a net beneath him.

  I assume that most of the people you train must have a bullish bias, which would have been problematical during the past two years. Have you found that to be the case, and if so what advice have you given them?