Stock Market Wizards

by Jack D. Schwager

  Didn’t everyone just fold once you played a hand?

  No, and you know why?—because they were not disciplined, and they wanted to play. The key is to know when to do nothing. Most people, even if they have a winning strategy, will not follow it because they lack discipline. For example, everyone knows how to lose weight: you eat less fat and exercise. So why are most people over-weight (assuming they don’t have a medical problem)? Because they lack discipline.

  I guess the analogy to the markets is that when you put on a trade, for a short while you get to see how it works out for limited risk. If it isn’t working out, you take a small loss, and if it goes in your favor, you have the potential for a large gain.

  That’s right. I have a saying: “Being wrong is acceptable, but staying wrong is totally unacceptable.” Being wrong isn’t a choice, but staying wrong is. To play any game successfully, you have to have some skill, an edge, but beyond that it’s money management. That’s true whether you’re playing poker or investing. In either case, the key is managing the downside. Good traders manage the downside; they don’t worry about the upside.

  You can’t get beat if you have a great defense. I would always prefer to bet on a football team that has a great defense as opposed to one that has a great offense. If a trade doesn’t work out quickly, I take a small loss, and I may have to take a small loss many times.

  What if you get stopped out of a trade five times? Don’t you find it difficult to get back in the sixth time?

  Not if it meets my criteria. Again, poker provides a good analogy. Previous hands mean nothing. The current hand determines the probabilities. You have to make the correct decision based on that information. Whether you lost or won in previous hands is totally irrelevant. Therefore, I have no problem putting on the same trade many times.

  Early on, when I got stopped out of a position, that was it. I wiped it out of my mind and started looking for another stock. I began to notice, however, that many times I would get stopped out of a stock, then look at it a few months later and see that it had doubled or even tripled. I would exclaim to myself, “God, I was in that stock!” I realized that I needed to develop a plan to get back on board after I was stopped out of a position.

  I guess there is a psychological difficulty involved in reentering a position at a higher price after you’ve been stopped out.

  Yes, and even worse, you might get stopped out again. If you are, can you get in a third time? I can do it as many times as necessary to get the trade right. Sometimes when a stock stops you out several times, it sets up as a much higher probability trade.

  Can you give me a specific example?

  Let’s say I buy a stock because of a signal by my model and the market dips enough to stop me out. The stock then witnesses a huge reversal and closes near the high of the day. That price action may be an indication that there was a shakeout, which knocked out most of the weak hands, and the stock is ready to go up. Putting the long position back on at that point may well be a higher probability trade than the original trade.

  In that type of situation, do you get in on the close or on the next opening?

  It depends. I have specific setups that must be met before I enter the trade.

  What do you mean by a setup?

  The initial condition is based on the long-term price action. Then there are confirming fundamental conditions, which may be overridden in certain circumstances. Finally, determining the entry point is based strictly on the price action.

  I assume the type of price action you’re using for confirmation to enter a trade is much shorter term than the type of price action you initially use to screen for a potential buy candidate?

  That’s correct.

  In other words, you might call your combination of entry conditions a price action sandwich.

  That’s exactly what it is—a price action sandwich.

  * * *

  One of Minervini’s associates who had been sitting in as an observer during the interview chuckled at this last remark. Apparently he considered the analogy apt and had certainly never heard the methodology described this way.

  * * *

  Were there any other major pivotal points in your transition from failure to success?

  After I had been trading for several years following my initial wipeout in the markets, I decided to do an analysis of all my trades. I was particularly interested in seeing what happened to stocks after I sold them. When I was stopped out of a stock, did it continue to go lower, or did it rebound? When I took profits on a stock, did it continue to go higher? I got tremendous information out of that study. My most important discovery was that I was holding on to my losing positions too long. After seeing the preliminary results, I checked what would have happened if I had capped all my losses at 10 percent. I was shocked by the results: that simple rule would have increased my profits by 70 percent!

  Yes, but did you take into account the fact that by capping your losses, you were also knocking out some previous winners that initially went down more than 10 percent and then rebounded?

  You’re absolutely right, and that was the next thing I checked. I found that it didn’t make too much of a difference. Capping my losses at 10 percent only knocked out a few of my winners. I noticed that the winning trades usually worked from the onset. I realized that it was not only totally unnecessary to go through the pain of holding on to positions with large open losses, but also actually detrimental to do so.

  I also realized that by holding on to some of my losing positions for extended periods of time, I was tying up my capital. Therefore, the impact of the large losers went beyond the losses themselves, since holding on to these positions was keeping me from making profits elsewhere. If I took this impact into account, the benefit of capping my losses was astronomical.

  Based on your earlier comments, you are obviously risking far less than the 10 percent maximum loss cap you used in this study. How do you decide where to place your stop-loss points?

  Not every trade I put on is the same. I will use much wider stops on long-term trades than short-term trades. I will also use much wider stops when I think the market is in the early stages of a bull move than if I think the market is overdone and due for a correction. The essential principle is that the stop-loss point should be a function of the expected gain.

  Do any other experiences stand out as important in your transformation into a highly successful trader?

  I learned not to impose any artificial restrictions on my upside potential. At one point during the summer of 1995, I was up over 100 percent year to date, which achieved my original goal for the entire year. I was seriously considering booking the year. A friend of mine asked, “What makes you think you can’t make 200 percent?” I thought about it for a day or two, and said to myself that he’s right. I ended that year up 407 percent.

  I know you use both fundamental and technical analysis. Do you weight one more than the other?

  Roughly speaking, I would say my weighting is fifty-fifty. But there is an important distinction between the relative importance I assign to price action versus fundamentals. Although I would never bet on my fundamental ideas without some confirming price action, I might consider buying a stock with apparent negative fundamentals if its relative price performance is in the top 2 percent of the market.

  Why is that?

  Because the price action may be telling you that the stock is discounting a potential change in the fundamentals that is not yet evident. The combination of strong price action and weak current fundamentals often occurs in turnaround companies or companies with a new technology whose potential is not yet widely understood.

  How many charts do you review each day?

  I run preliminary computer screens on roughly ten thousand companies and narrow the list down to about eight hundred stocks. Each night, I review the charts for all these stocks. My first pass-through is very quick, and on average I’ll spot about 30 to 40 stocks that look interesting. I then revi
ew these stocks more closely, scrutinizing the company’s fundamentals, if I haven’t already done so recently, and select several that might be considered for purchase the next day.

  What length price charts do you look at?

  Anything from ten years down to intraday, but I always look at a five-year, one-year, and intraday chart.

  What kind of price patterns are you looking for when you put on a trade?

  I don’t use the conventional chart patterns. I don’t find them particularly useful.

  So what do you look for in a chart?

  Many of the patterns that I have observed and found useful are more complex variations of conventional chart patterns. I have a list of patterns that I’ve named. These are patterns that repeat over and over. They have repeated since the 1800s, and they will repeat forever. When I look at charts and see these patterns, I don’t know how anyone in the world could miss them. But, of course, they do, just as I did early in my career.

  How many of these patterns are there?

  About twenty.

  Can you provide one as an example.

  I’d rather not.

  How did you discover these patterns?

  I started with common chart patterns and found that they worked great sometimes and didn’t work at all at other times. I spent a lot of time focusing on when patterns worked.

  I constantly try to figure out how the market can trick or frustrate the majority of investors. Then after the majority have been fooled I get in at what I call the “point of smooth sailing.” A so-called failed signal can actually be the beginning of a more complex pattern that is far more reliable than the initial signal based on a conventional pattern.

  For example.

  For example, assume a stock breaks out of a trading range on high volume. It looks great. People buy it, and then the stock collapses. In this scenario, most people will view the original breakout as a failed technical signal. The original breakout, however, may be only the beginning of a more complex pattern that is far more reliable than the breakout itself.

  Could you detail one of these patterns?

  I don’t want to do that. It’s not that I think revealing them would make a difference. I could print a description of these patterns in The Wall Street Journal, and I think that 99 percent of the people who would read the article wouldn’t use them or use them the way I do.

  Then why not reveal them?

  Because it’s not what’s important to trading successfully. What is important is controlling your losses and having a plan. Besides, for someone to be successful, they have to develop their own methodology. I developed my method for myself; it wouldn’t necessarily be a good fit for anyone else.

  * * *

  Although I am convinced that Minervini believes this is true, I also think he doesn’t want to divulge any of his original chart analysis because, on some level, he obviously must think that such a disclosure might adversely affect the efficacy of the patterns he uses, which is perfectly reasonable. My further efforts to get him to provide some specifics about his chart methodology proved futile. He didn’t even want to reveal the names of his chart patterns on the record; he read a list of their names to me only after I had turned off my tape recorder.

  * * *

  I assume you use these price patterns as triggers to get you into a trade. Do you also use them to get out of a trade?

  Yes.

  The same patterns?

  Yes and no. The same patterns are interpreted differently, depending on where they occur. For example, if a pattern occurs during a collapse as opposed to during a runaway bull market, it might have a precisely opposite interpretation. You can’t blindly interpret a pattern without considering where it occurs within the larger price picture.

  When you said earlier that you don’t look at conventional chart patterns, do you mean to imply that you don’t attach any significance to breakouts to new highs?

  No, a stock going to a new high is typically a bullish event because the market has eliminated the supply of all previous buyers who had a loss and were waiting to get out at even. That’s why stocks often run up very rapidly once they hit new high ground—at that point, there are only happy investors; all the miserable people are out.

  But don’t stocks often break out to new highs and then come right back into the prior range?

  That usually doesn’t happen if you buy breakouts to new highs after a correction to the first leg in a bull trend. In that case, stocks usually take off like a rocket after they break out to new highs. Less skilled traders wait to buy the stock on the pullback, which never comes.

  When do you get breakouts that fail?

  In the latter stages of a bull market after the stock has already run up dramatically. Chart patterns are only useful if you know when to apply them; otherwise, you might as well be throwing darts.

  What advice would you have for a novice whose goal was to become a successful trader?

  First and foremost, understand that you will always make mistakes. The only way to prevent mistakes from turning into disasters is to accept losses while they are small and then move on.

  Concentrate on mastering one style that suits your personality, which is a lifetime process. Most people just cannot weather the learning curve. As soon as it gets difficult, and their approach isn’t working up to their expectations, they begin to look for something else. As a result, they become slightly efficient in many areas without ever becoming very good in any single methodology. The reality is that it takes a very long time to develop a superior approach, and along the way, you are going to go through periods when you do poorly. Ironically, those are the periods that give you the most valuable information.

  What else?

  You need to have a plan for every contingency. When a pilot and copilot are flying a jetliner and something goes wrong with an engine, you can be sure that they don’t have to figure out what to do on the spur of the moment; they have a contingency plan. The most important contingency plan is the one that will limit your loss if you are wrong. Beyond that, you need a plan to get back into the trade if you’re stopped out. Otherwise, you’ll often find yourself getting stopped out of a trade, and then watching the position go up 50 percent or 100 percent while you’re on the sidelines.

  Don’t you then find yourself sometimes getting stopped out and reentering a trade multiple times?

  Sure, but I don’t have a problem with that. I would rather get stopped out of a trade five times in a row, taking a small loss each time, than take one large loss.

  What are some other relevant contingency plans?

  A plan for getting out of winning trades. There are two ways to liquidate a trade—into strength or into weakness—and you need a plan for both.

  What other advice do you have for novice traders?

  Many amateur investors get sloppy after gains because they fall into the trap of thinking of their winnings as the “market’s money,” and in no time, the market takes it back. It’s your money as long as you protect it.

  Also, you don’t have to make all-or-nothing decisions. If a stock is up and you’re unsure what to do, there’s nothing wrong with taking profits on part of it.

  What mistakes do people make in trading?

  They let their egos get in the way. An investor may put in hours of careful research building a case for a company. He scours the company’s financial reports, checks Value Line, and may even try the company’s products. Then, soon after he buys the stock, his proud pick takes a price dive. He can’t believe it! He makes excuses for the stock’s decline. He calls his broker and searches the Internet, looking for any favorable opinions to justify his position. Meanwhile, he ignores the only opinion that counts: the verdict of the market. The stock keeps sliding, and his loss keeps mounting. Finally, he throws in the towel and feels completely demoralized—all because he didn’t want to admit he had made a mistake in timing.

  Another mistake many investors make is that they allow themselves to be
influenced by what other people think. I made this mistake myself when I was still learning how to trade. I became friends with a broker and opened an account with him. We played this game called “bust the other guy’s chops when his stock is down.” When I had a losing stock position, I was embarrassed to call him to sell the stock because I knew he would ride me about it. If a stock I bought was down 5 or 10 percent, and I thought I should get out of it, I found myself hoping it would recover so I wouldn’t have to call him to sell it while it was down. Before I knew it, the stock would be down 15 or 20 percent, and the more it fell, the harder it became for me to call. Eventually, I learned that you have to ignore what anybody else thinks.

  Many people approach investing too casually. They treat investing as a hobby instead of like a business; hobbies cost money. They also don’t take the time to do a post-trade analysis on their trades, eliminating the best teacher: their results. Most people prefer to forget about their failures instead of learning from them, which is a big mistake.

  What are some misconceptions people have about trading?

  They think it is a lot easier than it is. Sometimes people will ask me whether they can spend one weekend with me so I can show them how I do this stuff. Do you know what a tremendous insult this is? It’s like my saying to a brain surgeon, “If you have a few extra days, I’d like you to teach me brain surgery.”

  The current market mania, particularly in the dot.com and other Internet stocks, has deceived many people into believing that trading is easy. Some guy buys Yahoo, makes four times as much as the best fund managers, and thinks he is a genius.

  How important is gut feel to successful trading?

  Normal human tendencies are traits that cause you to do poorly. Therefore, to be successful as a trader you need to condition abnormal responses. You hear many traders say that you have to do the opposite of your gut response—when you feel good about a position, you should sell, and when you feel terrible about it, you should buy more. In the beginning that’s true, but as you condition yourself for abnormal responses, somewhere along the line you become skilled. Then your gut becomes right. When you feel good, you actually should go long, and when you fell bad, you should sell. That’s the point when you know you have reached competency as a trader.