Stock Market Wizards

by Jack D. Schwager

  An honest self-appraisal in respect to confidence may be one of the best predictors of a trader’s prospects for success in the markets. At the very least, those who consider career changes to become traders or risking a sizable portion of their assets in the market should ask themselves whether they have absolute confidence in their ultimate success. Any hesitation in the answer should be viewed as a cautionary flag.

  11. Hard Work

  The irony is that so many people are drawn to the markets because it seems like an easy way to make a lot of money, yet those who excel tend to be extraordinarily hard workers—almost to a fault. Consider just some of the examples in this book:

  As if running a huge trading company were not enough, Shaw has also founded a number of successful technology companies, provided venture capital funding and support to two computational chemistry software firms, and chaired a presidential advisory committee. Even when he is on a rare vacation, he acknowledges, “I need a few hours of work each day just to keep myself sane.”

  Lescarbeau continues to spend long hours doing computer research even though his systems, which require very little time to run, are performing spectacularly well. He continues to work as if these systems were about to become ineffective tomorrow. He never misses a market day, to the point of hobbling across his house in pain on the day of his knee surgery so that he could check on the markets.

  Minervini works six-day workweeks, fourteen-hour trading days, and claims not to have missed a market day in ten years, even when he had pneumonia.

  Cook continues to do regular farm work in addition to spending fifty to sixty hours a week at trading. Moreover, for years after the disastrous trade that brought him to the brink of bankruptcy, Cook worked the equivalent of two full-time jobs.

  Bender not only spends a full day trading in the U.S. markets, but then is up half the night trading the Japanese stock market.

  12. Obsessiveness

  There is often a fine line between hard work and obsession, a line that is frequently crossed by the market wizards. Certainly some of the examples just cited contain elements of obsession. It may well be that a tendency toward obsessiveness in respect to the markets, and often other endeavors as well, is simply a trait associated with success.

  13. The Market Wizards Tend to Be Innovators, Not Followers

  To list a few examples:

  When Fletcher started his first job, he was given a desk and told to “figure it out.” He never stopped. Fletcher has made a career of thinking up and implementing innovative market strategies.

  Bender not only developed his own style of trading options but created an approach that sought to profit by betting against conventional option models.

  Shaw’s entire life has been defined by innovation: the software company he launched as a graduate student; his pioneering work in designing the architecture of supercomputers; the various companies he founded; and his central role in developing the unique complex mathematical trading model used by D. E. Shaw.

  By compiling detailed daily diaries of his market observations for over a decade, Cook was able to develop a slew of original, high-reliability trading strategies.

  Minervini uncovered his own menagerie of chart patterns rather than using the patterns popularized in market books.

  By jotting down all his market observations, Masters was able to design his own catalyst-based trading model.

  Although he was secretive about the details, based on their incredible performance alone, it is quite clear that Lescarbeau’s systems are unique.

  14. To Be a Winner You Have to Be Willing to Take a Loss

  In Watson’s words, “You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.”

  15. Risk Control

  Minervini believes that one of the common mistakes made by novices is that they “spend too much time trying to discover great entry strategies and not enough time on money management.” “Containing your losses,” he says, “is 90 percent of the battle, regardless of the strategy.” Cohen explains the importance of limiting losses as follows: “Most traders make money only in the 50 to 55 percent range. My best trader makes money only 63 percent of the time. That means you’re going to be wrong a lot. If that’s the case, you better make sure your losses are as small as they can be.”

  Risk control methods used by the traders interviewed included the following:

  Stop-loss points. Both Minervini and Cook predetermine where they will get out of a trade that goes against them. This approach allows them to limit the potential loss on any position to a well-defined risk level (barring a huge overnight price move). Both Minervini and Cook indicated that the stop point for any trade depends on the expected gain—that is, trades with greater profit potential will use wider stops (accept more risk).

  Reducing the position. Cook has a sheet taped to his computer reading: GET SMALLER. “The first thing I do when I’m losing,” he says, “is to stop the bleeding.” Cohen expresses the virtual identical sentiment: “If you think you’re wrong, or if the market is moving against you and you don’t know why, take in half. You can always put it on again. If you do that twice, you’ve taken in three-quarters of your position. Then what’s left is no longer a big deal.”

  Selecting low-risk positions. Some traders rely on very restrictive stock selection conditions to control risk as an alternative to stop-loss liquidation or position reduction (detailed in item 17).

  Limiting the initial position size. Cohen cautions, “A common mistake traders make…is that they take on too big of a position relative to their portfolio. Then when the stock moves against them, the pain becomes too great to handle, and they end up panicking or freezing.” On a similar note, Fletcher quotes his mentor, Elliot Wolk, “Never make a bet you can’t afford to lose.”

  Diversification. The more diversified the holdings, the lower the risk. Diversification by itself, however, is not a sufficient risk-control measure, because of the significant correlation of most stocks to the broader market and hence to each other. Also, as discussed in item 52, too much diversification can have significant drawbacks.

  Short selling. Although the common perception is that short selling is risky, it can actually be an effective tool for reducing portfolio risk (see item 58).

  Hedged strategies. Some traders (Fletcher, Shaw, and Bender) use methodologies in which positions are hedged from the onset. For these traders, risk control is a matter of restricting leverage, since even a low-risk strategy can become a high-risk trade if the leverage is excessive. (See, for example, the discussion of LTCM in the Shaw interview.)

  16. You Can’t Be Afraid of Risk

  Risk control should not be confused with fear of risk. A willingness to accept risk is probably an essential personality trait for a trader. As Watson states, “You have be willing to accept a certain level of risk, or else you will never pull the trigger.” When asked what he looks for when he hires new traders, Cohen replies, “I’m looking for people who are not afraid to take risks.”

  17. Limiting the Downside by Focusing on Undervalued Stocks

  A number of the traders interviewed restrict their stock selection to the universe of undervalued securities. Watson focuses on the stocks with relatively low price/earnings ratios (8 to 12). Okumus buys stocks that have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value.

  One reason all these traders focus on buying stocks that meet their definition of value is that by doing so they limit the downside. Another advantage of buying stocks that are trading at depressed levels is that the stocks in this group that do turn around will often have tremendous upside potential.

  18. Value Alone Is Not Enough

  It should be stressed that although a number of traders considered undervaluation a necessary condition for purchasing a stock, none of them viewed it as a suf
ficient condition. There always had to be other compelling reasons for the trade because a stock could be low priced and stay that way for years. Even if you don’t lose much in buying a value stock that just sits there, it could represent a serious investment blunder by tying up capital that can be used much more effectively elsewhere.

  19. The Importance of Catalysts

  A stock can represent great value and still stagnate for years, tying up valuable capital. Therefore, an essential question that needs to be asked is: What is going to make the stock go up?

  Watson’s stock selection process contains two essential steps. First, the identification of stocks that fulfill his value criteria, which is the easy part of the process that merely defines the universe of stocks in which he prospects for buy candidates. Second, the search for catalysts (recent or impending) that will identify which of these value stocks have a compelling reason to move higher over the near term. To discover these catalysts, he conducts extensive communication with companies, as well as their competitors, distributors, and consumers. By definition, every trade requires a catalyst.

  Masters has developed an entire trading model based primarily on catalysts. Through years of research and observation, he has been able to find scores of patterns in how stocks respond to catalysts. Although most of these patterns may provide only a small edge by themselves, when grouped together, they help identify high-probability trades.

  20. Most Traders Focus on When to Get in and Forget About When to Get Out

  When to get out of a position is as important as when to get in. Any market strategy that ignores trade liquidation is by definition incomplete. A liquidation strategy can include one or more of the following elements:

  Stop-loss points. Detailed in item 15.

  Profit objective. A number of traders interviewed (e.g., Okumus, Cook) will liquidate a stock (or index) if the market reaches their predetermined profit target.

  Time stop. A stock (or index) is liquidated if it fails to reach a target within a specified time frame. Both Masters and Cook cited time stops as a helpful trading strategy.

  Violation of trade premise. A trade is immediately liquidated if the reason for its implementation is contradicted. For example, when IBM, which Cohen shorted in anticipation of poor earnings, reported better-than-expected earnings, Cohen immediately covered his position. Although he still took a large loss on the trade, the loss would have been significantly greater if he had hesitated.

  Counter-to-anticipated market behavior (see item 21).

  Portfolio considerations (see item 22).

  Some of these elements may make sense for all traders (e.g., exiting on counter-to-anticipated market behavior); others are very dependent on a trader’s style. For example, the use of stops to limit losses is essential to Minervini, who uses a timing-based methodology, but is contradictory to the approach used by Okumus and Watson, who tend to buy undervalued stocks after very sharp declines. (The latter traders, however, would still use stop-loss strategies for short positions, which are subject to open-ended losses.) As another example, profit objectives, which are an integral part of some traders’ methodologies, could be detrimental to other traders and investors by limiting profit potential.

  21. If Market Behavior Doesn’t Conform to Expectations, Get Out

  A number of traders mentioned that if the market fails to respond to an event (e.g., earnings report) as expected, they will view it as evidence that they are wrong and liquidate their position. When I interviewed Cohen, he was bullish on the bond market, which at the time was in a long-term decline. He gave me a number of reasons why he believed the bond market would witness a substantial rebound in the ensuing months, and he implemented a long position as I sat next to him. The next few days, the bond market did indeed witness a bounce, but the rally soon faltered, with bond prices sliding to new lows. When I spoke to Cohen on a follow-up phone interview a week after my visit to his firm, I asked him whether he was still long the bond market, which he had been so bullish on several weeks earlier. “No,” Cohen replied, “you trade your theory and then let the market tell you whether you are right.”

  22. The Question of When to Liquidate Depends Not Only on the Stock but Also on Whether a Better Investment Can Be Identified

  Investable funds are finite. Continuing to hold one stock position precludes using those funds to purchase another stock. Therefore, it may often make sense to liquidate an investment that still looks sound if an even better investment opportunity exists. Watson, for example, employs what he calls a pig-at-the-trough philosophy. He is constantly upgrading his portfolio—replacing stocks that he still expects will go higher with other stocks that appear to have an even better return/risk outlook. Thus, the key question an investor needs to ask regarding a current holding is not “Will the stock move higher?” but rather “Is this stock still a better investment than any other equity I can hold with the same capital?”

  23. The Virtue of Patience

  Whatever criteria you use to select a stock and determine an entry level, you need to have the patience to wait for those conditions to be met. For example, Okumus will patiently wait for a stock to decline to his “bargain” price level, even if it means missing more than 80 percent of the stocks he wants to buy. In mid-1999, Okumus was only 13 percent invested because, as he stated at the time, “There are no bargains around. I’m not risking the money I’m investing until I find stocks that are very cheap.”

  24. The Importance of Setting Goals

  Dr. Kiev, who has worked with both Olympic athletes and professional traders, is a strong advocate of the power of setting goals. He contends that believing that an outcome is possible makes it achievable. Believing in a goal, however, is not sufficient. To achieve a goal, Kiev says, you need to not only believe in it but also commit to it. Promising results to others, he maintains, is particularly effective.

  Dr. Kiev stresses that exceptional performance requires setting goals that are outside a trader’s comfort zone. Thus, the trader seeking to excel needs to continually redefine goals so that they are always a stretch. Traders also need to monitor their performance to make sure they are on track toward reaching their goals and to diagnose what is holding them back if they are not.

  25. This Time Is Never Different

  Every time there is a market mania, the refrain is heard, “This time is different,” followed by some explanation of why the particular bull market will continue, despite already stratospheric prices. When gold soared to near $1,000 an ounce in 1980, the explanation was that gold was “different from every other commodity.” Supposedly, the ordinary laws of supply and demand did not apply to gold because of its special role as a store of value in an increasingly inflationary world. (Remember double-digit inflation?) When the Japanese stock market soared in the 1980s, with price/earnings ratios often five to ten times as high as corresponding levels for U.S. companies, the bulls were ready with a reassuring explanation: The Japanese stock market is different because companies hold large blocks of each other’s shares, and they rarely sell these holdings.

  As this book was being written, there was an explosive rally in technology stocks, particularly Internet issues. Stocks with no earnings, or even a glimmer of the prospect of earnings, were being bid up to incredible levels. Once again, there was no shortage of pundits to explain why this time was different; why earnings were no longer important (at least for these companies). Warnings about the aspects of mania in the current market were mentioned by a number of the traders interviewed. By the time this manuscript was submitted, many of the Internet stocks had already witnessed enormous percentage declines. The message, however, remains relevant because there will always be some market or sector that rekindles the cry, “This time is different.” Just remember: It never is.

  26. Fundamentals Are Not Bullish or Bearish in a Vacuum; They Are Bullish or Bearish Only Relative to Price

  A great company could be a terrible investment if its price rise has already more tha
n discounted the bullish fundamentals. Conversely, a company that has been experiencing problems and is the subject of negative news could be a great investment if its price decline has more than discounted the bearish information. As Galante expressed when asked for her advice to investors, “A good company could be a bad stock and vice versa.”

  27. Successful Investing and Trading Has Nothing to Do with Forecasting

  Lescarbeau, for example, emphasized that he never made any predictions and scoffed at those who made claim to such abilities. When asked why he laughed when the subject of market forecasting came up, he replied: “I’m laughing about the people who do make predictions about the stock market. They don’t know. Nobody knows.”

  28. Never Assume a Market Fact Based on What You Read or What Others Say; Verify Everything Yourself

  When Cook first inquired about the interpretation of the tick (the number of New York Stock Exchange stocks whose last trade was an uptick minus the number whose last trade was a downtick), he was told by an experienced broker that if the tick was very high, it was a buy signal. By doing his own research and recording his own observations, he discovered that the truth was exactly the opposite.

  Bender began his option trading career by questioning the very core premises underlying the option pricing models used throughout the industry. Convinced that the conventional wisdom was wrong, he developed a methodology that was actually based on betting against the implications of the option pricing models in wide use.

  29. Never, Ever Listen to Other Opinions

  To succeed in the markets, it is essential to make your own decisions. Numerous traders cited listening to others as their worst blunder. Walton and Minervini lost their entire investment stake because of this misjudgment. Talking about this experience, Minervini said, “My mistake had been surrendering the decision-making responsibility to someone else.” Watson got off cheap, learning this lesson at the bargain basement price of a blown grade on a class project. Cohen talks about someone he knows that has the skill to be a great trader, but will never be one because “he refuses to make his own decisions.”