The New Market Wizards: Conversations with America's Top Traders

by Jack D. Schwager

Patience was an element that a number of the supertraders stressed as being critical to success. James Rogers said it perhaps most colorfully, “I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime.”

by not wanting to trade, I had inadvertently transformed myself into a master of patience. By forcing myself to wait until there was a trade that appeared so compelling that I could not stand the thought of not taking it, I had vastly improved the odds.

To win at the markets you need confidence as well as the desire to trade. I believe the exceptional traders have these two traits most of the time; for the rest of us, they may come together only on an occasional basis. In my own case, I had started out with the confidence but without the desire to trade, and I ended up with neither. The next time I start trading, I plan to have both.

Moral: If you can’t take a small loss, sooner or later you will take the mother of all losses.

I don’t think you can consistently be a winning trader if you’re banking on being right more than 50 percent of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.

If my perception that the fundamentals have changed is not the market’s perception, then there’s something going on that I don’t understand. You don’t want to hold a position when you don’t understand what’s going on. That doesn’t make any sense.

Many people think that trading can be reduced to a few rules. Always do this or always do that. To me, trading isn’t about always at all; it is about each situation. So many people want the positive rewards of being a successful trader without being willing to go through the commitment and pain. And there’s a lot of pain.

Today’s futures markets encompass all the world’s major market groups: interest rates (e.g., T-bonds), stock indexes (e.g., the S&P 500), currencies (e.g., Japanese yen), precious metals (e.g., gold), energy (e.g., crude oil), and agricultural commodities (e.g., corn). Although the futures markets had their origins in agricultural commodities, this sector now accounts for only about one-fifth of total futures trading. During the past two decades, the introduction and spectacular growth of many new contracts have resulted in the financial markets (currencies, interest rate instruments, and stock indexes) accounting for approximately 60 percent of all futures trading. (Energy and metal markets account for nearly half of the remaining 40 percent.)

The essence of a futures market is in its name. Trading involves a standardized contract for a commodity, such as gold, or a financial instrument, such as T-bonds, for a future delivery date, as opposed to the present time. For example, if an automobile manufacturer needs copper for current operations, it will buy its materials directly from a producer. If, however, the same manufacturer were concerned that copper prices would be much higher in six months, it could approximately lock in its costs at that time by buying copper futures now. (This offset of future price risk is called a hedge.)

When the trade was easy, I wanted to be in, and when it wasn’t, I wanted to be out. In fact, that is part of my general philosophy on trading: I want to catch the easy part.

The beginning of a price move is usually hard to trade because you’re not sure whether you’re right about the direction of the trend. The end is hard because people start taking profits and the market gets very choppy. The middle of the move is what I call the easy part.

I never try to buy a bottom or sell a top. Even if you manage to pick the bottom, the market can end up sitting there for years and tying up your capital. You don’t want to have a position before a move has started. You want to wait until the move is already under way before you get into the market.

When I get hurt in the market, I get the hell out. It doesn’t matter at all where the market is trading. I just get out, because I believe that once you’re hurt in the market, your decisions are going to be far less objective than they are when you’re doing well. And if the market had rallied 1,800 points that day to close higher, I couldn’t have cared less. If you stick around when the market is severely against you, sooner or later they’re going to carry you out.

Every day I thought, “If only I had bought it yesterday, I would have been OK.” But I had a twofold problem. First, here was one of the greatest price moves in the history of commodities, and I was missing it. Second, the cash I had in the bank was steadily losing value because of the inflationary environment. I felt really horrible about the situation. I finally ended up buying gold on the exact day it made its high. I bought fifty contracts. The next day, the market opened $150 lower. I was out $750,000, but I was so relieved that the torture was finally over that I couldn’t have cared less about the money I lost. In fact, I was actually praying for the market to open lower.

basically learned that you must get out of your losses immediately. It’s not merely a matter of how much you can afford to risk on a given trade, but you also have to consider how many potential future winners you might miss because of the effect of the larger loss on your mental attitude and trading size.

If you’re always waiting for a reaction before entering the market, don’t you take a chance of missing major moves? Certainly, but so what? I’ve got thirty-eight markets on my screen. If I miss moves in ten of them, there will be ten others that have a price move. The worst thing that can happen to you in the markets is being right and still losing money. That’s the danger in buying on rallies and selling on breaks these days.

One of the things I did that worked in those early years was analyzing every single trade I made. Every day, I made copies of my cards and reviewed them at home. Every trader is going to have tons of winners and losers. You need to determine why the winners are winners and the losers are losers. Once you can figure that out, you can become more selective in your trading and avoid those trades that are more likely to be losers. What other advice would you have for traders? The most important advice is to never let a loser get out of hand. You want to be sure that you can be wrong twenty or thirty times in a row and still have money in your account. When I trade, I’ll risk perhaps 5 to 10 percent of the money in my account. If I lose on that trade, no matter how strongly I feel, on my next trade I’ll risk no more than about 4 percent of my account. If I lose again, I’ll drop the trading size down to about 2 percent. I’ll keep on reducing my trading size as long as I’m losing. I’ve gone from trading as many as three thousand contracts per trade to as few as ten when I was cold, and then back again.

Is this drastic variation in your trading size a key element to your success? Absolutely, because every trader will go through cold spells.

In essence, then, you treat McKay as a trend as well. Definitely, and there’s a logical reason for that. When you’re trading well, you have a better mental attitude. When you’re trading poorly, you start wishing and hoping. Instead of getting into trades you think will work, you end up getting into trades you hope will work.

In other words, you want to wait until you get back into the proper frame of mind, but the only way you can do that is by winning, and you don’t want to bet large in the meantime. That’s right.

The bottom line is that the trading styles of successful traders tend to match their personalities.

My trading style blends both of these opposing personality traits. I take the risk-oriented part of my personality and put it where it belongs: trading. And, I take the conservative part of my personality and put it where it belongs: money management. My money management techniques are extremely conservative. I never risk anything approaching the total amount of money in my account, let alone my total funds.

You’re implying that it doesn’t make any difference what one’s personality is, as long as there’s no conflict between personality and trading style. That’s right, it doesn’t make any difference because there are so many different trading styles that you can always find one that will suit your personality.

Any specific advice for a losing trader? Sometimes the reason people lose is that they’re not sufficiently selective. Upon analysis, a trader may find that if he only concentrates on the trades that do well and lets go of the other types of trades, he might actually be successful. However, if a trader analyzes his trades and still can’t make money, then he probably should try another endeavor.

Each trader must select the appropriate market arena, choose between system trading and discretionary trading, fundamental and technical methods, position trading and spread trading, short-term and long-term horizons, aggressive and conservative approaches, and so on. For all of these opposing choices, one alternative will suit the trader’s personality, while the other will lead to internal conflict.

it is remarkably common for traders to adopt methods entirely unsuited to their personalities. There are traders who are good at system development but end up consistently overriding and interfering with their own systems, with disastrous results. There are traders who are naturally inclined toward developing long-term strategies but end up instead trading short term because of impatience or a compulsion to “do something.”

When I interviewed Eckhardt, he was working on a book about the nature of time (his basic premise is that the passage of time is an illusion). Eckhardt brings many strengths to the art of trading system design: years of experience as a trader both on and off the floor, an obviously keen analytical mind, and rigorous mathematical training. This combination gives Eckhardt an edge over most other trading system designers.

I went in with the idea that I could apply the analytical techniques that I had picked up as a mathematician to the markets in a straightforward manner. I was wrong about that.

In the coin toss example you just provided, computer simulations make it possible to generate huge data samples that allow you to conclude that the mean has no limit. But how can you definitively state that the variances of commodity price distributions are not finite? Isn’t the available data far too limited to draw such a conclusion? There are statistical problems in determining whether the variance of price change is infinite. In some ways, these difficulties are similar to the problems in ascertaining whether we’re experiencing global warming. There are suggestive indications that we are, but it is difficult to distinguish the recent rise in temperature from random variation. Getting enough data to assure that price change variance is infinite could take a century.

One important application concerns a situation in which you have several indicators for a certain market. The question is: How do you most effectively combine multiple indicators? Based on certain delicate statistical measures, one could assign weights to the various indicators. But this approach tends to be assumption-laden regarding the relationship among the various indicators. In the literature on robust statistics you find that, in most circumstances, the best strategy is not some optimized weighting scheme, but rather weighting each indicator by 1 or 0. In other words, accept or reject. If the indicator is good enough to be used at all, it’s good enough to be weighted equally with the other ones. If it can’t meet that standard, don’t bother with it.

There’s a simple consideration that absolutely invalidates all such angles-of-certain-size methods in a single swipe: The size of an angle on a bar chart is not invariant to changes of scale. For instance, consider the technique of drawing a line from the low of a move at a 45-degree angle. If you do this on two charts of the same contract but with different time and price scales, say from two different services, the 45-degree lines will be different. They will subsequently intersect the price series in different places. In fact, the angle of a line joining two prices on a bar chart is not a property of the price series at all. It depends completely on what units you use for price and time and how you space them on the chart, all of which are quite arbitrary. There are good methods and bad methods, but these angle techniques are no method. As an aside, note that trend lines that involve connecting two or more points on the price series are invariant under changes of scale and, hence, make sense in a way that lines determined by slopes do not. On differently scaled charts, a given trend line has different slopes, but it intersects the price series in precisely the same places.

What is your opinion about optimization? [Optimization refers to the process of testing many variations of a system for the past and then selecting the best-performing version for actual trading.] It’s a valid part of the mechanical trader’s repertoire, but if you don’t use methodological care in optimization, you’ll get results that are not reproducible.

If you avoid optimization altogether, you’re going to end up with a system that is vastly inferior to what it could be. If you optimize too much, however, you’ll end up with a system that tells you more about the past than the future. Somehow, you have to mediate between these two extremes.

Karl Popper has championed the idea that all progress in knowledge results from efforts to falsify, not to confirm, our theories. Whether or not this hypothesis is true in general, it’s certainly the right attitude to bring to trading research. You have to try your best to disprove your results. You have to try to kill your little creation. Try to think of everything that could be wrong with your system, and everything that’s suspicious about it. If you challenge your system by sincerely trying to disprove it, then maybe, just maybe, it’s valid.

The human mind was made to create patterns. It will see patterns in random data. A turn-of-the-century statistics book put it this way: “Too fine an eye for pattern will find it anywhere.” In other words, you’re going to see more on the chart than is truly there. Also, we don’t look at data neutrally—that is, when the human eye scans a chart, it doesn’t give all data points equal weight. Instead, it will tend to focus on certain outstanding cases, and we tend to form our opinions on the basis of these special cases. It’s human nature to pick out the stunning successes of a method and to overlook the day-in, day-out losses that grind you down to the bone. Thus, even a fairly careful perusal of the charts is prone to leave the researcher with the idea that the system is a lot better than it really is.

I don’t like to buy retracements. If the market is going up and I think I should be long, I’d rather buy when the market is strong than wait for a retracement. Buying on a retracement is psychologically seductive because you feel you’re getting a bargain versus the price you saw a while ago. However, I feel that approach contains more than a drop of poison. If the market has retraced enough to make a significant difference to your purchase price, then the trade is not nearly as good as it once was. Although the trade may still work, there’s an enhanced chance that the trend is turning. Perhaps even more critical, a strategy of trying to buy on retracements will often result in your missing the trade entirely or being forced to buy at an even higher price. Buying on retracements is one of those ploys that gives psychological satisfaction rather than providing any benefits in terms of increased profits. As a general rule, avoid those things that give you comfort; it’s usually false comfort.

Do you have any rational explanation for why trend-following systems work? People tend to focus on the few broad outcomes that appear most probable and ignore the low-probability scenarios. As various possible outcomes become less and more likely, certain neglected ones of small probability pop into view—a threshold phenomenon. The market has to discount these “new” possibilities somewhat discontinuously. Evidently, the success of trend-following means that moves of a characteristic size are more than randomly likely to be the beginnings of such discontinuous adjustments. Of course, the inference problem facing the trend follower is to distinguish the initial parts of such adjustments from random swings.

Is the idea that if a system really worked—by that I mean a combination of good profitability, low volatility, and durability—it wouldn’t make any monetary sense for someone to sell it? Occasionally, it might happen that somebody comes up with something really good and sells it because he needs the money. But in my experience, something good isn’t discovered on a Greyhound bus while leafing through the charts; it’s something developed over a period of years. Typically, if a person has invested sufficient time and money into developing a system, he or she will want to use the system, not sell it.

Contrary opinion attempts to push the idea of trading against the majority in individual trades. Although theoretically this approach might work given the right kind of information about market composition, in practice the information available to contrary opinion traders is of questionable significance. For instance, consider the consensus numbers. These are based on recommendations from market newsletters, advisory services, and so on. Therefore, these numbers model a very nonrepresentative group of traders—those who trade on market-letter advice. I don’t know even one. In any case, this is an empirical question: Do the consensus figures work? Our research indicates that it’s marginally profitable to buy—not to sell—a market with an extremely high bullish consensus.

Do you have any opinion about popular technical overbought/oversold-type indicators, such as RSI and stochastics? I think these indicators are nearly worthless. I’m not implying that you shouldn’t do research on these approaches—you can be very promiscuous in your research, but not in your trading.

Having done the research, would you term these approaches “bogus indicators”? Yes, they’re close to zero in terms of their profit expectations. What these patterns make during market consolidations, they lose during trends.

Why do you believe these approaches are so popular if they’re ineffective for trading purposes? For one thing, when you look at these indicators superimposed on a price chart, they look much better than they really are. The human eye tends to pick up the times these indicators accurately called minor tops and bottoms, but it misses all the false signals and the extent to which they were wrong during trends.

Do you believe that attempts to apply artificial intelligence to trading can succeed? I think that eventually cybernetic devices will be able to outperform humans at every task, including trading. I can’t believe that just because we’re made of carbon and phosphorus there are things we can do that silicon and copper can’t. And since cybernetic devices lack many of our human limitations, someday they’ll be able to do it better. I have no doubt that eventually the world’s best trader will be an automaton. I’m not saying this will happen soon, but probably within the next few generations.

A good part of the academic community insists that the random nature of price behavior means that it’s impossible to develop trading systems that can beat the market over the long run. What’s your response? The evidence against the random walk theory of market action is staggering. Hundreds of traders and managers have profited from price-based mechanical systems.

When I first started in this business, mechanical trading was considered crackpot stuff. Since then, there has been a steadily increasing number of papers providing evidence that the random walk theory is false. System trading has gone from a fringe idea to being a new kind of orthodoxy. I don’t think this could have happened if there weren’t something to it. However, I have to admit that I find it unsettling that what began as a renegade idea has become an element of the conventional wisdom.

Of course, you can’t actually prove that price behavior is random. That’s right. You’re up against the problem of trying to prove a negative proposition. Although the contention that the markets are random is an affirmative proposition, in fact you’re trying to prove a negative. You’re trying to prove that there’s no systematic component in the price. Any negative proposition is very difficult to confirm because you’re trying to prove that something doesn’t exist. For example, consider the negative proposition that there are no chocolate cakes orbiting Jupiter. That may be true, but it’s very hard to prove. The random walk theory has the disadvantage of being a negative proposition. Nevertheless, in the absence of any evidence to the contrary, it might be a plausible theory to maintain. At this point, however, I think there is enough contrary evidence so that any academic who still espouses the idea that the markets are random is not looking at the realities.

System traders still have an important old ally: human nature. Human nature has not changed. Fortunately, there are still a lot of people trading on their instincts. But there’s no question that the game has become much more difficult. In evolutionary biology, one of the proposed solutions to the question of why sexual (as opposed to asexual) reproduction is so abundant is the Red Queen Hypothesis, based on the character in Alice in Wonderland in whose country you had to run as fast as you could just to stay in place. The idea is that competition is so severe that a species has to evolve as fast as it can just to stay where it is; sexual reproduction provides a kind of evolutionary overdrive. Similarly, there is such strong competition in the systems trading niche that the trader has to develop systems as fast as he or she can to merely stay in place.

Is the implication that the increasing proportion of professionals in the total trading universe will change the nature of the markets in such a way that previously valid systems may no longer work?

I think that’s true. That’s why I’m willing to accept systems with somewhat lower theoretical performance if I think they have the property of being different from what I believe most other system traders are using. When I raise the point with would-be system designers that much historical research may be invalidated by the changing nature of futures markets, they invariably reply that the solution is to develop systems based on recent data—as if it were that easy. There’s a serious problem with this approach. Recent data has to be less statistically significant than long-term historical data simply because there is a lot less of it. Systems developed solely on recent data are flimsily supported. There’s no way around this basic fact.

How important is intelligence in trading? I haven’t seen much correlation between good trading and intelligence. Some outstanding traders are quite intelligent, but a few aren’t. Many outstandingly intelligent people are horrible traders. Average intelligence is enough. Beyond that, emotional makeup is more important