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

by Jack D. Schwager

Is predetermining an exit point something that you’ve done for the last few years? No, that’s something that I’ve done since my first day in the business. I’ve always had a point where I knew that I was getting out. Does taking a loss have an emotional impact on you? None. Taking a loss never affects me, but I don’t take big losses.

I discovered that you can’t train people how to trade by just imparting knowledge. The key to trading success is emotional discipline. Making money has nothing to do with intelligence. Think of all the bright people that choose careers on Wall Street. If intelligence were the key, there would be a lot more people making money trading.

To be a successful trader, you have to be able to admit mistakes. People who are very bright don’t make very many mistakes. In a sense, they generally are correct. In trading, however, the person who can easily admit to being wrong is the one who walks away a winner. Besides trading, there is probably no other profession where you have to admit when you’re wrong.

In trading, you can’t hide your failures. Your equity provides a daily reflection of your performance. The trader who tries to blame his losses on external events will never learn from his mistakes. For a trader, rationalization is a guaranteed road to ultimate failure

Essentially, I would look for people with the ability to admit mistakes and take losses quickly. Most people view losing as a hit against their self-esteem. As a result, they postpone losing. They think of all sorts of reasons for not taking losses. They select a mental stop point and then fail to execute it. They abandon their game plan.

How do you handle losing streaks? We all go through periods when we’re out of sync with the market. When I’m doing things correctly, I tend to expand my rate of involvement in the market. Conversely, when I start losing, I cut back my position size. The idea is to lose as little as possible while you’re in a losing streak. Once you take a big hit, you’re always on the defensive. In all the months I lost money, I always ended up trading small—sometimes trading as little as 1 percent of the account. When I get into a losing streak, I like to read a nonfiction book to learn something new. That action accomplishes two things. First, it takes my mind off of trading; second, by enhancing my knowledge, I help improve my self-esteem. The key is to do something positive.

Why do most people lose money in the market? I know this will sound like a cliché, but the single most important reason that people lose money in the financial markets is that they don’t cut their losses short. It is a curiosity of human nature that no matter how many books talk about this rule, and no matter how many experts offer this advice, people still keep making the same mistake.

The key to building wealth is to preserve capital and wait patiently for the right opportunity to make the extraordinary gains.

Do you use chart analysis? Yes, but I like to keep it simple. My primary methodology is a three-step process to define important trend changes. Let me take the example of trying to identify a top in a rising market. The first step is waiting for the uptrend line to be broken. In my experience, I have not found trend lines to be particularly reliable. It is essential that you draw the trend line correctly. Most people draw trend lines incorrectly.

One way or another, it all comes down to odds. Unless you can find some way to get the odds in your favor, trading, like any other 50/50 game with a cost to play (commissions and execution slippage in this case), will eventually be a losing proposition. Sperandeo has taken the definition of odds to an actuarial-like extreme. Just as insurance companies guarantee that the odds are in their favor by classifying policyholders according to risk, Sperandeo categorizes the stock market by risk.

While his view is hardly universal, Sperandeo downplays the significance of intelligence to trading success. Based on his experience in training thirty-eight traders, Sperandeo concluded that intelligence was virtually irrelevant in predicting success. A far more important trait to winning as a trader, he says, is the ability to admit mistakes. He points out that people who tie their self-esteem to being right in the markets will find it very difficult to take losses when the market action indicates that they are wrong.

I realized that every time I had a loss, I needed to learn something from the experience and view the loss as tuition at the College of Trading. As long as you learn something from a loss, it’s not really a loss.

After losing money for five consecutive years from your start in trading, didn’t you ever think that you might not be cut out for this endeavor? No, never. What gave you the confidence? You obviously weren’t getting any reinforcement from the market. My reinforcement came when my losses gradually became smaller and smaller. I was getting very close to the breakeven point. I also kept my losses at a manageable level. I always traded a very small account

Did you stop trading when you lost whatever amount of money you had set aside to risk in a given year? That never happened. I had developed the concept of never taking a trade that would jeopardize my ability to continue trading. I always limited the risk on any trade to a level that I knew would permit me to come in and play the game again if I were wrong.

there’s a tendency to feel a rush when the market is going your way and devastation when it’s going against you. These emotions do absolutely nothing to make you a good trader. It’s far better to keep the equity swings manageable and strive for a sense of balance each day, no matter what happens. That trade was the catalyst for my adopting a formula that limited both my profits and drawdowns by notching back the number of contracts traded in each market to a tolerable level. The key is that the number of contracts traded fluctuates in accordance with each market’s volatility.

Getting back to my first question, can you explain how you manage such a composed attitude in trading the markets? When I come to work each day, I know that the risk and volatility in my portfolio is exactly the same as it was yesterday, last week, and last month. So why should I let my emotions go up and down if I’m in exactly the same exposure all the time?

What would you say to the trader who says, “I’m making money overall, and I’m using stops to limit my losses, but I still have a lot of anxiety about trading. I still can’t stand to lose.”? I would tell that trader to think of each trade as one of the next one thousand trades he’s going to make. If you start thinking in terms of the next one thousand trades, all of a sudden you’ve made any single trade seem very inconsequential. Who cares if a particular trade is a winner or a loser? It’s just another trade. Do you do any mental exercises to relax, or is that not necessary now that you’re fully computerized? I probably do more mental exercises now than I ever did. Each morning while I’m driving to work, I make a conscious effort to relax. I mentally rehearse any conflict that might happen that day. The process of mentally organizing and relaxing before I get to work helps me start my day in a very positive frame of mind.

focus my total attention on trading well, and let the results take care of themselves. It sounds almost as if you’re viewing yourself from the outside, completely detached. When I was in high school I had an extreme fear of getting up in front of the class and talking. My knees would literally tremble. I eventually learned to deal with the situation by disassociating and observing myself. I was able to have this observer show up in times of stress. When I found myself shaking, my observer would say, “Why are you shaking, Tom? Just relax. You’re talking too fast. Slow down a little bit.” Eventually, I found that the observer was there all the time. If you’re watching yourself doing everything, you get pretty close to watching a movie. The observer is watching you play a role in this movie called Life.

If instead of saying, “I’m going to do this trade,” you say, “I’m going to watch myself do this trade,” all of a sudden you find that the process is a lot easier.

there is a single theme that keeps recurring in this volume, as it did in Market Wizards, it is that psychology is critical to success at trading. Certainly this idea is repeated strongly in the Basso interview. However, there is a more important lesson here: In order to achieve success in life, you must have the right mental attitude, without which success in trading is a Pyrrhic victory.

As James Gleick described it in his excellent book, Chaos: Making a New Science,

I have also worked with a programmer to develop neural network trading indicators, which I’m now using as a market tool. [A key characteristic of neural network programs is that they are not static; rather, they evolve as they “learn” from the data.] This project has also led to lots of calls to other people across the country who are working on applying neural networks to trading.

Does it ever bother you when you lose? Not at all. It never bothered me to lose, because I always knew that I would make it right back. I always knew that no matter what happened, I could go into any marketplace, with any amount of money, and make a living.

Another mistake I’ve frequently made is participating in too many markets at one time, which leads to sloppy trading.

My philosophy is to try to be profitable every day! Of course, I don’t quite achieve that consistency, but that’s my goal. I’m probably profitable nearly every week. Remember, I do this for a living, and I use my own money. I really value the fact that I’ve learned to trade as a craft. Like any craft, such as piano playing, perfection may be elusive—I’ll never play a piece perfectly, and I’ll never buy the low and sell the high—but consistency is achievable if you practice day in and day out.

In our initial phone conversation, you mentioned that you’ve shared your trading methods with other traders. Aren’t you concerned that revealing your approach could destroy its effectiveness as other people start to use it? I truly feel that I could give away all my secrets and it wouldn’t make any difference. Most people can’t control their emotions or follow a system. Also, most traders wouldn’t follow my system, even if I gave them step-by-step instructions, because my approach wouldn’t feel right to them. They wouldn’t have the same confidence or comfort in the trading method as I do. But for argument’s sake, let’s say that showing my methods to other traders did eventually cause some of the patterns that I follow to change. If these patterns changed, new ones would be created, and I’m confident that I would find them.

Never fear the markets. Never fear making a mistake. If you do make a mistake, don’t complicate the position by trying to hedge it—just get out.

Never be greedy. It’s OK to leave money on the table. If you can’t get in at a favorable price, let the trade go and start looking for the next trade.

If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.

Are traders like Raschke confident because they succeed, or do they succeed because they are confident? Probably a little bit of both. However, the key point is that exuberant confidence appears to be one of the essential elements in exceptional achievement as a trader, and I assume in many other endeavors as well. Occasionally, an interview provokes me to reassess my view of reality. I have long assumed that markets might be predictable over the long term but that short-term price movements are largely random. Raschke holds exactly the opposite point of view. She believes that in the markets, much as in weather forecasting, short-term predictions can be quite accurate but long-term forecasting is a virtual impossibility. With her ability to see patterns that others don’t, she has been able to trade short-term price swings with a consistency that would defy the laws of probability, if indeed there were no patterns in these movements. Raschke has made me a believer. Clearly, there are predictable movements in price even over periods as short as a few days or a single day.

Five basic trading principles appear to be elemental to Mark Ritchie’s trading success. These can be summarized as follows: 1. Do your own research. 2. Keep each position size so small that it almost seems to be a waste of your time. 3. Have the patience to stay with a winning position as long as that position is working, even if it means keeping a single position for years. 4. View risk of open profits differently from the risk as measured from starting equity in a trade. The point is that in order to ride winning positions to their maximum potential, it is necessary to endure periodic losses in open profits greater than the risk level that would be advisable when a position is first implemented. 5. Recognize and control your greed.

The type of trading done by CRT has little direct relevance to individual traders. The primary lessons to be drawn from this interview, I believe, are not related to trading, but rather management. The enormous financial success and widespread employee loyalty enjoyed by CRT is no doubt a consequence of Joe Ritchie’s managerial philosophy: Share the responsibility and share the profits. This policy makes so much common sense that you wonder why more companies don’t use it. Corporate America, are you listening?

At that time, I got interested in playing blackjack by reading a book called Beat the Dealer by Ed Thorp. From 1971 to 1975, I went to the Nevada casinos regularly.

What element of the blackjack playing experience do you believe contributed to your success as a trader? The experience of going through extensive losing periods and having the faith to stick with the system because I knew that I had the edge was something that helped me a great deal when I went into the pit. Also, the risk control experience was very beneficial. In blackjack, even if you have the edge, there are going to be periods of significant losses. When that happens, you have to cut back your bet size in order to avoid the possibility of ruin. If you lose half your stake, you have to cut your bet size in half. That’s a difficult thing to do when you’re down significantly, but it’s essential to surviving.

The way you express it, blackjack and trading are very similar. That’s right. All you need is a mathematical advantage and the money management controls to assure that you stay in the game. Everything else takes care of itself.

Now correct me if I’m wrong. In blackjack, the rules are absolutely dictated. The dealer has to draw another card or he has to stick, depending on his card count, whereas in poker, people have more choice, and reading your opponent becomes a factor. Therefore, even if you have the edge mathematically, if people can read your emotions correctly or you can’t read theirs, you lose the edge. Right, you lose the edge in a major way. Bluffing is an essential element of the game. There’s a mathematician who has written some very good books on poker strategy, but he’s never been able to make any money playing poker.

Is there a certain personality type that is best suited to being a successful trader? Based on my experience with the traders I’ve hired, I would say that successful blackjack, chess, and bridge players are more likely to fit the profile of a good options trader.

Another pertinent lesson that Hull applied to blackjack, as well as trading, is that if you have a winning method, you must have the faith to keep applying it even during losing periods. The trick, however, is to reduce the risk by reducing your bet or trade size so that the ratio between risk and equity stays relatively constant. Although Hull is predominantly an arbitrage trader, he occasionally takes directional trades, which have tended to be quite successful. Hull’s rules for directional trading, although not explicitly stated, can be inferred from the interview: Trade infrequently and only when you have a strong idea. Trade the opposite side of the predominant news stories. Time your trade to coincide with an event that has the potential to lead to a panic climax.