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Ed Thorp
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Lessons From A Trading Great: Ed Thorp

Ed Thorp, the father of quant investing, might be the most impressive market wizard. He turned seemingly random processes into predictable events, transforming the art of speculation into a science decades before Wall Street’s quants became mainstream.

His domination in the financial world began in the casino. Thorp figured out how to beat the most “unbeatable” games. In roulette, he created a wearable computer that gave him a 44% edge. And in blackjack, he developed the very first card counting system that’s still widely used today.

These gambling skills transferred perfectly to markets. Thorp’s first hedge fund, Princeton Newport Partners, never had a down year. It compounded money at 19.1% for almost 20 years — destroying the S&P 500.

His second fund, which he ran from August 1992 to September 2002, performed just as well with an annualized return of 18.2%.

Thorp’s list of discoveries, inventions, and people he’s influenced and invested in is comically long:

  • He discovered an options pricing formula before the Black-Scholes model became public.
  • He started the first ever quant hedge fund.
  • He was the first to use convertible and statistical arbitrage.
  • He was the first limited partner in Ken Griffin’s Citadel — one of the most successful hedge funds ever.
  • His books on blackjack and trading heavily influenced “bond king” Bill Gross.
  • He discovered that Bernie Madoff was a fraud many years before it became public.

And the list goes on…

Thorp’s advice on approaching games of incomplete information is methodical and scientific, making it very useful to incorporate into your own trading process. The following is his most valuable wisdom with our commentary attached:

Rare Events (Fat Pitches)

Fat pitches — the types of trades Buffett, Druck, and Soros salivate over— happen seldomly. And that makes sense because is takes extraordinary circumstances to push markets far enough from equilibrium to create these opportunities.

When these dislocations occur, it pays to go on high alert. It’s possible to make your year or even your career in a few days by hitting these fat pitches on the nose.

Here are a few of Thorp’s best plays:

1987 Crash

Black Monday was a traumatizing experience for most traders… but not for Thorp. When the crash started to accelerate Thorp was having his daily lunch date with his wife Vivian. The office called to report the news and Thorp didn’t even flinch. He had already accounted for all possible market scenarios, including this one, and didn’t have any reason to panic. He calmly finished his lunch and then went home to think about how to exploit the situation. This is what he came up with:

After thinking hard about it overnight I concluded that massive feedback selling by the portfolio insurers was the likely cause of Monday’s price collapse. The next morning S&P futures were trading at 185 to 190 and the corresponding price to buy the S&P itself was 220. This price difference of 30 to 35 was previously unheard of, since arbitrageurs like us generally kept the two prices within a point or two of each other. But the institutions had sold massive amounts of futures, and the index itself didn’t fall nearly as far because the terrified arbitrageurs wouldn’t exploit the spread. Normally when futures were trading far enough below the index itself, the arbitrageurs sold short a basket of stocks that closely tracked the index and bought an offsetting position in the cheaper index futures. When the price of the futures and that of the basket of underlying stocks converged, as they do later when the futures contracts settle, the arbitrageur closes out the hedge and captures the original spread as a profit. But on Tuesday, October 20, 1987, many stocks were difficult or impossible to sell short. That was because of the uptick rule.

It specified that, with certain exceptions, short-sale transactions are allowed only at a price higher than the last previous different price (an “uptick”). This rule was supposed to prevent short sellers from deliberately driving down the price of a stock. Seeing an enormous profit potential from capturing the unprecedented spread between the futures and the index, I wanted to sell stocks short and buy index futures to capture the excess spread. The index was selling at 15 percent, or 30 points, over the futures. The potential profit in an arbitrage was 15 percent in a few days. But with prices collapsing, upticks were scarce. What to do?

I figured out a solution. I called our head trader, who as a minor general partner was highly compensated from his share of our fees, and gave him this order: Buy $5 million worth of index futures at whatever the current market price happened to be (about 190), and place orders to sell short at the market, with the index then trading at about 220, not $5 million worth of assorted stocks—which was the optimal amount to best hedge the futures—but $10 million. I chose twice as much stock as I wanted, guessing only about half would actually be shorted because of the scarcity of the required upticks, thus giving me the proper hedge. If substantially more or less stock was sold short, the hedge would not be as good but the 15 percent profit cushion gave us a wide band of protection against loss.

In the end we did get roughly half our shorts off for a near-optimal hedge. We had about $9 million worth of futures long and $10 million worth of stock short, locking in $1 million profit. If my trader hadn’t wasted so much of the market day refusing to act, we could have done several more rounds and reaped additional millions.

Kovner Oil Tanker

In the 1980s, Bruce Kovner discovered a trading opportunity in buying oil tankers for scrap value. Thorp instantly recognized the fat pitch and invested.

Along with Jerry Baesel, the finance professor from UCI who joined me at PNP, I spent an afternoon with Bruce in the 1980s in his Manhattan apartment discussing how he thought and how he got his edge in the markets. Kovner was and is a generalist, who sees connections before others do.

About this time he realized large oil tankers were in such oversupply that the older ones were selling for little more than scrap value. Kovner formed a partnership to buy one. I was one of the limited partners. Here was an interesting option. We were largely protected against loss because we could always sell the tanker for scrap, recovering most of our investment; but we had a substantial upside: Historically, the demand for tankers had fluctuated widely and so had their price. Within a few years, our refurbished 475,000-ton monster, the Empress Des Mers, was profitably plying the world’s sea-lanes stuffed with oil. I liked to think of my part ownership as a twenty-foot section just forward of the bridge. Later the partnership negotiated to purchase what was then the largest ship ever built, the 650,000-ton Seawise Giant. Unfortunately for the sellers, while we were in escrow their ship unwisely ventured near Kharg Island in the Persian Gulf, where it was bombed by Iraqi aircraft, caught fire, and sank. The Empress Des Mers operated profitably into the twenty-first century, when the saga finally ended. Having generated a return on investment of 30 percent annualized, she was sold for scrap in 2004, fetching almost $23 million, far more than her purchase price of $6 million.

Sometimes the best trades aren’t on public exchanges. Looking outside traditional trading vehicles can reveal huge opportunities other traders pass up.

SPACs

An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs. These “special purpose acquisition corporations” were marketed during the preceding boom in private equity investing. Escrowing the proceeds from the initial public offering (IPO) of the SPAC, the managers promised to invest in a specified type of start-up company. SPACs had a dismal record by the time of the crash, their investments in actual companies losing, on average, 78 percent. When formed, a typical SPAC agreed to invest the money within two years, with investors having the choice—prior to the SPAC buying into companies—of getting back their money plus interest instead of participating.

By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV. These SPACs had from two years to just a few remaining months either to invest or to liquidate and, before investing, offer investors a chance to cash out at NAV. In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 percent, cashing out in a few months. This was at a time when short-term rates on US Treasuries had fallen to approximately zero!

Runaway Inflation

Short-term US Treasury bill returns went into double-digit territory, yielding almost 15 percent in 1981. The interest on fixed-rate home mortgages peaked at more than 18 percent per year. Inflation was not far behind. These unprecedented price moves gave us new ways to profit. One of these was in the gold futures markets.

At one point, gold, for delivery two months in the future, was trading at $400 an ounce and gold futures fourteen months out were trading for $500 an ounce. Our trade was to buy the gold at $400 and sell it at $500. If, in two months, the gold we paid $400 for was delivered to us, we could store it for a nominal cost for a year, then deliver it for $500, gaining 25 percent in twelve months.

Notice the commonalities between Thorp’s fat pitches:

  • They’re rare and typically occur during crises. Crises create large dislocations that cause investors to act irrationally, creating huge opportunities.
  • They all have asymmetric risk/reward ratios.
  • Fast action was needed to capture each of them. Fat pitches don’t last long. Other traders will eventually find them and pounce.
  • They’re all “one of a kind” opportunities. The exact scenario had never happened before and creative thinking was needed to capitalize. Although history rhymes, it does not repeat. The next fat pitch won’t be exactly like the last one.  

Gambling As Training

Understanding gambling games like blackjack and some of the others is one of the best possible training grounds for getting into the investment world. You learn how to manage money, you learn how to compute odds, you learn how to reason what to do when you have an advantage.

Gambling is investing simplified. Both can be analyzed using mathematics, statistics, and computers. Each requires money management, choosing the proper balance between risk and return. Betting too much, even though each individual bet is in your favor, can be ruinous.

Notice how Thorp didn’t say anything about MBAs, economic degrees, or finance classes. Those don’t prepare you for the core challenges you’ll face as a trader like position sizing and risk management.

Our favorite cross-training exercise at Macro Ops is poker. Poker forces you to think in terms of probabilistic outcomes while managing your risk and establishing an edge.

Edge

You can’t succeed in trading without an edge. And a good way to find that edge is by asking yourself how the market is inefficient and how you can exploit it.

In A Man For All Markets Thorp details sources of inefficiency:

In our odyssey through the real world of investing, we have seen an inefficient market that some of us can beat where:

  1. Some information is instantly available to the minority that happen to be listening at the right time and place. Much information starts out known only to a limited number of people, then spreads to a wider group in stages. This spreading could take from minutes to months, depending on the situation. The first people to act on the information capture the gains. The others get nothing or lose. (Note: The use of early information by insiders can be either legal or illegal, depending on the type of information, how it is obtained, and how it’s used.)
  2. Each of us is financially rational only in a limited way. We vary from those who are almost totally irrational to some who strive to be financially rational in nearly all their actions. In real markets the rationality of the participants is limited.
  3. Participants typically have only some of the relevant information for determining the fair price of a security. For each situation, both the time to process the information and the ability to analyze it generally vary widely.
  4. The buy and sell orders that come in response to an item of information sometimes arrive in a flood within a few seconds, causing the price to gap or nearly gap to a new level. More often, however, the reaction to news is spread out over minutes, hours, days, or months, as the academic literature documents.

He then explains how to exploit these inefficiencies (emphasis mine):

  1. Get good information early. How do you know if your information is good enough or early enough? If you are not sure, then it probably isn’t.
  2. Be a disciplined rational investor. Follow logic and analysis rather than sales pitches, whims, or emotion. Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down. Don’t gamble unless you are highly confident you have the edge. As Buffett says, “Only swing at the fat pitches.”
  3. Find a superior method of analysis. Ones that you have seen pay off for me include statistical arbitrage, convertible hedging, the Black-Scholes formula, and card counting at blackjack. Other winning strategies include superior security analysis by the gifted few and the methods of the better hedge funds.
  4. When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. This means the earliest traders gain the most and their continued trading tends to reduce or eliminate the mispricing. When you have identified an opportunity, invest ahead of the crowd.

Pay special attention to his second point: Don’t trade unless you’re sure you have an edge that’ll create better than random outcomes.

An easy way to do this is by backtesting or paper trading your strategy before investing in it.

It’s also a good idea to try finding a solid trading edge in markets you love. As Thorp explains:  

To beat the market, focus on investments well within your knowledge and ability to evaluate, your “circle of competence.”

If you love following small companies then just trade those. If you come from an energy background then focus on crude oil and natural gas. And if you like math and volatility, options are a good place to start. Only venture into a new market after spending a significant amount of time studying it!

Efficient Markets

Anyone who’s actually traded knows the Efficient Market Hypothesis is bogus. It’s a poor mental model used by lazy academics. Thorp has a much better take:

When people talk about efficient markets they think it’s a property of the market. But I think that’s not the way to look at it. The market is a process that goes on. And we have, depending on who we are, different degrees of knowledge about different parts of that process.

. . . market inefficiency depends on the observer’s knowledge. Most market participants have no demonstrable advantage. For them, just as the cards in blackjack or the numbers at roulette seem to appear at random, the market appears to be completely efficient.

Markets aren’t actually random. They only appear random to those without expertise. The right knowledge transforms the market from a sequence of random numbers into a predictable process.

Combining Technicals With Fundamentals

In the mid 2000s Thorp developed a trend following futures strategy. During the process he discovered that combining fundamental information with technical signals was superior to just technicals alone.

Here he is in Hedge Fund Market Wizards:  

The fundamental factors we took into account varied with the market sector. In metal and agricultural markets, the spread structure—whether a market is in backwardation or contango—can be important, as can the amount in storage relative to storage capacity. In markets like currencies, however, those types of factors are irrelevant.

Combining technicals with fundamentals can boost your win rate. Find the key fundamental drivers in your market and add them into your process.

Anchoring

In A Man For All Markets Thorp describes his first ever trade buying a company called Electric Autolite. In the subsequent two years the stock declined 50%. He decided to hold out, hoping it would return to his entry point so he could break even. The stock eventually did rebound and Thorp got out for a scratch, but he later realized how stupid that was. Here’s Thorp reflecting on it:

What I had done was focus on a price that was of unique historical significance to me, only me, namely, my purchase price.

Thorp’s early mistake is called anchoring. Humans tend to place special significance on price levels they originally entered at. But in reality, these prices have little significance. Don’t ever emotionally attach yourself to any price.

Interpreting Financial Headlines

It’s important to take news headlines with a grain of salt. Journalists build narratives behind every market move because it’s their job. Thorp warns about getting caught up in the noise:

Routine financial reporting also fools investors. “Stocks Slump on Earnings Concern” cried a New York Times Business Day headline. The article continued, “Stock prices fell as investors continued to be concerned about third-quarter results.” A slump? Let’s see. “The Dow Jones Industrial Average (DJIA) declined 2.96 points, to 10,628.36.” That’s 0.03 percent, compared with a typical daily change of about 1 percent. Based on the historical behavior of changes in the DJIA, a percentage change greater than this happens more than 97 percent of the time. The Dow is likely to be this close to even on fewer than eight days a year, hardly evidence of investor concern.

One way to separate signal from noise is to track the market’s expected move for the day. To calculate the expected percentage move of the S&P 500, take the VIX and divide it by the the square root of 252. If price stays within that band, any “news” for the day is likely not worth paying attention to.

Correlation

All the trading greats stress the importance of correlation. A low correlation among positions diversifies the portfolio and creates a much better risk/reward profile.

Here’s Thorp from HFMW:

We tracked a correlation matrix that was used to reduce exposures in correlated markets. If two markets were highly correlated, and the technical system went long one and short the other, that was great. But if it wanted to go long both or short both, we would take a smaller position in each.

A common problem traders face when monitoring correlation is the lookback period. Thorp found that 60 days was best. A shorter window is too noisy and a longer one will produce correlations that aren’t relevant anymore.

The Moore Research Center has a free to use correlation matrix for all major macro markets. Check it here.

Leverage

Use leverage incorrectly and you’ll blow up. But properly harness it and you can engineer a risk to reward ratio that perfectly suits you.

Heres Thorp:

The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.

Don’t rely on a risk control model that uses probability to estimate your max loss. Always assume the absolute worst case and manage from there.

Position Sizing

Thorp popularized the position sizing formula called the Kelly Criterion. Here he is from Hedge Fund Market Wizards:

The Kelly criterion is the bet size that will produce the greatest expected growth rate in the long term. If you can calculate the probability of winning on each bet or trade and the ratio of the average win to average loss, then the Kelly criterion will give you the optimal fraction to bet so that your long-term growth rate is maximized.

Here’s the version of the formula that works best for trading:

So for example, if a trade has a 1:1 reward to risk ratio, with a 60% chance of winning, you would bet:

((1)(.6)-(.4))/1 = .2 or 20% of your account

The one issue with Kelly sizing is that we’ll never know our true win rate or reward to risk ratio in markets. The best we can do is estimate.

Also, the effectiveness of a trading edge changes over time. Because markets evolve, the same edge won’t work forever.

This is why Thorp only uses the Kelly number as a reference. In practice it’s better to bet around half-Kelly because you get about three-quarters of the return with half the volatility.

If you’re less certain of your edge, you should bet an even smaller amount. When Thorp was working on his trend following model in the mid 2000s, he was simulating 1/10 of the Kelly number.

Thorp also has advice on drawdowns. He suggests lowering your position size during rough patches and then ramping up again as you come out of them.

If we lost 5 percent, we would shrink our positions. If we lost another few percent, we would shrink our positions more. The program would therefore gradually shut itself down, as we got deeper in the hole, and then it had to earn its way out. We would wait for a threshold point between a 5 percent and 10 percent drawdown before beginning to reduce our positions, and then we would incrementally reduce our position with each additional 1 percent drawdown.

This is an extremely robust risk management technique used by almost all the trading greats. To read more about them, download our special report by clicking here.

 

 

Lessons From A Trading Great Amos Hostetter
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Lessons From Commodities Corporation Founder & Trader Amos Hostetter

Amos Hostetter cofounded Commodities Corporation (otherwise known as CC) along with Helmut Weymar back in 1969. CC is the trading shop that produced more legendary trading talent than the Yankees have All-Stars. Alumni include: Bruce Kovner, Michael Marcus, Paul Tudor Jones, Ed Seykota and more…

Hostetter was considered the wise sage and mentor of the group. He’s credited with imbuing many of these trading greats with the wisdom and knowledge they used to achieve their grand heights.

Upon his untimely death in a car accident in 1977, the directors of Commodities Corporation commissioned one of their traders, Morris Markovitz, to gather and record Hostetter’s timeless philosophy on markets and trading. The goal was to ensure future CC traders could benefit from his invaluable teachings. The resulting work was an internal booklet titled Amos Hostetter; A Successful Speculator’s Approach to Commodities Trading.

Hostetter’s trading philosophy could be boiled down to the following (in Hostetter’s own words):

  1. Try to acquire every bit of fundamental information available. Read extensively.
  2. Simultaneously, post daily charts on commodities and develop a feel for trends.
  3. Follow the fundamentals in your trading but only if and as long as the charts do not cast a negative vote.

He regarded money management as the first priority for any serious market speculator. From Markovitz (emphasis mine):

Sound money management is crucial to successful trading. The best market analysis won’t get a trader to the bottom line — consistent profits — unless he has a sound money-management policy. This is an area where Mr. Hostetter excelled.

Sometimes it is hard to draw a sharp line between trading principles and money-management principles. If I were to paraphrase a famous saying, I think it would provide an accurate summary of one of Mr. Hostetter’s most important trading and money-management principles: the market, to be commanded, must be obeyed. As a trader, Mr. Hostetter was aware of his own fallibility. He tried to protect himself from errors by the trading rules he used and by trying to anticipate areas of potential surprise. This alone, however, was not enough. If the market moved against him for a reason he did not understand, he would often exit without waiting for a trading rule to take him out: as a money manager, he knew he could not afford the luxury of a prolonged argument with the market.

Perhaps his most important money-management principles was “Take care of your losses and the profits will take care of themselves.” This means that a trader should place strong emphasis on keeping his losses small, because two or three large losses in succession would be a crippling blow.

His risk management principle of “taking care of your losses” is similar to Howard Marks of Oaktree Capital: “if we avoid the losers, the winners will take care of themselves.” This truth is the single most important law of speculation. It sounds glib, but cutting your losses and letting your winners run is the most common thread amongst all great traders. If I could travel back in time 15 years, I’d go back and beat this fact into my thick skull… and I’d be much richer today for it.

Hostetter used a multi-pronged approach to assessing markets and potential trades. It’s from him that Michael Marcus likely developed the “Marcus-Trifecta” to gauge markets — looking at “technicals, fundamentals, and market tone”. Here’s an overview of his approach to fundamentals:

Mr. Hostetter’s fundamental approach was, to use his own phrase, “broad brush.” This means that he would look at the overall balance sheet and the statistics that applied to the commodity in which a trade was contemplated. Then, certain basic questions would be asked:

— Will production exceed consumption this season (a stocks build-up)? If so, then the initial premise would be bearish.

— Will consumption exceed production (a stocks draw-down)? If so, then the initial premise would be bullish.

The initial premise would then be refined by other considerations. For example: weather could destroy the current production estimate for an agricultural commodity; a change in general economic conditions could destroy the demand or consumption estimate; the high price of meat could increase demand for potatoes.; the low price of corn could increase demand for soybean meal; and so forth. The last two items are intended to illustrate the flexibility, or creativity, of Mr. Hostetter’s thinking, and represent the personal style he brought to commodity analysis. He held facts in the highest regard, yet he remained constantly alert to the principle that the facts can and do change.

The key phrase is flexibility of thinking, which is the opposite of stubbornness. Mr. Hostetter knew that, whatever his fundamental analysis might show today, there was a good chance it would show something different by the time the last day of the season had arrived… In brief, Mr. Hostetter would never wed himself to a precise position on the outlook for the future; he had often enough experienced the phenomenon of a significant price change before the reasons behind it became general knowledge. He kept himself prepared for surprises, in both directions, in advance. If one does a little “dreaming” about the possibilities on both sides, then he is in possession of possible explanations for surprises, and will be less hesitant to act if and when they come.

Maintaining an open-mind and staying aware of your biases is critical. Markets serve ample helpings of humble pie to those who arrogantly wed themselves to a “market prediction”.

Hostetter took a nuanced approach to using technicals, similar to how we utilize price action in our trade analysis at Macro Ops. Markovitz writes:

Mr. Hostetter definitely did not accept the clear-cut dichotomy between fundamental and technical trading. Both methods can be used successfully, but he blended the two. It is my impression that Mr. Hostetter would have agreed with the following statement:

The pure fundamentalist concerns himself with production, consumption, stocks, and other basic economic data, viewing these as the causes and price as the effect, while the pure technician regards price as its own cause. In fact, to draw a sharp line of choice between these two approaches is not the best policy. Price itself should also be regarded as a fundamental. It can play the role of cause or effect or both under different circumstances.

The market’s own behavior can, in a real sense, be classified as a fundamental variable. The method of analysis, however, is completely different. The technical aspect of Mr. Hostetter’s trading consists primarily of:

1. Trend following
2. Support and resistance areas
3. Pattern recognition

These are listed in order of their importance, although any one of them may be the dominant influence at a  given time.

Within this technical framework Hostetter employed a number of useful heuristics to help him read the tape:

Many of the techniques Mr. Hostetter used depended on a time factor. In general, as with congestion areas, most patterns accrue more significance if they take more time to form, and a trader should be aware of time as well as price when considering any technical pattern. For example, a bear market that has persisted for a year is unlikely to form its bottom in a week, nor is a two-month bull market likely to take a year to form a top. A trader should keep in mind the duration of recent major moves and expect commensurate time periods for the formation of the current pattern. (Patience is an important virtue — hastiness rarely pays).

I find Hostetter’s thoughts on the “time factor” useful in analyzing where price may be headed. Markets tend to follow a certain symmetry over long periods of time. Some technical heuristics Hostetter used are:

  • He would become seriously concerned if a bull market was unable to make a new high for thirty days (the same is true for a bear market that hadn’t made new lows for thirty days).
  • A poor price response to bullish news is itself an ill omen for long positions, especially if other cautionary signs are present (e.g., the bull market is old, the vigor has shown some signs of waning, prices are near a fundamental objective, etc.)
  • The most important timing issue is patience. One should wait for his opportunity, wait until everything lines up according to his expectations. It is far better to miss an opportunity here or there than to jump in too early without a clear plan. Too much patience is rarely the problem for any trader.
  • A trader should do his fundamental homework, keep his eye on the charts, and patiently observe. Once he is able to form a definite fundamental opinion, he should wait for confirming market action before proceeding.

Practicing the necessary patience to win is one of the hardest aspects of speculation. Fear is man’s strongest emotion and is behind one of a trader’s most common foibles — the fear of missing out (FOMO). Success comes to those who realize that Pareto’s Law dominates the distribution of returns. Only a handful of trades a year will account for the majority of profits. It pays to sit and wait patiently for those fat pitches to come along.

Lastly, here’s a list of maxims and trading do’s and don’ts as recorded by Hostetter in his own words.

GENERAL PRINCIPLES AND MARKET MAXIMS

  • A very general and important rule is: take care of your losses and your profits will take care of themselves. This is both a trading maxim and a money-management tool. A trader needs big winners to pay for his losses and he won’t capture these big wins unless he stays with the trend all the way.
  • There is never any objection to taking a loss. There must always be a good reason before you can permit yourself to close out a profit.
  • When in doubt, get out. Don’t gamble. Be sure, however, that your doubt is based on something real (fundamentals, market action, etc.), and not simply on your own nervousness about the price level. If it is only the price level that is making you nervous, then either stick with the winner or at worst use a more sensitive stop-loss point. Give the major trend all the chance you can to increase your profits.
  • All major trends take a long time to work themselves out. There are times when the best approach is just to sit and do nothing, letting the power of the underlying trend work for you while others argue about the day-to-day news. Be patient.
  • Surprising price response to news is one of the most reliable price forecasters. Bullish response to bear news, or vice-versa, means that the price had already discounted the news and the next move will probably go the other way. Actually, this is only one example of a wider principle: When a market doesn’t do what it “should”, then it will probably do what it “shouldn’t”, and fairly soon. (Note that false breakouts, up or down, are also subsumed under this more general principle. When new lows are achieved in a long-term bear market, for example, the market ‘ ‘should” follow through with weakness—after all, it is a bear market. If, instead, it rallies quickly, this provides some evidence against the bear market premise).

THE DANGERS IN TRADING CAUSED BY HUMAN NATURE

  1. Fear — fearful of profit and one acts too soon.
  2. Hope — hope for a change [in the] forces against one.
  3. Lack of confidence in one’s own judgment.
  4. Never cease to do your own thinking.
  5. A man must not swear eternal allegiance to either the bear or bull side. His concern lies in being right.
  6. Laziness prevents a trader from keeping posted to the minute.
  7. The individual fails to stick to facts.
  8. People believe what it pleases them to believe.

DON’TS

  1. Don’t sacrifice your position for fluctuations.
  2. Don’t expect the market to end in a blaze of glory. Look out for warnings.
  3. Don’t expect the tape to be a lecturer. It’s enough to see that something is wrong.
  4. Never try to sell at the top. It isn’t wise. Sell after a reaction if there is no rally.
  5. Don’t imagine that a [market] that has once sold at 150 must be cheap at 130.
  6. Don’t buck the market trend.
  7. Don’t look for breaks. Look out for warnings.
  8. Don’t try to make an average from a losing game.
  9. Never keep goods that show a loss and sell those that show a profit. Get out with the least loss and sit tight for greater profits.

SUGGESTIONS

  1. Experience must teach. Follow it invariably.
  2. Observation gives the best tips of all. Observe [market] behavior and experience shows how to profit.
  3. Buying on a rising market is the comfortable way. The point is not so much to buy as cheap as possible or go short at top prices, but to buy and sell at the right time.
  4. Remember [a market is] never too high for you to begin buying or too low to begin selling. Let your tape reading show you when to begin. After the initial transaction don’t make a second unless the first shows a profit.
  5. There is a great deal in starting right in every enterprise.
  6. When something happens on which you did not count when your plans were made, it behooves you to utilize the opportunity.
  7. In a bear market it is always wise to cover if complete demoralization develops suddenly.
  8. Stick to facts only and govern your actions accordingly.
  9. What is abnormal is seldom a desirable factor in a trader’s calculations. If a [market] doesn’t act right, don’t touch it.

To get more wisdom from trading greats like Hostetter, click here.

 

 

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Lessons From A Trading Great: Jim Leitner

Jim Leitner is the greatest macro trader you’ve never heard of. He was once a currency expert on Wall Street, pulling billions from the markets, but now he plays the game through his own family office.

Leitner understands the Macro Ops “go anywhere” mentality better than any other trader:

Global macro is the willingness to opportunistically look at every idea that comes along, from micro situations to country-specific situations, across every asset category and every country in the world. It’s the combination of a broad top-down country analysis with a bottom-up micro analysis of companies. In many cases, after we make our country decisions, we then drill down and analyze the companies in the sectors that should do well in light of our macro view.

I never lock myself down to investing in one style or in one country because the greatest trade in the world could be happening somewhere else. My advice is to make sure that you do not become too much of an expert in one area. Even if you see an area that is inefficient today, it’s likely that it won’t be inefficient tomorrow. Expertise is overrated.

He’ll jump into any asset or market, no matter how esoteric. Some of his craziest investments include inflation-linked housing bonds in Iceland and a primary equity partnership in a Ghanaian brewer. He even had the balls to jump into Turkish equities and currency forwards with 100% interest rates and 60% inflation during the late 90’s… the man is a macro beast.

FX Trading

Leitner was one of the first traders to understand and implement FX carry trades. A carry trade involves borrowing a lower interest rate currency to buy a higher interest rate currency. The trader earns the spread between the two rates. Here’s his own words from Drobny’s Inside The House Of Money:

The most profitable trade wasn’t a trade but an approach to markets and a realization that, over time, positive carry works. Applying this concept to higher yielding currencies versus lower yielding currencies was my most profitable trade ever. I got to the point in this trade where I was running portfolios of about $6 billion and I remember central banks being shocked at the size of currency positions I was willing to buy and hold over the course of years.

FX carry trades can be extremely lucrative. But if you get caught holding a currency during a surprise devaluation, it can instantly erase all your profits and them some. Leitner was able to protect himself by keeping a close eye on central bank action:

I was always able to sidestep currency devaluations because there were always clear signals by central banks that they were pending and then I just didn’t get involved. Devaluations are such a digital process that it doesn’t make sense to stand in front of the truck and try to pick up that last nickel before getting run down.You might as well wait, let the truck go by, then get back on the street and continue picking up nickels.

Leitner understands that currencies mean revert in the short-term and trend in the long-term. He’s explored the use of both daily and weekly mean reversion strategies:

The other thing that is pretty obvious in foreign exchange is that daily volatilities are much higher than the information received. Think of it like this:

The euro bottomed out in July 2001 at around 0.83 to the dollar and by January 2004 it was trading at 1.28. That’s a 45 big figure move divided by 900 days, giving an average daily move of 5 pips, assuming straight line depreciation. Say one month option volatility averaged around 10 percent over that period, implying a daily expected range of 75 pips.That’s a signal-to-noise ratio of 1 to 15. In other words, there was 15 times as much noise as there was information in prices!

Noise is just noise, and it’s clearly mean reverting. Knowing that, we should be trading mean reverting strategies. In the short term, it’s a no brainer to be running daily and weekly mean reverting strategies. When things move up by whatever definition you use, you should sell and when they move back down, you should buy. On average, over time you’re going to make money or earn risk premia.

Options

No one has mastered global macro options better than Leitner. He knows when they’re overpriced and when they make a great bet:

Short-dated volatility is too high because of an insurance premium component in short-dated options. People buy short-dated options because they hope that there’s going to be a big move and they’ll make a lot of money. They spend a little bit to make a lot and, on average, it’s been a little bit too much. When they do make money they make a lot of money, but if they do it consistently they lose money. Meanwhile, someone who consistently sells short-dated volatility, on average, would make a little bit of money. It’s a good business to be in and not too dissimilar to running a casino. So there is a risk premia there that can be extracted. (Side note: this is the risk premia we harvest in Vol Ops, one of our portfolios in the Macro Ops Hub).

Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price. We need to make a distinction between volatility and the future drift of the currency. Since the option’s seller (the investment bank) hedges its position daily, it makes money selling options. Since some buyers do not delta hedge but instead allow the spot to drift away from the strike, they make money on the underlying trend move in the currency. So both the seller of the option and the buyer make money. The profit for the seller comes from extracting the risk premia in the daily volatility, and for the buyer it comes from the fact that currency markets tend to exhibit trending behavior.

We had a study done on the foreign exchange options market going back to 1992, where one-year straddle options were bought every day across a wide variety of currency pairs.We found that even though implied volatility was always higher than realized volatility over annual periods, buying the straddles made money. It’s possible because the buyer of the one-year straddles is not delta hedging but betting on trend to take the price far enough away from the strike that it will cover the premium for the call and the put. Over time, there’s been enough trend in the market to carry price far enough away from the strike of the one-year outright straddle to more than cover the premium paid.

If the option maturity is long enough, trend can take us far enough away from the strike that it’s okay to overpay.

This is a key concept that very few option traders understand. High vol doesn’t mean huge trends. And low vol doesn’t mean no trends. It’s possible to have low vol trends and high vol ranges.

Leitner exploits this kink in option theory by “overpaying” for optionality from a volatility perspective, but still winning from trending markets.

These overpriced long-dated options become essential in choppy markets. They allow you to “outsource” risk management. You can play for a long-term trend without the risk of getting stopped out by a head fake:

Options take away that whole aspect of having to worry about precise risk management. It’s like paying for someone else to be your risk manager. Meanwhile, I know I am long XYZ for the next six months. Even if the option goes down a lot in the beginning to the point that the option is worth nothing, I will still own it and you never know what can happen.

Psychology, Emotions, And Fallibility

Like every other star trader, Leitner has strong emotional control. He views all trades within a probabilistic framework and fully accepts his losses:

At Bankers, I came to realize that I was absolutely unemotional about numbers. Losses did not have an effect on me because I viewed them as purely probability-driven, which meant sometimes you came up with a loss. Bad days, bad weeks, bad months never impacted the way I approached markets the next day.To this day, my wife never knows if I’ve had a bad day or a good day in the markets.

Along with reigning in his emotions, he also acknowledges his own fallibility:

Another thing that I realize about myself that I don’t see in other traders is that I’m really humble about my ignorance. I truly feel that I’m ignorant despite having made enormous amounts of money.

Many traders I’ve met over the years approach the market as if they’re smarter than other people until somebody or something proves them wrong. I have found this approach eventually leads to disaster when the market proves them wrong.

It’s not possible to “crack” the market. You’re guaranteed to eventually be proven wrong no matter how smart you are. And when that time comes, you have to stop the bleeding before death occurs. The trading graveyard is littered with “smart guys” who thought they solved the market puzzle… don’t be one of them.

Investment Narratives

A compelling narrative is both a blessing and a curse.

On the one hand, understanding the dominant market narrative will keep you on the right side of a powerful trend. But it can also lure you into some dumb trades. Not all narratives are rooted in fundamental reality. Oftentimes a false trend will form and lead to a boom/bust process. Here’s Leitner’s take:

We need to quantify things and understand why things are cheap or expensive by using some hard measure of what cheap or expensive means. Then there has to be a combination of story and value. A story is still required because a story will appeal to other people and appeal is what drives markets. If there’s no story and something’s cheap, it might just stay cheap forever. But if there’s a story involved, make sure that you first look at the numbers before you get involved to be sure there is some quantitative backing to the idea.

Leitner’s team always starts with quantitative scans when hunting for equities. If the quant data doesn’t check out, there’s a higher risk of falling prey to an overhyped narrative.

In equities, we start by looking at various valuation measurements like price to book, price to earnings, and price to cash flow. It’s very important to not be too story-driven. A way to avoid that is by using quantitative screens to determine what is cheap. Once you find things that are cheap, then look for stories that argue why it shouldn’t be cheap. Maybe a stock is cheap but it’ll stay cheap forever because there’s no good story attached to the cheapness.

Longs Vs Shorts

It’s no surprise that being long financial assets has a positive expected value over time. Stocks and bonds pay a premium to incentivize investors to move out of cash and take risk.

This is why you need twice your normal conviction to go short. The system is designed to move higher over time, so you better have a damn good reason to fight that drift.

Owning assets, or being long, is easier and also more correct in the long term in that you get paid a premium for taking risk.You should only give your money to somebody if you expect to get more back. Net/net it is easier to go long because over portfolios and long periods of time, you’re assured of getting more money back. Owning risk premia pays you a return if you wait long enough, so it’s a lot easier to be right when you’re going with the flow, which means being long. To fight risk premia, you have to be doubly right.

Leverage

Mention the word “leverage” around rookie traders and they’ll run for the hills. Most think it’s a quick way to blow up a trading account. But the pros view leverage as a tool that can completely transform and enhance risk-adjusted returns. Ray Dalio is traditionally the one credited with using this concept to make billions.

Let’s say you have a 30-yr bond that returns 6% a year above the cash rate. It has a max drawdown of 20%.

You then compare it to a stock index that returns 9% a year above the cash rate. It has a max drawdown of 50%.

By applying leverage, you can transform the bond into the higher performing asset. Using 2x leverage on the long bond will give you 12% returns with 40% drawdowns. This is a much better deal than the stock index on a risk-adjusted basis. This technique is known as “risk parity.”

Leitner applies it to his fixed income investments:

When using leverage, you want the highest Sharpe ratio because you’re borrowing money against your investment, and the best Sharpe ratios are found in the two years and under the sector of fixed income. On an absolute return basis, two years and under bonds are not going to pay as much as a 10-year bond because the yields are usually lower. But the risk-to-return ratio is also very different.You could be five times levered in the two-year and get a higher payout with the same risk as a 10-year bond because of duration.

Going levered long 2-year notes is a better risk-adjusted trade than going long a 10-year note. You get the same return in the levered 2-year, but with less volatility.

Most investors can’t exploit this because they can’t use leverage. But a macro trader using futures can perform all sorts of financial wizardry and vastly outperform a typical cash-only fund.

Portfolio Construction

Over time Leitner has adapted his strategy away from traditional global macro. Instead of using market timing, trend following, and gut feel — the pillars of old school macro — he’s shifted to a multi-strategy approach.

He combines various system-based strategies across five main asset classes: Equities, Fixed Income, Currencies, Commodities, and Real Estate. His goal is to earn the risk premia present in each category. He then reserves a certain amount of his cash for special situation big bets that only come around a few times a year.

We start off by acknowledging that we are ignorant, so we need to be systematic, clip some coupons, and earn some risk premia. It doesn’t matter if it is in currencies, bonds, commodities, real estate, or equities. Of course we have to be smart about it by reading a lot, talking to smart people, and being on top of it all, while acknowledging that we’re not that much smarter than the rest of the world.Then, every once in awhile, we’re going to stumble upon an exciting idea that’s going to give us some extra alpha and the ability to outperform.

After these five main asset categories, we have a last category which we call absolute return.This is where we stick those great, out-of-the-box ideas we come across about twice a year. Sometimes we’re lucky and find major mispricings once or twice a year, and sometimes we’re unlucky and it takes 18 months before the next one comes along. When we find these fantastic ideas, we’re willing to bet up to 10 percent of our fund on one idea. One that we think will double or triple, earning an extra 10 or 20 percent return for the entire portfolio.

The absolute return category is there in order to leave us open to making unsystematic money.

The multi-strat approach is the most robust way to allocate capital. Most of the macro legends of the 70s, 80s, and 90s have moved to a family office format and implemented something similar to what Leitner describes. At Macro Ops we too use a combination of discretionary and systematic strategies to make sure the cash register keeps ringing year after year.

For more details on how Jim Leitner analyzes, sizes, and manages his trades, check out our Ops Notes by entering your email below:

 

 

Ray Dalio
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Lessons From a Trading Great: Ray Dalio

Ray Dalio is the founder of Bridgewater. Two years ago, Bridgewater surpassed Soros’ Quantum fund for the title of most profitable hedge fund of all time; returning over $46 billion since inception. Read more

Paul Tudor Jones
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Lessons from a Trading Great: Paul Tudor Jones (PTJ)

From Jack Schwager’s Market Wizards:

October 1987 was a devastating month for most investors as the world stock markets witnessed a collapse that rivaled 1929. That same month, the Tudor Futures Fund, managed by Paul Tudor Jones, registered an incredible 62 percent return. Jones has always been a maverick trader. His trading style is unique and his performance is uncorrelated with other money managers. Perhaps most important, he has done what many thought impossible: combine five consecutive, triple-digit return years with very low equity retracements. (I am fudging slightly; in 1986, Paul’s fund realized only a 99.2 percent gain!) Read more

Stanley Druckenmiller
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Lessons From A Trading Great: Stanley Druckenmiller

The “greatest money making machine in history”, a man with “Jim Roger’s analytical ability, George Soros’ trading ability, and the stomach of a riverboat gambler” is how fund manager Scott Bessent describes Stanley Druckenmiller. That’s high praise, but if you look at Druckenmiller’s track record, you’ll find it’s well deserved. Read more

Lessons From A Trading Great George Soros.jpg
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Lessons From A Trading Great: George Soros

Remember the scene from the 90’s classic, The Sandlot, where “Smalls” loses his father’s Babe Ruth autographed baseball to “The Beast” and the other kids question him in disbelief, saying: Read more

,

Lessons from a Trading Great: Jesse Livermore

“Boy Wonder”, “Boy Plunger” and the “Great Bear of Wall St.” are a few of the monikers Jesse Livermore was known by.

Livermore was immortalized in the trading classic Reminiscences of a Stock Operator by Edwin Lefevre — a book your author has read countless times over the years and still pulls new wisdom from with each revisit.

Reminiscences has stood the test of time because it, more than any other book, explains the fundamental truths that lie at the heart of successful speculation. It’s no doubt a reflection of Livermore’s deep and intimate understanding of this great game.

One of the ironies I’ve learned through years of dissecting the habits and practices of top traders like Livermore is that there is nothing special to what they do. I’m not implying that what they’re able to do isn’t impressive; of course it is. I simply mean that they have no special or secret knowledge or ability that’s unique to them.

Most people start out in this game looking for that “thing”; whether it be a special insight or indicator or strategy or whatever, that will show them how to win. They think if they can just find the secrets to what make the greats great, then they’ll be set. But in reality… if there’s any secret at all, it’s that there is no secret.

All of the important truths that a speculator needs to understand were plainly communicated by Livermore over 75 years ago.

Does that mean you can read Reminiscencesand instantly become a great trader? Well, let me ask you this: can you read the classic Ben Hogan’s Five Lessons on golf and go out and play scratch golf? Of course not! And that’s because both books have all the foundational knowledge you need to succeed but they don’t supply the practice that ingrains the lessons and transforms that knowledge into wisdom.

Here’s how Livermore put it, “The training of a stock trader is like a medical education. The physician has to spend long years learning anatomy, physiology, materia medica and collateral subjects by the dozen. He learns the theory and then proceeds to devote his life to the practice.”

The practice is the hard part. It takes time and a Herculean effort. Blisters and portfolio losses. There are no short-cuts. But practice without knowledge is wasted effort. It’s like trying to run on your hands because nobody ever told you to use your feet.

So with that, here’s the knowledge (with some commentary by me), as given by Livermore many years ago. What you do with it is up to you but I suggest you try running with your feet.

Learn How to Lose

An old broker once said to me: ‘If I am walking along a railroad track and I see a train coming toward me at sixty miles an hour, do I keep on walking on the ties? Friend, I sidestep. And I do not even pat myself on the back for being so wise and prudent.’

To be a great trader you have to be a great loser. Sounds like a contradiction right? Well it isn’t. The fact is, great traders will typically have more losing trades than profitable ones. They’ll spend more time in an equity drawdown than at new highs. Some of this is due to the natural 90/10 distributions of markets (Pareto’s Law), but much of it is actually by design.

Mark Spitznagel wrote in The Dao of Capital that the most valuable lesson he learned from his Chicago trading pit mentor, Everett Klipp, was that “you’ve got to love to lose money.” If you love to take small losses then you’ll never take a large one. That’s important because it’s the large ones that’ll kill ya’.

Humans are naturally averse to losing (obvious statement). Our psychological programming attaches a lot of nonsensical meaning to taking losses in the market. We are evolutionarily wired to be bad emotional traders. The key is to invert this instinctual response and learn to “love to lose”. Livermore talks about this inversion:

Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong — not taking the loss — that is what does damage to the pocketbook and to the soul.

And here’s a simple and yet KEY… KEY fundamental truth to good trading: never add to your losers, sell what shows you a loss, and let run what shows you a profit.

Of all speculative blunders there are few worse than trying to average a losing game. My cotton deal proved it to the hilt a little later. Always sell what shows you a loss and keep what shows you a profit. That was so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse.

This lesson was important enough that Paul Tudor Jones had it plastered on the wall right above his desk.

ptj_losers_average_losers

Livermore’s occasional failure to follow this rule is what led to the multiple blowups he experienced throughout his career. He lost when he failed to follow his advice that it’s “foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let this thought be written indelibly upon your mind.”

Livermore learned the hard way that our natural instincts must be flipped.

Instead of hoping he must fear and instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.

The Importance of Understanding General Conditions

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

Not many people realize this, but Livermore was the original “global macro” guy. His “greatest discovery” was the importance of macro — or what he called “general conditions”.

He had the same realization that hedge fund manager Steve Cohen had decades later, which is “that 40 percent of a stock’s price movement is due to the market, 30 percent to the sector, and only 30 percent to the stock itself.”

After Livermore made this discovery he said “I began to think of basic conditions instead of individual stocks. I promoted myself to a higher grade in the hard school of speculation. It was a long and difficult step to take.”

This revelation completely changed the way he approached markets and trading. While everybody was piking around, losing money playing the “stock picking” game, Livermore was studying general conditions. He now understood the simple fundamental truth that you want to be long in a bull market and short in a bear market.

I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, ‘Well, you know this is a bull market!’ he really meant to tell them that the big money was not in the individual fluctuations but in the main movements — that is, not in reading the tape but in sizing up the entire market and its trend.

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks.

It’s when Livermore started playing the macro game that he really started making the big money.

I cleared about three million dollars in 1916 by being bullish as long as the bull market lasted and then by being bearish when the bear market started. As I said before, a man does not have to marry one side of the market till death do them part.

But I can tell you after the market began to go my way I felt for the first time in my life that I had allies — the strongest and truest in the world: underlying conditions. They were helping me with all their might. Perhaps they were a trifle slow at times in bringing up the reserves, but they were dependable, provided I did not get too impatient.

General conditions (macro) continue to be — BY FAR — the biggest potential source for alpha in trading. That’s because most market participants are still focused on the stock picking game and remain completely ignorant of the most significant driver of their stock’s price action. Learning to read the underlying conditions is like swinging the trading equivalent of Thor’s Hammer… it makes that much of a difference.

Patience, Psychology and the Dangers of Overtrading

It sounds very easy to say that all you have to do is to watch the tape, establish your resistance points and be ready to trade along the line of least resistance as soon as you have determined it. But in actual practice a man has to guard against many things, and most of all against himself — that is, against human nature.

Livermore understood man’s foibles perhaps better than most. He made and lost multiple fortunes, the size of which, most could hardly fathom. He knew well the fundamental truth that becoming a great trader is as much about self-mastery as it is about market mastery.

Market Wizard Ed Seykota said “I think that if people look deeply enough into their trading patterns, they find that, on balance, including all their goals, they are really getting what they want, even though they may not understand it or want to admit it.”

True professional speculation is often a tedious and boring affair, where one can go months without putting on a trade because the general conditions are not right.

There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class.

Most traders that I see are not really in the game to make money by strictly following a sound trading process. They want quick profits; the thrill of gambling; high adrenaline entertainment. Basically the same lizard brain “wants” that drive the large profits for Vegas casinos.

This is why most people overtrade. And they overtrade a lot. Here’s Livermore’s thoughts on why that’s bad.

There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. No man can always have adequate reasons for buying or selling stocks daily–or sufficient knowledge to make his play an intelligent play.

The overtrading by others brings us to another fundamental truth: that other’s impatience can be our profits if we’re willing to practice infinite patience.

The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages. Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes.

When putting on a trade it’s better to be a little late than a little early. As Livermore put it, “don’t take action with a trade until the market, itself, confirms your opinion. Being a little late in a trade is insurance that your opinion is correct. In other words, don’t be an impatient trader.”

Self-mastery leads to market mastery. Livermore said “the human side of every person is the greatest enemy of the average investor or speculator. Fear keeps you from making as much money as you ought to. Wishful thinking must be banished.”

Price Action and Path of Least Resistance

There is what I call the behavior of a stock, actions that enable you to judge whether or not it is going to proceed in accordance with the precedents that your observation has noted. If a stock doesn’t act right don’t touch it; because, being unable to tell precisely what is wrong, you cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit.

Livermore was one of the best at reading the tape. His years of studying price action gave him a sort of “sixth sense” for knowing what the market was doing and where it was headed. This is one of those “practice” elements where only so much instruction can be given… the rest needs to be learned and experienced.

But one of the important lessons that Livermore talked about is studying price action in order to determine the “path of least resistance”, saying:

For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance. They will do whatever comes easiest, therefore they will go up if there is less resistance to an advance than to a decline; and vice versa.

The path of least resistance is all about understanding accumulation/distribution or consolidation/expansion zones. A chart is simply a two dimensional representation of supply/demand. The path of least resistance is the price level that supply/demand is likely to move towards based off past and current accumulation/distribution levels.

Learn to read supply and demand action with practice and your trading will become more fluid. Livermore stated, “It would not be so difficult to make money if a trader always stuck to his speculative guns — that is, waited for the line of least resistance to define itself and began buying only when the tape said up or selling only when it said down.”

A critical part to what he’s saying is to wait for the path of least resistance to present itself. Attempting to anticipate trend changes is a costly and foolish endeavor.

One of the most helpful things that anybody can learn is to give up trying to catch the last eighth — or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

Trend reversals are a process, not an event. Livermore notes “that a market does not culminate in one grand blaze of glory. Neither does it end with a sudden reversal of form. A market can and does often cease to be a bull market long before prices generally begin to break.”

The trend is your friend and there are separate trends on different time intervals. The more trends that line up on each interval, the lesser resistance on the trade’s path.

Big Bets and Sitting Tight

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money.

The average trader is quick to take a profit and slow to book a loss. Going back to the importance of inverting our trading nature, it’s as important to let profits run as it is to cut losses short. Remember, we’ll lose more than we’ll be right. So we need those winners to be significantly larger to pay for our losers. Livermore said, “they say you never grow poor taking profits. No, you don’t. But neither do you grow rich taking a four point profit in a bull market.”

Livermore explained successful trading plainly, “I study because my business is to trade. The moment the tape told me that I was on the right track my business duty was to increase my line. I did. That is all there is to it.”

The fundamental truths of speculation, as laid out by Livermore three quarters of a century ago, can be summarized as follows:

  • Cut your losses: Never average down and never hope losses reverse. Just cut.
  • Infinite patience: Good trades are few and far between. Trade for profits, not for action.
  • Learn macro: Understanding general conditions is essential to being a market master and not a piker.
  • Price action is king: Learn to read the tape and don’t argue with markets — they know more than you.
  • Big bet/sit tight: Ride your winners for all their worth. This conviction comes with practice.
  • Self-mastery: You are your greatest impediment to your own success. “Know thyself”.

These lessons are as true today as they were then. As Livermore put it, “there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

One just needs to look to Stanley Druckenmiller — perhaps the closest modern day equivalent to Jesse Livermore — to see that these truths still hold true. Here’s Druck:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

Livermore said that “A man can have great mathematical ability and an unusual power of accurate observation

and yet fail in speculation unless he also possesses the experience and the memory. And then, like the physician who keeps up with the advances of science, the wise trader never ceases to study general conditions, to keep track of developments everywhere that are likely to affect or influence the course of the various markets.”

If you’re craving more lessons from the trading greats, then check out our in-depth special report by clicking here.

 

 

Michael Marcus
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Lessons From a Trading Great: Michael Marcus

Michael Marcus turned $30,000 into $80 million over a 20 year period — not too shabby.

He was profiled in Schwager’s original classic Market Wizards, giving one of the more impressive interviews in a book filled with many. Read more

Bruce Kovner
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Lessons from a Trading Great: Bruce Kovner

Bruce Kovner retired in 2011 from Caxton Associates, the hedge fund he founded and ran for 28 years.

Over that time the fund returned an average of 21 percent a year since its inception. In comparison, the SPX averaged just 11%. Kovner had only one losing year (in 94’). Before Caxton, while trading at the famous Commodities Corp, he averaged close to 90% over 10 years. Impressive numbers by any measure. Read more