The Little Book of Market Wizards by Jack D. Schwager

Contents  ˅

Preface 1) Failure Is Not Predictive 2) What Is Not Important 3) Trading Your Own Personality 4) The Need for an Edge 5) The Importance of Hard Work 6) Good Trading Should Be Effortless 7) The Worst of Times, the Best of Times 8) Risk Management 9) Discipline 10) Independence 11) Confidence 12) Losing Is Part of the Game 13) Patience 14) No Loyalty 15) Size Matters 16) Doing the Uncomfortable Thing 17) Emotions and Trading 18) Dynamic versus Static Trading 19) Market Response 20) The Value of Mistakes 21) Implementation versus Idea 22) Off the Hook 23) Love of the Endeavor Appendix

"The day you stop learning is the day you begin decaying." Although it was Isaac Asimov who made this quote, he wasn't the only writer who felt that way. In an apparent attempt to avoid decay, Jack Schwager wanted to learn what made the best traders so successful. His quest took 25 years and involved dozens of interviews with the top traders.

Over the years, Schwager used those interviews as the subject of four Market Wizards books. He learned the success of the Market Wizards was not because they all use a similar trading method. They don't.

The Wizards approach the markets in different ways, but one common factor unites them. They all follow a core set of trading principles. This was the ultimate lesson Schwager discovered and was the reason for writing this book. More than any system or method, it's these key trading ideas which give the best chance for long-term success.

"Past performance is not indicative of future results." This financial warning is required by law for a simple reason. Good times don't last forever. But this chapter shows, neither do bad times.

The first trading experience for Michael Marcus was as a college student in the 1960s. He opened a small account which quickly became even smaller. He knew nothing about trading and was taking advice from someone who knew even less.

After getting rid of his advisor, Marcus added $500 to his account, which he then promptly lost. Not willing to give up, he cashed in $3,000 from a life insurance policy his father had left him.

Using the $3,000 and a newsletter recommendation, Marcus bought some corn futures contracts. Due to a blight disease which hit the corn crop, his $3,000 grew to $30,000.

Convinced the corn blight would return the next year, Marcus borrowed $20,000 from his mother. After adding this to his $30,000 account, he bought all the corn futures he could. Unfortunately, the financial performance warning was proven right. The blight didn't return and Marcus closed out his account with only $8,000 remaining.

Despite his apparent lack of trading ability, Michael Marcus was persistent. Putting the corn blight disaster behind him, Marcus kept on trading. In fact, he eventually became so good, he was hired as a trader at an elite trading company. Over a period of 10 years, Marcus turned $130,000 into over $80 million.

Tony Saliba is another Wizard who experienced early failure. His first trading experience was so bad, it left him feeling suicidal. Saliba started by trading options with a borrowed $50,000. In two weeks of trading, he ran his account up to $75,000. Feeling he could do no wrong, Saliba kept trading.

Once again, past performance was no guarantee of future success. After trading for six more weeks, Saliba wiped out his $25,000 profit, along with $35,000 of the borrowed $50,000. Not surprisingly, this experience left him severely depressed. But like Marcus, Tony Saliba didn't quit. He later became so consistent, he put together a streak of 70 consecutive winning months.

Schwager found initial failure was common in his Market Wizard interviews. But so too was persistence. The lesson for beginning traders is to expect early failure. For this reason, it's smart to trade only small amounts while gaining experience.

When learning any skill, success is stupidly simple. Do what works, and don't do what doesn't work. Looking for the one system, the one trading method, or some ancient secret formula, is one thing which doesn't work. There is no secret formula. There is no one system or method which the best traders use.

Jim Rogers is a trader who excels at predicting long-term trends. In his interview with Schwager, he mentioned the eight year bear market in gold would last another 10 years. It did. Rogers also thought a roaring Japanese bull market would peak within a year or two and drop 80 to 90 percent. As predicted, within a year, the Japanese market topped out and the Nikkei index lost about 80 percent over the following years.

Rogers honed his trading skill when he partnered with George Soros in 1973. They started the Quantum Fund which became one of the most successful hedge funds ever. Rogers based his market opinions only on the fundamentals of the situation. He thought technical analysis was worthless, and traders who used it could only make money by selling their services.

But apparently, Jim Rogers never read a Market Wizards book. If he had, he might have seen the Marty Schwartz interview. For 9 years, Schwartz had tried to make money using fundamental analysis, and never succeeded. In frustration, he switched to trading with only technical analysis. This change in market approach, helped Schwartz turn a $40,000 account into $20 million.

Both Rogers and Schwartz were ridiculously successful. Yet one was a pure fundamentalist and the other a pure technician. The point is, fundamental and technical analysis are only tools. They can make trading easier, but they don't make profits automatic. It's the trader who determines success, not the tools.

Stocks are often seen as a single entity, called the stock market. But in reality, stocks are distinct assets with unique characteristics. Each stock follows a price path which is different from all others. Traders too are unique. Each trader should find the trading path which offers them the best fit.

As one of the best futures traders ever, Paul Tudor Jones' trading style is a perfect match to his personality. When Schwager interviewed him, they were at Jones' office while the markets were open. In between interview questions, Jones was watching price quotes, placing orders, and dealing with his staff. Obviously a man not easily distracted.

At the same time of day, Gil Blake was sitting at his desk in his bedroom. Maybe he would place a trade that day, maybe not. And it wouldn't be a futures contract, it would be a mutual fund. Basically, a guy who could use some extra caffeine in his coffee.

But Blake's lack of trading activity and subdued nature didn't prevent his success. Over a 12 year period, he had a 45 percent average annual return.

Neither one of these two traders would be as successful working in the other man's environment. But each had found the right trading style for their personality.

Finding the right trading style is not always easy. Marty Schwartz had been trained to pick stocks with fundamental analysis. But it was a poor fit and resulted in 9 losing years before he switched to technical analysis.

A trading style and personality mismatch often occurs with traders who buy systems. Unless the system is aligned with their personality, they are unlikely to get the results promised.

When a system is a personality mismatch, following it becomes difficult and stressful. This situation makes it more likely a trader will quit the system when it has a losing streak. And by quitting, the trader misses the compensating profits which inevitably follow.

It's a myth good money management can turn a losing system into a winner. If money management was that powerful, gamblers would bankrupt casinos. Unless a gambler or a trader has an edge, they will eventually go broke.

Money management is like polishing a knife. The polishing makes the knife work better, but the knife must first have an edge. The edge a trader must have is a profitable method. And like a polished knife, money management can make the edge its most effective.

Natural talent only goes so far with trading or any skill. The best in a field are tireless workers.

David Shaw is an example of the work ethic the top traders have. In addition to running his own quantitative trading firm, he spun off and sold a number of related technology companies. Shaw also applied his talents to computational biochemistry and served as an advisor to President Clinton. Even on vacation, Shaw always worked at least a few hours a day.

John Bender was another trader who was a ceaseless worker at whatever he did. In the last years of his life, Bender bought up large tracts of land in Costa Rica and established a wildlife preserve. The money for the land came from his years as an options trader. Bender would regularly follow the global markets for 20 hours a day. Trading for himself and the Soros Quantum fund, he produced an average annual compound return of 33 percent with only a 6 percent maximum drawdown.

One of the appeals of trading is its simplicity. All you need to know is how to buy and sell some financial asset. And when there's a strong bull market, as happened with stocks in the 1990s, making a profit seems easy.

But the pros know making a profit is not easy. To be profitable in the long run requires following a number of principles. And one of these principles is hard work. The best traders succeed because they put in the time, effort, and thought, other traders don't.

There are two stages to any skill, preparation and process. The learning and effort needed to acquire the skill is the preparation. The performance of the skill is the process.

Learning how to be a profitable trader requires hard work. It's like learning to drive a car. At first, it's mentally demanding and uncomfortable. But once the skill is acquired, trading, like driving, is comfortable and effortless.

Losing streaks in trading are inevitable. The Market Wizards offer two recommendations on how to lower the stress of losing streaks. Either reduce the position size or take a break from trading.

Losing streaks make trading stressful, which is the opposite of what the process should be. Risking less or getting away from trading are effective ways to reduce the stress and bring emotions back into balance.

Trading a smaller position size may also be appropriate during a winning streak. Some Market Wizards have their biggest losses following their biggest profits. So they begin to reduce their risk exposure when trading is going exceptionally well.

If the size of this chapter is an indication of its importance, then it's the most important chapter in the book. This is appropriate since risk control is fundamental to profitable trading. Although he made triple digit annual returns trading, Paul Tudor Jones said, "Don't focus on making money; focus on protecting what you have."

Effectively managing risk is what separates winning traders from losing traders. Losing traders focus too much on perfecting entry techniques and don't give enough attention to loss control. Winning traders know it's more important to minimize losses instead of maximizing gains. Limiting losses is not only financially rewarding, but by reducing the stress losses cause, better trading decisions can be made.

A call option is the right to buy a specific asset at a fixed price. The call's price rises and falls in step with the asset's price. A put option gives the buyer the right to sell the asset at a fixed price. As the asset price moves up or down, the put's price goes in the opposite direction.

Sometimes a stop is hit on a short-term price reversal and then the market continues in its original direction. The trader was right on the overall trade direction, but misses out on the profit after the minor reversal. Using options instead of buying or selling the asset, avoids this situation. No matter what short-term price swings occur, an option maintains its fixed buy or sell price. This lets options gain the profit that occurs after a short-term price reversal.

Placing stops is not a science. Most of the Market Wizards have painful stories about stops and the difficulties of controlling risk. The hedge fund manager, Colm O'Shea, had the experience of correctly forecasting future interest rates, and yet lost money on his trade.

O'Shea thought interest rates would not rise over a current three month period, but the existing futures market premium said otherwise. However, in three months time, O'Shea was proven right. His opinion should have netted him a large profit, but instead all he had was a string of losses. The problem was O'Shea's risk to reward was out of balance. He placed his stops too close and kept getting stopped out on minor fluctuations.

If O'Shea had made the size of his stops in proportion to the projected gain, he would have made the profit he foresaw. Although it was an expensive lesson, he did gain a better understanding of good stop placement. It was O'Shea who provided the rule to place a stop where prices should not go, if the trade idea is correct.

It's not often mentioned, but keeping losses small has two benefits. There's the obvious financial aspect of not endangering an account. But there's also the mental and emotional side to losses. Small losses are to be expected and their emotional impact is little if any.

A large loss threatens both a trader's account and mental state. The loss can be so depressing, trading is avoided and good trades passed up. A large loss may also cause the opposite reaction. The trader might take on excessive risk in order to make up for the loss.

Keeping losses small avoids financial and emotional pain. Avoiding both, helps lead to long-term success.

The greatest source of risk in any trade, is the trader. If the trader is a computer, the trade will be executed as planned. The same can't always be said for a human trader. Proper execution of a trading plan requires either a machine or a trader with machine-like discipline. Randy McKay's trading experience provides an example of discipline and what happens when it's absent.

Early in Randy McKay's career, his discipline was severely tested. In November 1978, he had built up a large position in the British pound. Over one weekend there was a surprise economic event. And the surprise was not a happy one.

Monday morning McKay's position was showing a $1.5 million loss. Exiting losing trades is a necessary part of discipline. McKay immediately got out of the trade. Considering the size of the loss, he could have waited to see if the price would recover. But McKay had no regrets about not waiting for a possible recovery. Nor did he care if it did.

One time ten years later, McKay's discipline decided to take a vacation. He was holding a large position in the Canadian dollar. McKay thought with the profit from the trade, he would reach his trading goal of $50 million.

Just before leaving on a trip to Jamaica, McKay checked the dollar's quote. The quote was so far out of its normal price range, he thought it was a mistake, and left to catch his flight.

But the quote was not a mistake and it was not good. The next day when McKay checked from Jamaica, the bad news was even worse. At that point, his position was down $3 million. So he applied his usual discipline and closed out the entire position. Wrong.

Instead, McKay closed out only about 20 percent of his position, and decided to hold the rest for a few more days. Those turned out to be very expensive days. He finally closed out the remaining position with a $7 million loss. His discipline never took another vacation.

Markets are unforgiving. Discipline is not easy. But neither is taking a $7 million loss.

Great traders don't follow the path of the crowd. Great traders create their own path. They prefer their own trading style instead of imitating the style of someone else. Great traders trade off their own opinions, right or wrong, rather than listen to another trader's advice.

After he had written Market Wizards, Schwager started to occasionally get calls from one of the traders interviewed. At the time, Schwager was his company's technical analyst. During one call, the two talked about the Japanese yen. Schwager thought the yen was headed lower, but the Market Wizard gave him dozens of technical reasons Schwager was wrong.

After this discussion, Schwager was going to leave town and would not be able to watch the market. He knew to ignore someone else's opinion, but decided to close out his short yen position. Later Schwager realized leaving town was only an excuse to justify a bad decision. He could have simply put on a stop to protect the position.

Was the Market Wizard wrong and Schwager was right? Actually they were both right. It turned out the two traders were operating with different time frames. Schwager made trades of two weeks or longer and the Market Wizard traded intra-day. When the yen kept going lower, the Wizard trader exited his long position and went short. He followed only the market and not Schwager's opinion. The result was he ended up with the profit Schwager could have had.

Winning traders are confident traders. Paul Tudor Jones was so confident in his ability, he had 85 percent of his net worth in his trading accounts. Another successful futures trader, Monroe Trout, had 95 percent of his net worth in his accounts. But Gil Blake beat them both. He took out four second mortgages over three years to increase the size of his trading account.

It's a chicken and egg question. Does winning make a trader confident or does confidence make a trader a winner? Whichever it is, it's clear confidence in your trading ability is a requirement for success.

Good traders have no problem taking losses. These traders know their profits will outweigh their losses. But bad traders can't stand to take losses. They hold losing trades with the excuse, they'll get out once they're even.

This situation is like the difference between gamblers and a casino. When gamblers lose, they keep betting by deluding themselves they'll quit just as soon as they break even. But winning traders are like the casino. They will lose on some individual bets, but over time, the odds and the profits are in their favor.

Top traders also know not all losses or profits are the same. Profits and losses can be the result of either a good or bad trade. A good trade is one made following a profitable method. A bad trade is one made for any other reason.

Because even the best trading method will have losses, a good trade will result in some losses. Conversely, a trade made on a whim could result in a profit. But only good trades have the probability of long-term profits.

Patience is not in our DNA. If we want something, we want it now. But unfortunately, traders who lack patience, are very unlikely to be successful.

One of the reasons profitable trading is hard, is because trade entries and exits require patience. The impatient trader values making a trade now, instead of waiting for the best trades. As Warren Buffett said, "There are no called strikes on Wall Street." Baseball players have to swing at some pitches, but traders don't, and shouldn't.

The best traders know to wait for the good trades, and to wait long enough before exiting the profitable ones. But no patience is allowed for losing trades. They get closed out quickly.

Poor traders do the opposite. They hold onto losing trades in the hope of a recovery. But they have no patience with profitable trades, and get out too soon.

Both actions are the sign of a trader who wants to be right. The losing trade doesn't count as a mistake as long as the loss is not taken. And by closing out the profitable trade, the trader sees this as evidence of being right. But the size of trade profits count as much as their frequency. And the market adage, "No one ever went broke taking a profit", is wrong. You can go broke if the profit you take, doesn't cover the losses.

Opinions are unique. Their owners may give them greater value than anything or anyone. And their opinion may have no relationship to reality. But markets have no loyalty to opinions and traders shouldn't either.

Taking a trading loss can be emotionally painful. It's clear evidence of a wrong opinion. But good traders must accept that their opinions and trades will sometimes be wrong.

Good traders abandon even their strongest opinions when the market shows they're wrong. And when the best traders are wrong, they will often completely reverse their trade position.

One difference between amateur traders and the pros, is the amount they risk on a trade. Amateurs treat all trades alike and risk the same amount on each, which is usually too much. Professional traders qualify their trades. The greater probability for a trade's success, the more pros are willing to risk.

However, even the best traders can risk too much at times, especially early in their career. When choosing trade position size, it's best to be conservative, especially if inexperienced.

Two risk factors which all traders should be aware of are volatility and correlation. As market volatility goes up, so does risk. Trade size should be scaled back when markets are volatile.

Position size should also be reduced if trading correlated markets at the same time. Markets are considered correlated if they move in the same way at the same time. Holding a position in two highly correlated markets, is like holding two positions in just one. In a failed attempt to reduce risk with diversification, the risk is actually doubled.

"If it feels good, do it", was a popular phrase of the 1960s. It was given as a reason for self-indulgent behavior. Richard Dennis, a trader who made millions, had a different view on comfort and the markets. For him, "If it feels good, don't do it."

The hedge fund trader, Joel Greenblatt, unintentionally tested what comfort in the stock market can lead to. Greenblatt had created a value formula for rating stocks. He put a list of the best rated stocks on his website. People could either put together their own portfolio or let Greenblatt do it for them.

Since Greenblatt and the public chose from the same list of stocks, their average results should have been about the same. But after 2 years, the portfolios Greenblatt put together, did 25 percent better than the public's portfolios.

Greenblatt's portfolios involved no timing. He bought the stocks and held them. The public was free to buy and sell the stocks in their portfolio and they did. This allowed them to do what was comfortable. And comfort resulted in buying and selling at the wrong time. In fact, the public's portfolios did worse than random selection from the stock list.

The outcome of this accidental psychology test, has been backed up by studies in behavioral economics. People often act in financially damaging ways since it's more comfortable than the alternative. Inexperienced traders take profits too soon to avoid the chance of the profit turning into a loss. But they hold onto losing trades in the usually false hope of a recovery. The public could take the correct approach by holding onto winners and dumping the losers. But that's uncomfortable, so they don't.

Larry Hite uses a computerized system to trade. A friend thought trading that way must be boring and wondered how Hite could do it. Hite told the friend, "I don't trade for excitement; I trade to win." That should be the motto for all traders.

Trading is not a place for emotions to take charge. Market Wizards know this and some of their most painful losses were due to impulsive trades. When Bruce Kovner made a rash decision with a futures trade, he lost 50 percent of his account. The money lost hurt, but his loss of rationality pained him at least as much, if not more.

Schwager makes a distinction between impulsive trades and intuitive ones. He sees intuition as the result of experience and not an emotional reaction to a trade situation.

It's emotions, not intuition, when traders ignore negative news because it goes against their opinion or a current trade. It's also emotion when traders think the market must be ready to reverse because they missed getting in on the trend. It's emotions which cause a lack of the objectivity needed to make good trades.

The survival of a species depends on how well it can adapt to environmental changes. The economic survival of a trader also depends on adapting to environmental changes.

Edward Thorp has a long record of consistent high returns, yet he doesn't attach himself to only one way of trading. In 1979, he did a study of a wide range of factors which might have predictive value for stocks. The most effective item researched, was based on which stocks had recently gone up or down the most. In the near term, generally the stocks which had recently lost the most tended to do better than the stocks which had recently gained the most.

Thorp would short the recent strong stocks and buy the recent weak ones. This is a market neutral approach. A market neutral portfolio profits from the spread between the long and short trades, regardless of the overall market direction.

When this approach became less profitable, he applied the strategy to market sectors instead of individual stocks. Later this revision also became less profitable. Thorp then balanced the portfolio in relation to various mathematical factors. Eventually this too lost its edge and the strategy was abandoned. But the important point is, Thorp was able to prolong the life of the basic strategy by adapting to changes in the market.

A simple way to adapt to possible market changes, is by scaling entries and exits. Every trade has only one perfect entry and one perfect exit price. A trader is never likely to hit either. But what a trader can do, is buy and sell in steps.

If market prices have just had a strong move, they may pause and retrace some of the move or simply keep going. By taking only a partial position at this point, two good things happen. Not as much is at risk if the market does retrace. And if there's no retracement, at least some profit is made on the continued move.

The same strategy applies when holding a position after a strong move. Exiting part of the position secures some profit and doesn't expose the entire position to a possible retracement. At the same time, the remaining open position can still capture additional profit.

Some traders apply the scaling principle in what's called, trading around a position. Each time a trade shows a profit, some of the profit is taken. Then more is added back to the initial position when the market has a retracement. It's a constant buying and selling process which lasts as long as the trend does.

Every trade entry and exit is less than perfect and scaling is a way to adapt to this imperfection. However, scaling in and out of a trade is not perfect either. Sometimes the entries and exits will be done at just the wrong time. But only partial losses occur in these cases and markets left prematurely, can always be re-entered.

Hamlet wasn't talking about trading when he said, "...there is nothing either good or bad, but thinking makes it so." But the same idea applies to markets. In trading, market news is never simply good or bad. It's the collective thought of the market about the news which makes it good or bad.

If a market is strong, it can shake off real or apparent bad news. And if a market is weak, even good news can't reverse the trend.

Following an important news event, compare the expectations to how the market responds. Is the market response in proportion to the significance of the news? If a very bearish news event doesn't affect a bull market, the market is strong. But if a very bullish report results in no gain or even a slight decline, the market is not as strong as it appears.

The importance of watching market reactions to news was evident during a strong bull market in soybeans. Michael Marcus was holding a large long position in the beans. One day, an extremely bullish government export report came out after the market close. Soybeans, like other futures, have a limit on how much prices are allowed to change from one day to the next. In strong markets, prices can hit this limit and not trade off that price. This is called locked limit. It was expected soybeans would lock limit up for the next three days.

In hopes of adding to his position, Marcus placed a buy order after the report came out. He thought there might be some trading the next day before soybeans locked limit up. The next day, soybeans opened limit up, but dropped back slightly and Marcus got his order filled.

But prices continued to remain below limit up and Marcus saw the market wasn't as strong as it was supposed to be. He immediately placed sell orders to close out his position. In his haste, he ended up selling more contracts than he had bought, and was then short the market. This proved to be a lucky accident, as he made a profit on the short contracts too.

In trading, the market's opinion is the only opinion that matters. Traders should do as Marcus did and pay attention to the market's response to news, not the news.

In life and in trading, it's not wrong to make mistakes. What's wrong, is to not learn from the mistakes and then repeat them.

Every trade is an experiment. Whatever the outcome, the result should be analyzed. Those parts of a trade which didn't work, should be examined to see what went wrong. Those parts which did work, should be repeated and if possible, done to a greater degree.

A popular way to track the good and bad parts of a trade, is with a trading journal or log. Before each trade, write down the reasons and expectations for the trade. Then once the trade is completed, compare the results to the pre-trade thoughts.

Financial markets offer a number of ways to implement any trade idea. And sometimes, the implementation is more important than the reason behind the trade.

Colm O'Shea saw the 1999 Nasdaq market as a bubble market and felt it would soon collapse. The obvious trade would be to short the market. But during a market collapse, rallies can be fast and very strong.

To profit from the idea and avoid the risk of shorting stocks, O'Shea took long positions in bonds. He reasoned a declining market would lead to a declining economy, declining interest rates, and a rise in bond prices.

Starting in 2000, the Nasdaq did begin a volatile decline. Interest rates also declined and bond prices rose in a much smoother fashion than stocks. In this case, the volatility could have also been managed by using stock options. No matter how volatile a stock was, an option would have limited the risk to a fixed amount.

Smart traders know the only opinion that matters is the market's opinion. So when their expectations don't match the market's direction, they know to get out. But sometimes, when the market contradicts expectations, they should hold on.

Marty Schwartz has a principle of how to react to certain market gifts. Some trades might make a trader nervous to hold them over the weekend or even overnight. But if a market currently offers a better than expected exit price, it's usually best to hold the position.

This principle is similar to following market reaction to news events. If expectations are negative for a trade position, but the market moves favorably, it's a signal to ignore the expectations.

For many people, business is a game, and the money they make is the score. In their interviews, Market Wizards saw trading as a challenging intellectual game. Trading was more than making money, it was a skill they enjoyed mastering.

Trading is a process with a goal to make more money than is lost. But traders who love the goal more than the process are unlikely to achieve success.

The appendix goes over the basics of how options work.

PJ Nance

Previous
Day Trading the Currency Market by Kathy Lien Based on her experience teaching others how to trade, Kathy Lien has two objectives for the book. She wants to cover the fundamentals of the foreign exchange (FX)…	…