The New Market Wizards: Conversations with America's Top Traders (18 page)

Can you expand on what you consider the normal human habits that lead to losing?

Decision theorists have performed experiments in which people are given various choices between sure things (amounts of money) and simple lotteries in order to see if the subjects’ preferences are rationally ordered. They find that people will generally choose a sure gain over a lottery with a higher expected gain but that they will shun a sure loss in favor of an even worse lottery (as long as the lottery gives them a chance of coming out ahead). These evidently instinctive human tendencies spell doom for the trader—take your profits, but play with your losses.

This attitude is also culturally reinforced, as exemplified by the advice: Seize opportunities, but hold your ground in adversity. Better advice to the trader would be: Watch idly while profit-taking opportunities arise, but in adversity run like a jackrabbit.

One common adage on this subject that is completely wrongheaded is: You can’t go broke taking profits. That’s precisely how many traders
do
go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.

Are there any other natural human tendencies that you think tend to sabotage success in trading?

There is what I refer to as “the call of the countertrend.” There’s a constellation of cognitive and emotional factors that makes people automatically countertrend in their approach. People want to buy cheap and sell dear; this by itself makes them countertrend. But the notion of cheapness or dearness must be anchored to something. People tend to view the prices they’re used to as normal and prices removed from these levels as aberrant. This perspective leads people to trade counter to an emerging trend on the assumption that prices will eventually return to “normal.” Therein lies the path to disaster.

What other aspects of human nature impede trading success?

What really matters is the long-run distribution of outcomes from your trading techniques, systems, and procedures. But, psychologically, what seems of paramount importance is whether the positions that you have
right now
are going to work. Current positions seem to be crucial beyond any statistical justification. It’s quite tempting to bend your rules to make your current trades work, assuming that the favorability of your long-term statistics will take care of future profitability. Two of the cardinal sins of trading—giving losses too much rope and taking profits prematurely—are both attempts to make
current
positions more likely to succeed, to the severe detriment of long-term performance.

Having seen people who have survived as traders and those who haven’t, what do you think are the characteristics that differentiate these two groups?

The people who survive avoid snowball scenarios in which bad trades cause them to become emotionally destabilized and make more bad trades. They are also able to feel the pain of losing. If you don’t feel the pain of a loss, then you’re in the same position as those unfortunate people who have no pain sensors. If they leave their hand on a hot stove, it will burn off. There is no way to survive in this world without pain. Similarly, in the markets, if the losses don’t hurt, your financial survival is tenuous.

I know of a few multimillionaires who started trading with inherited wealth. In each case, they lost it all because they didn’t feel the pain when they were losing. In those formative first few years of trading, they felt they could afford to lose. You’re much better off going into the market on a shoestring, feeling that you can’t afford to lose. I’d rather bet on somebody starting out with a few thousand dollars than on somebody who came in with millions.

What can a losing trader do to transform himself?

I can address two situations. If a trader doesn’t know why he’s losing, then it’s hopeless unless he can find out what he’s doing wrong. In the case of the trader who knows what he’s doing wrong, my advice is deceptively simple: He should stop doing what he is doing wrong. If he can’t change his behavior, this type of person should consider becoming a dogmatic system trader.

Were there any trades in your experience that proved especially difficult on an emotional level?

One day in my first year of trading, I went long soybeans just a few cents from limit-up. The market proceeded to go from limit-up to limit-down without an uptick. It took about three minutes. This display convinced me to get short at limit-down. Two minutes later, the market was limit-up again.

What did that experience teach you?

It was my first lesson in risk management. I lost more than half my equity on those two trades in five minutes.

How did you recover from that loss?

Trading small, making a lot of little decisions rather than trying to make a few blockbuster trades.

Do you find it difficult to deal with the emotional impact of large losses?

In many ways, large profits are even more insidious than large losses in terms of emotional destabilization. I think it’s important not to be emotionally attached to large profits. I’ve certainly made some of my worst trades after long periods of winning. When you’re on a big winning streak, there’s a temptation to think that you’re doing something special, which will allow you to continue to propel yourself upward. You start to think that you can afford to make shoddy decisions. You can imagine what happens next. As a general rule, losses make you strong and profits make you weak.

Allow me to broaden my question then. Do you find it difficult to deal with the emotionality of trading—whether due to large losses or large profits?

Trading can be a positive game monetarily, but it’s a negative game emotionally. On a few occasions, I’ve had the following experience: A group of markets to which I’m heavily committed open sharply against me, almost at my loss cutoff point. The loss seems crushing; I may even be wondering if my risk hasn’t been set too high. Then, miraculously, I’m not stopped out, and by midday these markets have gone roughly as much with me as they were against me earlier. How does this feel? There’s nothing in the elation that would approach compensating for the morning’s distress. The profit seems large, of course, but it doesn’t seem to help nearly as much as the earlier loss hurt.

To some extent, the foregoing example may simply be emotional exaggeration, but asymmetrical responses are perfectly valid. For example, if a price move brings the market to your stop point, you shouldn’t be thinking in terms of retracements. This is the kind of hopeful thinking that makes a trader keep giving a loss a little more room. Of course, the market may be retracing (as opposed to having reversed trend), but that’s not what you should be thinking about when it’s time to get out. Now consider the case where the market is sharply with you, rather than against you. Here it is quite appropriate to think about retracements. The sharpness of the move indicates that volatility has just increased; hence, even a windfall profit might dissipate rapidly. The situation is asymmetrical. When you’re losing and the thought that the market is retracing might be comforting, the concept is off limits for consideration. On the other hand, when you have a large profit and the idea of a retracement is a discomforting thought, it should be in the forefront of consideration. Trading is full of such asymmetries that make it an emotionally negative-sum proposition.

If trading is so emotionally unsatisfying, is the only rationale for doing it financial?

I can’t imagine why anyone would do it if it weren’t financially positive. This is one of the few industries where you can still engineer a rags-to-riches story. Richard Dennis started out with only hundreds of dollars and ended up making hundreds of millions in less than two decades—that’s quite motivating.

If you’re playing for the emotional satisfaction, you’re bound to lose, because what feels good is often the wrong thing to do. Richard Dennis used to say, somewhat facetiously, “If it feels good, don’t do it.” In fact, one rule we taught the Turtles was: When all the criteria are in balance, do the thing you least want to do. You have to decide early on whether you’re playing for the fun or for the success. Whether you measure it in money or in some other way, to win at trading you have to be playing for the success.

Trading is also highly addictive. When behavioral psychologists have compared the relative addictiveness of various reinforcement schedules, they found that intermittent reinforcement—positive and negative dispensed randomly (for example, the rat doesn’t know whether it will get pleasure or pain when it hits the bar)—is the most addictive alternative of all, more addictive than positive reinforcement only. Intermittent reinforcement describes the experience of the compulsive gambler as well as the futures trader. The difference is that, just perhaps, the trader can make money. However, as with most of the “affective” aspects of commodity trading, its addictiveness constantly threatens ruin. Addictiveness is the reason why so many players who make fortunes leave the game broke.

What advice do you have for dealing with the emotional pitfalls inherent in trading?

Some people are good at not expending emotional energy on situations over which they have no control. (I am not one of them.) An old trader once told me: “Don’t think about what the market’s going to do; you have absolutely no control over that. Think about what you’re going to do if it gets there.”

In particular, you should spend no time at all thinking about those roseate scenarios in which the market goes your way, since in those situations, there’s nothing more for you to do. Focus instead on those things you want least to happen and on what your response should be.

Any advice about handling the losing periods?

It helps not to be preoccupied with your losses. If you’re worried, channel that energy into research. Over the years at C&D [the company at which Dennis and Eckhardt were partners], we made our best research breakthroughs when we were losing.

Do you think that’s because those are the times you have the greatest motivation to improve your approach?

That’s probably true.

Among the observations you have made about markets and trading over the years, do any stand out as being particularly surprising or counterintuitive?

Some years back, a company ran an annual charting contest. The contestants had to predict the settlement prices of several futures for a certain date by a given deadline. Someone in our office [Dale Dellutri] decided, I believe prankishly, to use the random walk model. In other words, he simply used the settlement prices of the deadline as his prediction. He fell just short of becoming a prizewinner with this procedure. His name was among the first five of a list of fifty or so close runners-up.

This contest had hundreds of entrants. Therefore, more than 95 percent, and probably more than 99 percent, of the contestants scored worse than blind randomness. This is no mean feat.

The extremeness of the outcome in this story seems to support an apparent phenomenon that I’ve observed many times over the years, but for which I have no hard evidence: The majority of people trade worse than a purely random trader would.

Your hypothesis implies that most traders would be better off throwing darts than using their existing method—a provocative thought. How do you explain this phenomenon?

The market behaves much like an opponent who is trying to teach you to trade poorly. I don’t want to suggest that the market actually has intentions, because it doesn’t. An appropriate analogy is evolutionary theory, in which you can talk as though evolution has a purpose. For example, birds evolved wings in order to fly. Technically, that’s wrong. Birds aren’t Darwinians, and you can be sure no bird or protobird ever intended to evolve a wing. Nevertheless, natural selection acts very much like it intends for species to evolve things that are beneficial.

You can talk about the markets in a similar fashion. Anybody who has traded for a while begins to feel that the markets have certain personal characteristics. Very often the feeling you get is that “they are out to get you,” which is simply a personalization of the process. This illusion is well founded. The market does behave very much like a tutor who is trying to instill poor trading techniques. Most people learn this lesson only too well.

Please elaborate. What kind of lessons is the tutor teaching?