Lessons to Learn from Hedge Fund Market Wizards

01/24/2014 6:00 am EST


Jack Schwager

Author, Stock Market Wizards

The best-selling author of the popular Market Wizards books, Jack Schwager on TraderPlanet.com, details trading tips from 12 hedge fund market wizards.

What separates exceptional traders from the vast majority of participants?

The quest for an answer to this question was the motivation for my first Market Wizards book written nearly 25 years ago. Although I did get some satisfactory answers in that first book, I realized that the range of potential answers was open-ended, limited only by the successful traders interviewed. There were many common themes to be sure, but different traders brought new insights or at least different perspectives on the themes underlying trading success.

In the most recent book in the series, Hedge Fund Market Wizards, I continued my original quest with a set of 15 widely divergent traders—I don't think I could have made up a more diverse set of trading methodologies if I tried. At the end of the book, I distilled the insights from these interviews into 40 Market Wizard lessons. A sampling of these has been adapted for this article.

Find a Trading Method That Fits Your Personality
Traders must find a methodology that fits their own beliefs and talents. A sound methodology that is very successful for one trader can be a poor fit and a losing strategy for another trader. Colm O'Shea, one of the global macro managers I interviewed, lucidly expressed this concept in answer to the question of whether trading skill could be taught:

If I try to teach you what I do, you will fail because you are not me. If you hang around me, you will observe what I do, and you may pick up some good habits. But there are a lot of things you will want to do differently. A good friend of mine, who sat next to me for several years, is now managing lots of money at another hedge fund and doing very well. But he is not the same as me. What he learned was not to become me. He became something else. He became him.

Trade Within Your Comfort Zone
If a position is too large, the trader will be prone to exit good trades on inconsequential corrections because fear will dominate the decision process. Steve Clark, an event-driven manager, advises, you have to "trade within your emotional capacity." Similarly, Joe Vidich, a long/short equity manager warns, "Limit your size in any position so that fear does not become the prevailing instinct guiding your judgment."

In this sense, a smaller net exposure may actually yield better returns, even if the market ultimately moves in the favorable direction. For example, Martin Taylor, an emerging markets equities manager, came into 2008 with a very large net long exposure in high-beta stocks in an increasingly risky market. Uncomfortable with the level of his exposure, Taylor sharply reduced his positions in early January. When the market subsequently plunged later in the month, he was well-positioned to increase his long exposure.

Had Taylor remained heavily net long, he might instead have been forced to sell into the market weakness to reduce risk, thereby missing out in fully participating in the subsequent rebound.

Don’t Confuse the Concepts of Winning and Losing Trades with Good and Bad Trades
A good trade can lose money, and a bad trade can make money.

Even the best trading processes will lose a certain percentage of the time. There is no way of knowing a priori which individual trade will make money. As long as a trade adhered to a process with a positive edge, it is a good trade, regardless of whether it wins or loses because if similar trades are repeated multiple times, they will come out ahead. Conversely, a trade that is taken as a gamble is a bad trade regardless of whether it wins or loses because over time such trades will lose money.

If You Are Out of Sync with the Markets, Trying Harder Won’t Help
When trading is going badly, trying harder is often likely to make matters even worse. If you are in a losing streak, the best action may be to step away from the markets. Clark advises that the best way to handle a losing streak is to liquidate everything and take a vacation. A physical break can serve to interrupt the downward spiral and loss of confidence that can develop during losing periods. Clark further advises that when trading is resumed, the size should be kept small until confidence is regained.

NEXT PAGE: 4 More Lessons to Learn


The Road to Success is Paved with Mistakes
Ray Dalio, the founder of the world's largest hedge fund, strongly believes that learning from mistakes is essential to improvement and ultimate success. Each mistake, if recognized and acted upon, provides an opportunity for improving a trading approach. Most traders would benefit by writing down each mistake, the implied lesson, and the intended change in the trading process. Such a trading log can be periodically reviewed for reinforcement. Trading mistakes cannot be avoided, but repeating the same mistakes can be, and doing so is often the difference between success and failure.

The Importance of Doing Nothing
For some traders, the discipline and patience to do nothing when the environment is unfavorable or opportunities are lacking is a crucial element in their success. For example, despite making minimal use of short positions, Kevin Daly achieved cumulative gross returns in excess of 800% during a 12-year period when the broad equity markets were essentially flat. In part, he accomplished this feat by having the discipline to remain largely in cash during negative environments, which allowed him to sidestep large drawdowns during two major bear markets.

The lesson is that if conditions are not right, or the return/risk is not sufficiently favorable, don't do anything. Beware of taking dubious trades out of impatience.

How a Trade Is Implemented Can Be More Important Than the Trade Itself
A good example of this principle was provided by the way O'Shea traded his assumption that the bubble had burst in equities following the initial break from the March 2000 peak. He did not consider short positions in NASDAQ because of the danger of treacherous bear market rallies. Instead, O'Shea implemented his trade idea via a long bond position, reasoning that a bear market in equities implied that most assets would recede from inflated levels, which would lead to an economic slowdown and lower interest rates.

Even though the stock market ultimately went much lower, if O'Shea had implemented his idea through a short stock index position, there is a high likelihood that he would have been stopped out by the 40% rebound in the NASDAQ index during the summer of 2000. In contrast, the long bond position, which he had implemented instead of going short the equity index, witnessed a fairly smooth uptrend.

The trade was highly successful, not because the underlying premise was correct, which it was, but rather because of the way the trade was implemented.

If O'Shea had gone short the stock index instead, he would have been correct on his call, but most likely would have lost money by being stopped out during the steep bear market rally in equities.

Trading Around a Position Can Be Beneficial
Most traders tend to view trades as a two-step process: a decision when to enter and a decision when to exit. It may be better to view trading as a dynamic rather than static process between entry and exit points. The basic idea is that as a trade moves in the intended direction, the position exposure would be gradually reduced. The larger the move and the closer the market gets to a target objective, the more the position would be reduced.

After reducing exposure in this manner, the position would be reinstated on a market correction. Any time the market retraced to a correction reentry point, a net profit would be generated that otherwise would not have been realized. The choppier the market, the more excess profits trading around the position will generate. Even a trade in which the market fails to move in the intended direction on balance could still be profitable as a result of gains generated by lightening the total position on favorable trend moves and reinstating liquidated portions of the position on corrections.

This strategy will also reduce the chances of being knocked out of a favorable position on a market correction because if the position has already been reduced, the correction will have less impact and may even be desired to reinstate the liquidated portion of the position. The only time this strategy will have a net adverse impact is if the market keeps on going in the intended direction without ever retracing to correction reentry levels.
This negative outcome, however, simply means that the original trade was profitable, but that total profits are smaller than they would have been otherwise. In a nutshell, trading around a position will generate extra profits and increase the chances of staying with good trades at the expense of sometimes giving up a portion of profits on trades that move smoothly in the intended direction.

For Jimmy Balodimas, a frenetically active equities prop trader, trading around a position is a critical ingredient in his overall trading success. Not infrequently, it even allows him to be profitable on trades where he's wrong.

NEXT PAGE: 5 More Lessons to Learn


Position Size Can Be More Important Than the Entry Price
Too many traders focus only on the entry price and pay insufficient attention to the size of the position. Trading too large can result in good trades being liquidated at a loss because of fear. On the other hand, trading larger than normal when the profit potential appears to be much greater than the risk is one of the key ways in which many of the Market Wizards achieve superior returns.

Trading smaller, or not at all, for lower-probability trades and larger for higher-probability trades can even transform a losing strategy into a winning one.

For example, Edward Thorp, who started out devising strategies to win at casino games before achieving an extraordinary return/risk record as a hedge fund manager, discovered that by varying the bet size based on perceived probabilities, he could transform the negative edge in Blackjack into a positive edge. An analogous principle would apply to a trading strategy in which it was possible to identify higher and lower probability trades.

Determining the Trade Size
What is the optimal trade size? There is a mathematically precise answer: the Kelly criterion will provide a higher cumulative return over the long run than any other strategy for determining trade size.

Kelly Criterion
The Kelly criterion is the fraction of capital to wager to maximize compounded growth of capital. Even when there is an edge, beyond some threshold, larger bets will result in lower compounded return because of the adverse impact of volatility. The Kelly criterion defines this threshold.

The Kelly criterion indicates that the fraction that should be wagered to maximize compounded return over the long run equals:

F = PW – (PL/ W) where,
F = Kelly criterion fraction of capital to bet
W = Dollars won per dollar wagered (i.e., win size divided by loss size)

The problem, however, is that the Kelly criterion assumes that the probability of winning and the ratio of the amount won to the amount lost per wager are precisely known. Although this assumption is valid for games of chance, in trading, the probability of winning is unknown and, at best, can only be estimated. If win/loss probabilities can be reasonably estimated, then the Kelly criterion can provide a starting point for determining trade size.

Thorp recommends trading only half the Kelly amount (assuming win/loss probabilities can be estimated) because the penalty for overestimating the correct trade size is severe and because most people would find the volatility implied by the full Kelly amount too high for their comfort level. If win/loss probabilities can't be reasonably estimated, then the Kelly criterion can't be used.

Staring at the Screen All Day Can Be Expensive
Clark believes that watching every tick can lead to both overtrading and an increased chance of liquidating good positions. He advises finding a more productive use of time to avoid the pitfalls of watching the market too closely.

Pay Attention to How the Market Responds to News
A counter-to-anticipated response to market news may be more meaningful than the news item itself. Michael Platt, the cofounder of BlueCrest, one of the world's most successful hedge funds, recalls a trade in which there was a continuing stream of adverse news. He repeatedly expected to lose money after each news item, and yet the market did not move against him. Platt read the inability of the market to respond to the news as confirmation of his trade idea, and he quadrupled his position, turning it into one of his biggest winners ever.

By Jack Schwager on TraderPlanet.com

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