The Global Trader

When you look a little more closely at these natural-born—or trained–traders, they share a few characteristics that at first seem odd and irrelevant. One is that they do not read. You don’t find magazines and books in the homes of traders. The newspaper on their desk is opened to the crossword puzzle or maybe the sports page. They don’t watch television news. In fact, they may not know about major events like elections and wars unless they are trading a related commodity. Traders will talk with one another endlessly about the news pertinent to the security they are trading, but their knowledge is shallow and they rarely do real research.

Moreover, natural-born traders are aggressive and often rude. They don’t suffer beating around the bush and want to get to the point without much nicety. In the old days, they often used foul language, although that has become politically incorrect. Like policemen who view all non-policemen as another class of human beings (“civilians”), they can recognize one another. A trader will accord another trader far more respect than he will concede to any non-trader. In the hierarchy of respect, having the job title of “trader” in an institution is not enough, especially if the “trader” is unlucky enough to have an MBA or, heaven forbid, a Ph.D. Credentials like these cast a black cloud of doubt over the person’s ability to trade—and it is often an accurate prejudice. Street smarts is not the same thing as book-learned smarts. If such a trader becomes successful, i.e., makes money, he will be forgiven having those degrees, and true acceptance in the traders’ club arrives at the time the traders start teasing the MBA about them (or sometimes when they stop). Analysts now increasingly being attached to trading desks at financial institutions find they have no influence—unless they can correctly name entry and exit points, and never mind how they arrived at them.

Professional traders usually have no understanding of the institution they work for as having a corporate identity and purpose aside from their own function. They have little interest, either. Tell a bond trader at Citibank that the credit card division makes the most money of all divisions, and his eyes glaze over instantly. (If you told him there was going to be an earnings contest next year between his trading desk and the credit card division, that would perk him up.) In any business meeting of traders and non-traders in a firm, the traders contribute practically nothing except when it comes to their position limits or other conditions specific to their jobs; they simply refuse to think about other business issues and don’t get the point of strategic planning, marketing, public relations, or sales.

An uncanny gift for warp-speed arithmetic calculations is another characteristic of the professional trader. In currencies, for example, some traders can instantly calculate the reciprocal of the spot price (say 110 yen to the dollar) to get the futures price (9090, and forget about the decimal point). Most traders can perform complex calculations of probabilities in their heads. (Famous trader Russell Sands was the 1980 Backgammon World Champion.) Sometimes probability calculations seem to be little more than common sense, but when you ask a trader why he exited a position when the security was still rising, underneath the flippant response “it was going too far” is a deep knowledge of what has happened in the past and an estimate of exactly at what level further gains became improbable. If you were to check the math using a probability-based decision-rule formula, you’d find that the trader’s instinct was mathematically correct.

Gambling

For entertainment, traders love to tell fish stories to one another and sometimes to civilians, who respond the same way they respond to golf bores. No detail is too minor or exact. Traders remember every important trade they did in lurid detail, even years later, down to the last penny. That doesn’t mean they don’t embellish the stories, like the fish that becomes 24 inches when it was actually eight. Exaggerating the story afterward is one of the rewards of being a trader. Traders will even go on, at length, about bets they have made off the trading floor, on how many inches of snow fell in Central Park or who won the coin toss at the SuperBowl. Michael Lewis’ brilliant Liar’s Poker is a wickedly funny and coldly accurate depiction of traders’ culture, from the brass-balls bluff on the serial numbers on a banknote to the rapacious wiles of Big Swinging Dicks.

Are these silly side bets for entertainment and to relieve stress, or do traders have a disproportionately bigger problem with compulsive gambling than the general population? Nobody knows for sure, but Wall Street has funded many a junket to Las Vegas and Atlantic City, complete with bodyguards and suitcases loaded with cash. Van K. Tharp estimates that of the thousands of traders he has evaluated, about 10% are compulsive gamblers. This is more than ten times the incidence of compulsive gambling in the general population, put at 0.9% in the National Gambling Impact Study Commission issued in June 1999. The report also notes that while half the population of the U.S. plays the lottery in any given month, 5% of ticket buyers account for 51% of ticket sales. So the number is a little under 1%, up to 5%, making Tharp’s 10% estimate of the incidence of compulsive gambling among traders especially noteworthy. Most observers who have spent any time on a trading floor would (impressionistically) put the percentage much higher, over 50%.

Gamblers Anonymous states that the compulsive gambler has an inability and unwillingness to accept reality, is emotionally insecure and feels comfortable only in the gambling environment, and is immature, wanting instant gratification without hard work and responsibility. This is interesting and not a little bizarre, since the essence of successful securities trading is accepting reality (losses), believing that one’s position is correct (secure in the trading decision), and trading is hard work. Thus, those professional traders who become compulsive gamblers are seeking exactly the opposite feelings and conditions than the ones that pertain to their main job. We can guess that the reason insurance companies now offer “rogue trader” insurance is that some step over the line between disciplined speculation and gambling, which should not be possible if operations safeguards are properly in place.

The stress of trading is so severe that many traders become substance-abusers, too, although understandably we don’t have any statistics on that. Traders deliberately set out to pump up their adrenaline level ahead of the trading day, and then have to find ways to come off the high. Nick Leeson, in Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World, tells of the daily drinking to excess, with the other traders, that anesthetized him to the fraud he was committing. Other traders use a healthier way to let off steam. Sports often do the trick; famous trader Victor Niederhoffer is a five-time U.S. National Squash Champion. Balestra’s Jim Melcher was on the U.S. Olympic fencing team.

Adrenaline is a metaphor for energy, but it is a real substance, too, produced in the adrenal glands. Adrenaline raises blood pressure and stimulates the liver to release sugar. Its effect on the mind is called the “flight-or-fight” syndrome, and you can trigger the release of adrenaline by drinking caffeine or ingesting other substances, most of them illegal. You can also trigger its release by thinking. You can think about emotional situations in the past that got your juices flowing, or you can engage in a little aggressive horseplay in the office to serve the same purpose. Psychologist Adrienne Laris Toghraie writes that “Many traders press that internal panic button all day long, until the mechanism becomes so sensitive that it becomes trigger happy.” The result can be permanently high blood pressure, kidney damage, and adrenal failure, a lack of function that leads to insomnia. This is the physical manifestation of true burn-out, and recovery can’t be achieved in all cases.

The most noticeable characteristic of the natural-born trader is cockiness. Cockiness is more than self-confidence. Self-confident people can be quiet, humble, and self-effacing. Cocky people are loud (boastful), prideful (“full of themselves”), and seeking to be the center of attention. Cockiness is one step below arrogance, although plenty of traders go several steps beyond it. Think of Michael Douglas in the movie Wall Street. The character was arrogant and ruthless, and the only criticism of his portrayal among those who know trading rooms is that the moviemakers left out the practical jokes. In reality, the junior trader (Charlie Sheen) being groomed by Douglas would have been subjected to the coolness test in the form of cruel practical jokes, as well as the test of his ethics that is the story of the movie. Trading rooms can be the scene of the most awful (and juvenile) practical jokes. They are also a hotbed of jokes in really, truly bad taste.

The natural-born trader has a short attention span, but at the same time he is decisive and can turn on a dime. He reacts very quickly in tense situations where large sums of money are at stake, without losing his cool. After a particularly difficult trade, he may throw his chair across the room or destroy the telephone, but while the trade is in progress, he’s totally in control of himself and fully focussed on the trade and the trade alone. His concentration is complete. The building can start burning down around him and he literally will not notice.

People who aspire to quit their day jobs to become traders admire them and want to emulate them. But here is the portrait of the natural-born trader: he has limited knowledge and doesn’t read or do research, even about his own specialty. He is aggressive and rude, and treats non-traders badly. He can do sophisticated mathematical calculations in his head at lightning speed, but is so focussed on his work that he doesn’t grasp the bigger picture of the institution he works for. He can be a real boor and a bore, to boot, and the story he is telling you at excruciating length may not even be true. He is prone to a compulsive gambling problem and perhaps drug or alcohol addiction. He is cocky without necessarily being self-confident, and he is likely to make a farting noise into your telephone when you are speaking with your most valuable customer.

Because traders have a reputation for being limited and obnoxious, they often find it hard to find a job after trading. One says that to have “trader” on your resume is tantamount to saying you spent the last ten years in the state penitentiary. Prospective employers think you will have bad habits or at least be a bad influence. The transition to another kind of work is perhaps harder for traders than for others. If they burned out and literally couldn’t do the work any more because of physical damage, they blame themselves and feel paralyzing guilt. If they were fired, their outsized egos take it harder than people whose jobs did not require so much pumping up of self-regard. Worse, most jobs require a far wider worldview and broader knowledge than trading. Old traders often say that they literally aren’t good for anything except pumping gas. Even those who succeed in reinventing themselves and finding new careers get a wistful look in their eye when they reminisce, as though being on a trading desk was nirvana and those were the golden age of their lives, never to be surpassed. Traders like to boast that they had the most stressful job after air-traffic control—and to be an ex-trader is almost by definition to have burned out. The few exceptions, like former Treasury Secretary, Robert Rubin, are well and truly exceptional.

So You Want to be a Trader?

This description of the trader is a collection of impressions garnered over the years. It describes traders at institutions. It’s a bit of a caricature, but like all caricatures, you can recognize the person despite (or because of) the exaggerations. There are plenty of well-read, well-balanced, well-mannered traders out there with broad interests who grasp the nature of business beyond their own and enjoy humor for people over the age of 14.

The point is that when people fail at trading, there are hundreds of reasons, while all successful traders have one thing in common: the ability to concentrate on one thing to the exclusion (sometimes unhealthy) of everything else. They believe deeply, passionately in every position–but will dump it in a nanosecond. This is like cognitive dissonance, holding two contradictory ideas at once, but more than cognitive dissonance, because action is required. This is the source of the stress associated with trading. In essence, to be a good trader you have to believe you are right at the same time you are willing to act against the belief when proof appears that you are wrong, and you have to take that action immediately. The decision to make a trade is a rational one, requiring data, logic, and memory, but the decision to exit is an instinctive one, involving the subconscious. If the left brain is the side of the body that is rational, deductive and analytic, it is engaged in the first half of the trade. The right brain is the one that controls the exit, the side that is intuitive, inductive, holistic, and emotional.

This sets up tremendous tension and conflict. People who want to quit their day jobs, people who admire traders because of their ability to pull the trigger, forget that the stress that comes from holding two contradictory beliefs can transform you into a mass of insecurities, physical illnesses, and general bad behavior. You may escape the worst of the characteristics of the institutional trader because when working at home, you do not have the peer pressure of others egging you on (to take a weekend jaunt to Las Vegas or to head straight for the bar at the end of the day), but the very skill that will make you a good trader will also arouse old internal conflicts that eventually may damage your trading.

All commentators on trading as a profession emphasize that when you embark on a career as a trader, more of the journey is a journey of self-discovery than of learning nuts and bolts. Jack Schwager says in the preface to The New Market Wizards, Conversations with America’s Top Traders:

The secret to success in the markets lies not in discovering some incredible indicator or elaborate theory; rather it lies within each individual.

Fred Gehm, author of Quantitative Trading and Money Management, says “Every human mind conspires against itself. The trick is to recognize how, and work around it by adopting the right attitude.” Markets are in a constant state of change. In the face of uncertainty, the mind responds with anxiety defense mechanisms such as denial, rationalization and avoidance. Every trader brings to the job emotional baggage. One piece of baggage might be the need for continuous “approval” by the market (making profits), which leads to trading mistakes, in this instance, overtrading. At the opposite might be indecision—freezing when it’s time to pull the trigger—arising from a fear of commitment and thus a lack of commitment.

Psychologists, psychiatrists and others who work with traders agree that everyone sabotages himself one way or another. Nearly all have a fear of success (“I don’t deserve to make money because trading isn’t real work, like going to work with a lunchpail to pound stakes in railway ties, or roof a house.”). Robert Krausz, profiled in The New Market Wizards, a hypnotist rather than a psychiatrist or psychologist, says that the conscious and subconscious minds must be in harmony for a trader to be successful. The conscious mind may be asserting that the trader is in it for the money, but his subconscious mind must also agree that he deserves the winnings. An “alarming” number of people simply shouldn’t try trading—they are trying to punish themselves through the market. One case involved a man who was trading only for the excitement and thrill, and taking big losses he refused to acknowledge by hiding the unopened brokerage statements and blaming his wife for hiding them. He really wanted to quit his self-destructive trading, and did close the account after finally opening the statements, which was brought about through treatment.

Self-sabotage comes in many forms. We each have unique experiences, many of which constitute deep-seated unresolved psychological conflicts and all of which contribute to our individual mindsets. A mindset is a perception of how the world works, and on a subconscious level, it determines behavior. Psychologists call it the “paradigm.” Someone who has had a devastating childhood trauma may seek to play the drama out over and over again in trading. The trader may have a puritanical outlook and be self-denying, working hard rather than working effectively. Or he may be self-indulgent, working in a lazy fashion and seeking instant gratification. The trader’s mindset may make him blame everyone but himself for losses—it’s the broker’s fault, it’s the market’s fault. He may be overly dependent on others’ opinion and defensive against possible criticism by some non-specific outside agency. Adrienne Laris Toghraie is one of the coterie of psychologists and psychiatrists who specialize in helping traders overcome their personal demons in order to become good traders, or better traders, or even “master traders.” In addition to co-authoring with Jake Bernstein The Winning Edge–How to Use Your Psychological Power to Succeed in Trading and Investing, she writes articles for the magazine Technical Analysis of Stocks and Commodities. These article have titles like “The Whole Brain Trader” and “Strategies for Overcoming Fear,” and in them she recounts stories of trader-patients and how to overcome specific emotional components of the mindset.

Ari Kiev, a New York-based psychiatrist who was the first psychiatrist to the Olympic Sports Medicine Committee in the 1970’s and author of Trading to Win: the Psychology of Mastering the Markets, says that even successful traders are invested in limiting mindsets arising out of their past. How much profit you make does not depend on the market, but rather on your own conceptual system. A good trader makes money whether the market is going up or down, and up or down a little or a lot. The market is not the enemy; you need the market to inform you how to adapt. A good trader is able to adapt because he can identify and overcome personal limitations.

The Testosterone Trap

Women make better traders than men. In a study titled “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment” ” in the Quarterly Journal of Economics by Terrance Odean and Brad Barber (http://www.gsm.ucdavis.edu/~odean/papers/gender/gender.html), the authors found that men overtrade far more often than women, and get lower returns as a result. Odean examined more than 35,000 accounts at a discount brokerage firm from 1991 to 1997, and found that men trade 45% more than women. On a risk-adjusted basis, women made 1.4% more than the men. Moreover, when single men are compared to single women, the men trade a whopping 67% more—and the women get 2.3% more on a risk-adjusted basis. Odean credits the outcome to overconfidence by men. If you are able to visit a trading floor at a financial institution, you will find a good cross-section of persons represented—women, minorities, the handicapped. Markets are truly equal-opportunity employers, color and gender-blind and indifferent to handicaps if the performance is there.

Trading to Win

The first step, and a step that has to be taken over and over gain, is to commit to a specific money goal. In Kiev’s extensive experience, nearly every trader strenuously resists this step. They would prefer to say that the market will determine how much money they will make in the next week, month, year. But in practice, Kiev finds that setting a target helps the trader to focus, and focus leads to discipline. Discipline encompasses risk management as well as planning the trade, tracking and reviewing each decision, and controlling emotion so that the trader feels authentic self-confidence. Controlling emotion includes recovering from previous trades, whether gains or losses, through rational processes such as statistical risk analysis (e.g., the Sharpe ratio), but also through physical processes such as relaxation exercises and mental processes such as visual imagery of successful trading situations. The trader has to be aware of negative thoughts and make an effort to banish them.

Kiev’s principles for sustaining success start with becoming aware of the sequence of events associated with success. This is the intellectual work of deciding on a specific trade, and also an awareness of where your belief system might be intruding. You need to base the trading decision on the market, not what your mindset leads you to expect. You need to let go of anxiety by accepting that trading is an anxiety-inducing business, but not letting emotional investments get in the way, such as associating guilt with profits. You also need to let ego go, especially in recognizing losses. Don’t waste time and energy covering up that losses make you feel bad. Go ahead and feel bad—but then analyze the loss both in terms of risk management and in terms of any behavioral error you might have made. In the end, the secret is accepting reality, and that entails clarifying your vision by removing psychological obstacles.

In Mindtraps: Mastering the Inner World of Investing, Roland Barach identifies 88 psychological traps that traders fall into. Destructive patterns of behavior include perfectionism (“I would rather be right than make money”), guilt (“woulda, coulda, shoulda”), and falling in love with your position (“I’m going down on this wonderful ship”). Like Toghraie, Kiev and others, Barach recommends examining the beliefs and values that skew the mindset to unprofitable behaviors, and then applying the visual imagery of neuro-linguistic programming to overcome them. You identify the self-destructive behavior and make a list of defects to be overcome. You imagine having corrected them and how it makes you feel. You list the specific tasks you will have to perform in order to achieve the corrections, and then you practice correcting them, one at a time. Neuro-linguistic programming is a field of psychology which holds that by some mysterious but effective feedback process, when you imagine what it feels like to be successful—seeing it in your mind’s eye in detail, smelling and hearing it, and even imagining the position of your body—the imagined images become self-programmed into the mind. If you feel successful, you will be successful.

Good Traders Think Differently

Those who have made a study of the subject universally believe that a “real” trader thinks differently from the rest of us. He may be obnoxious, cocky, and limited, but he has achieved the mindset that is required to trade successfully. Trading in the Zone, by Mark Douglas, emphasizes that the successful trader simply thinks differently from the mass of wannabe traders who fail. The subtitle of the book is How to Create a State of Mind That Eliminates the Fear, Stress, and Anxiety From Your Trading. Douglas says the chief cause of internal conflict is unwillingness to accept the risk inherent in trading. We accept it with the rational mind, but do not accept it psychologically, creating fear. To banish stress and anxiety, we have to take responsibility. The market is neither your friend nor your enemy; it is what it is. Unknown forces are always at work in the market, and while you may know that your trading system will deliver eight gains out of the next 12 trades, you don’t know which ones they will be. All you need to focus on is that the odds are in your favor because you have developed a trading system that works, your “edge.” Everything else is probability. You don’t need to know what is going to happen next in order to make money, and in fact, anything can happen.

“… if you don’t expect the market to make you right, you have no reason to be afraid of being wrong. If you don’t expect the market to make you a winner, you have no reason to be afraid of losing. If you don’t expect the market to keep going in your direction indefinitely, there is no reason to leave money on the table. Finally, if you don’t expect to be able to take advantage of every opportunity just because you perceived it and it presented itself, you have no reason to be afraid of missing out.”

In the end, “every moment in the market is unique” and unlike anything that has ever happened before or will happen in the future. When you let go of all expectations about the market, you are at peace with not knowing what is going to happen next. This is the best state of mind, the “zone,” where you are at one with the market.

Edward Toppel, in Zen in the Markets, Confessions of a Samurai Trader, expresses the same view more poetically. Interspersing the text, which is as hard-headed as any trading book, albeit with chapter headings like “Hanging Out in the Present,” are Samurai Trader’s Maxims:

We do not see things as they are but as we are.

The greatest warrior is one who conquers himself.

The ideal action is one that leaves not a split second between the urge to action and the action itself.

Expect nothing, be prepared for everything.

Probably the single book that combines all the elements is Alexander Elder’s Trading for A Living—Psychology, Trading Tactics, Money Management. Elder is a psychiatrist who trains and coaches traders, and who trades himself. He correctly focuses on losses, and equates trading losers with drunks who have not yet found Alcoholics Anonymous. He says brokerage records show that 90% of people trading today will be out of the picture in a year. “Very few traders will begin the process of change and growth.” But for the rare individual, “the pain of hitting rock bottom will interrupt the vicious cycle of getting high from winning and then losing everything and crashing. When you admit that you have a personal problem that causes you to lose, you can begin building a new trading life. You can start developing the discipline of a winner.” Elder thinks we should have a “Trader’s Anonymous.” In a sense, we do. All over the world are traders’ clubs with an ostensible purpose of sharing software formulas and trading insights. In practice, the conversation at these meetings is often directed to personal trading problems (usually not being able to pull the trigger or pulling it too often) and alternative money management approaches.

The Art of the Trade

Most people who decide to become traders start out looking for a guru who will provide them with a trading system or at least a set of tips. There are hundreds, if not thousands, of trading advisors in every conceivable market. Some of them are charlatans who publish dishonest performance track records, but many of them are honorable and offer good advice. Oddly, most beginning traders lose money on advisors’ advice. Not really so odd: to replicate a track record, you have to take every trade. You can’t cherry-pick the ones that seem the most appealing and then complain that the blended track record was high only because it contained some trade you didn’t take.

Disappointed in advisors, beginning traders next typically decide to design their own trading system. Trading system software, books and training courses abound. Experienced traders call this the search for the Holy Grail, or the best-ever, fool-proof trading system. The significant word is “fool-proof.” Even if the would-be trader can bring himself to finish the system, this approach often fails, too, because he finds that in real-time, he can’t resist second-guessing and overriding it. One of the top system developers in the commodities industry, Keith Fitschen, found that he could not resist tampering with his Aberration system, but after giving it in black-box form to someone else (a broker) to execute, profits are consistently in the 50%-plus region.

So which comes first, the trading system or the personality adjustment that makes it possible to get into the “zone,” or a Zen-like oneness with the market? To trade successfully, you have to have a system and you have to believe in it fully so that you implement it without hesitation. R.E. McMasters writes in The Art of the Trade that “The best way to select a trading system is to figure out what fits you and your psychological profile.” The most effective trading system for a hyper, tense person is a day-trading approach. The best system for a laid-back person would be a trend-following system. A risk-averse middle-of-the-road type might be best suited to breakout or swing trading. As McMaster says, no one strategy is inherently better than any other. Each system is only as good as the person executing it. It’s important to preserve “psychological capital” in the quest for financial capital. Significantly, the publisher of McMaster’s book had originally titled it “Investing with Both Sides of Your Brain.” The book is concerned with integrating the rational and analytic with the intuitive and emotional. You must do the intellectual work of building a system, but in the end, you need to step outside yourself and let intuition and insight rule.

Van K. Tharp, another psychologist who is also a trader, writes in Trade Your Way to Financial Freedom that when you really understand the Holy Grail metaphor, you will indeed have found a magic methodology that works for you. That’s the secret—it is a system that works for you. Success in the market comes from internal control, and to design a system that suits you, you must recognize and overcome (or compensate for) your mental biases. Whatever system you develop, the single most important component is position-sizing—not entry rules or timing, as you might expect. In fact, you could use a coin toss to determine entries and still make profitable trades if you also employed correct money management.

This goes well beyond the usual tired old cliches of “take losses early and let your winners run,” or “don’t try to pick tops and bottoms,” or “never add to a losing position, only to winning ones.” Tharp, who surveyed over 4,000 traders, discovered that the one criterion that distinguished winners from losers was the presence or absence of absolute position-sizing rules that are always followed and never overridden. This is what distinguishes a trading plan from a trading system. As Krausz also says, the reasons traders cite as the reasons they lose money (lack of confidence, fear of loss, bad execution) are actually the result of not having a trading plan. They may have a computer program (a system) that dictates the timing of trades, but without a money management plan, the system is doomed.

As Tharp explains, position-sizing is what most people vaguely call “money management.” Position-sizing is not defining the maximum loss you will take, nor is it risk control. Rather, it is that component of the trading system that “answers the question ‘how much?’ throughout the course of a trade.” It will have the effect of dictating when to take profit and loss, but the purpose of the position-sizing rule is to prevent you from being kicked out of the game in ruin and to maximize the gain that can be made from any specific trading strategy, whatever the initial account size. It starts with an understanding of loss. Every trader takes losses and must accept that losses are inevitable. He must also accept that to limit losses and to return to a net winning position, he must accept and internalize this table:

Table 5.1. Recovery After Drawdowns

Drawdowns	Gain to Recovery
5%	5.3% gain
10%	11.1% gain
15%	17.6% gain
20%	25% gain
25%	33% gain
30%	42.9% gain
40%	66.7% gain
50%	100% gain
60%	150% gain
75%	300% gain
90%	900% gain

Source: Van K. Tharp, Trade Your Way to Financial Freedom (McGraw-Hill, 1999), p. 283.

“Drawdown” refers to the loss that you take in any single trade, and the “gain to recovery” number is how much you have to make in the next trade or set of trades merely to return to the starting equity stake. The most important measure of any trading system is its biggest losing trade. In the book, Tharp shows the results of a single trading system (based on a 55-day volatility breakout concept) using four different position sizing rules (two of a Martingale variety which adds to winning positions, and two that do not). Stops and re-entries are different in each of them, and the outcomes are very different. In fact, there are hundreds (if not an infinite number) of position sizing rules. Only a handful will be appropriate to your trading system and to you.

By now you should be suspecting that endless hours spent toiling at the computer to find the optimum two moving average crossover mode, or the best breakout system, or unlocking the mysteries of Elliott Wave counts, should be the last activity in the process of creating a trading plan, not the first and not even the most important. Ralph Vince, in Portfolio Management Formulas and The Mathematics of Money Management, has a clever way of expressing it: “The trading system is simply a vehicle to give you a positive mathematical expectation on which to use money management.” In other words, don’t spend time optimizing profit. Instead, you should direct your “energy to maximizing the certainty level of a marginal profit.”

Vince observes that reinvesting profits can turn a winning system into a losing system if returns are not consistent—an important warning. He argues that fixed fractional trading is mathematically always the best way of managing your “stake” (equity). Fixed fractional trading is a function of account size and the performance of the trading system, but at its root, you shouldn’t make a bet if you don’t have an expectation of a positive outcome. Obviously you can’t be innumerate (lacking knowledge of probabilities) and hope to master position-sizing. Fortunately, you can learn the theory of gambling and statistical logic, and you should make that effort before buying into any system, including your own. Probably the most readable book in this area is Fred Gehm’s Quantitative Trading and Money Management—but note that Mr. Gehm, who advised the largest trading organization in the world for many years (the Abu Dhabi Investment Authority) believes that the theory of the risk of ruin always precludes pyramiding (increasing the amount invested in wining positions).

Some People Just Don’t Get It

The press often reports that the vast majority of individuals who try to become traders fail. It’s not clear that this statistic is accurate. Perhaps 90% of people close their brokerage accounts with losses, but who is to say what percentage of new brokerage accounts are not opened by people who failed once before and are now succeeding? In fact, it seems highly likely that the second system, this time including money management rules and thus a “plan,” is the one that the trader can now believe in and therefore implement successfully.

Trading software houses like Equis (Metastock), Worden Brothers (TC2000), and Omega continue to prosper. Omega is a public company that claims over one million systems sold. Equis has sold over 35 million copies of Metastock since it began in 1983. The pages of trading magazines such as Futures, Active Trader and Technical Analysis of Stocks & Commodities remain brim-full of four-color, double-page advertisements, plus smaller ads for specialized systems that have been around since the 1970’s. Individuals are certainly continuing the quest and we have no proof of what percentage fail. For all we know, there may be hundreds of thousands—a million? more than a million?– of successful self-directed traders.

Can people learn to become traders? It would seem that some people don’t get it and never will get it. “It” is the burning desire to take advantage of market moves, buying at lows and selling at highs. Show them a chart where the price is going to an obvious extreme and ask them what they should do, and they look blank. The chart does not convey useful information to them. They can’t see what they are looking at. Tell them that the market is up 80% and their stock is up 120%, historical anomalies, and they will not understand that the right thing to do is get the hell out of Dodge. Their trading ideas are a hodgepodge of trite aphorisms and snippets of wise sayings that are actually dangerous out of context. They have no systematic way of viewing the market. They might even believe that every price is random and there is no point in trying to trade. The only thing you can do is buy and hold. But these people are not dummies and in fact may be intelligent and talented in their own fields. To some extent, they don’t get it because getting it requires a lot of work—such as understanding probability theory–and the truth is they have no taste for the work. To learn requires motivation to learn.

Those who do have a yen to trade can certainly be taught to trade. In The New Market Wizards, Schwager interviews several “Turtles,” people who were selected for a training experiment by famous trader Richard Dennis, who made a bet with his partner that he could teach people to trade. The Turtles had been sworn to secrecy for five years and were unwilling to reveal anything about the system they were taught. Later we found out that the 23 persons who were hand-picked by Dennis to take part in the experiment had tremendous success—a 32.4% per annum collective return over the period January 1985 to January 1996, handily beating the 16.5% annual return of the Commodity Trading Advisors Index published by TASS Management and well over the 12.8% return on the S&P 500 over the same period. Dennis reported that the Turtles, who were initially staked by him at $100,000 each, later raised to $1 million, made about $35 million for his firm before they broke up in 1988.

The Turtle trading system is of the trend-following style, normally not the most exciting and action-packed variety. But the Turtles spiced it up with aggressive money management rules, pyramiding (adding to positions and increasing leverage) but combining pyramiding with equal volatility weighting of each position (whatever its nominal size) and a strict limit of a maximum 2% loss of the total stake risked on any one trade. Two-thirds of trades did, in fact, result in losses of 2% or less. Diversification was across a broad range of commodities, “because you never know which ones will be big.” After a loss, each Turtle had to reduce the size of each trade but not the number of markets traded, in order to catch a trend if it developed.

Some other trading rules have emerged over the years, such as buying at any 20-day high and closing the position at the first 8-day low, and waiting three days after a trend reversal signal to execute a trade. But the trading rules are not the point—the point is that trading can be taught, if the student is motivated and if the trading system also includes a money management plan, exactly as the psychologists, psychiatrists and trading coaches have discerned.

The Plan

Don’t even think of becoming a trader without a plan. Even with a plan, as a trader you are seeking to find the “sweet spot” represented by the intersection of all the circles in the chart, and it is very, very small. First you have to get in tune with market psychology. Some people have a tin ear and cannot hear what the market is telling them. Next, your trading system has be relevant to the market you are trading. It may be wonderful in equities and dreadful in soybeans. This is a somewhat controversial statement, because maybe people believe that a winning system can be applied in any market. In many cases, this is no doubt true, but it depends to some extent on the nature of the system. For example, a breakout system works beautifully on some securities (buy when the last highest high has been surpassed), but in others you should do the exact opposite (sell when a higher high is reached).

Finally, your money management rules need to match the trading system and your personality, as well as be suited to the market you are trading. If the market typically moves 100 points every day with a net gain in the direction of the trend of 75 points, you would be using the wrong system to target gains of 20 points with a stop loss of 10 points. It’s conceivable that you could have a winning trading system and a winning money management system that would work in a market different from the one you are trading—but not in the one you are trading.

Figure 5.2, The Sweet Spot

Summary and Conclusions

Natural-born and trained traders are different from the rest of us. They have an innate combination of personality traits that together make up what is needed for success in trading. They may or may not be well-balanced in the conventional sense of the word, and anyone attempting to acquire their traits runs the risk of acquiring some of the side-effects, too, like a gambling problem or early burn-out. Still, traders can be trained, although learning to become a successful trader is not what most people think it is—buying a software package and a live-quote screen subscription. Instead it is an intellectual and spiritual endeavor. Some of the smartest people will never become successful traders because following prices endlessly in wait for the planned set-up can become boring and soul-numbing. Trading is not a part-time hobby, but a career just like becoming a cordon bleu chef or an astronaut. The best advice you will get from the psychiatrists, psychologists and coaches is to practice in advance of putting down any actual cash. Keep a simulated trade ledger and a diary. (You can pretend-trade at several websites, including the Chicago Mercantile Exchange, www.cme.com, and visit www.auditrack.com.) Most of all, go back and look at Table 5.1, “Recovery after Drawdowns.” If you lose 75% of your stake, you have to make 300% to get back to your starting point. Is it realistic to expect your market, your personality and work habits, your trading system and your money management system to deliver that?