The Way of the Dollar

tennis players –or poker players, come to that. “It’s the same thing in trading”, continues Steidlmayer, having made it clear that in golf he’s a tyro and a hopeless worrier. “When I’m trading well I don’t care if I have a monetary loss on because I’m going to handle it”. (The Big Hitters*).

It’s OK to lose. It’s the other side of the coin of winning– you winsome and you lose some. You just have to ensure that your losses are to scale.

Ed Seykota* has to be one of the most successful traders ever (one of his accounts rose from $5,000 to $15m in 16 years, after significant withdrawals). He is also a sage and guru, positively venerated by his friends and co-traders– “a genius”, Michael Marcus has called him. When asked by Jack Schwager what were the elements of good trading he replied “The elements of good trading are: (1) cutting losses, (2) cutting losses and (3) cutting losses. If you can follow those three rules, you may have a chance.” He was saying “Listen. The old lore about cutting losses and letting profits run really does go to the heart of the matter .” Jesse Livermore* had already thrown some light on the subject. “The successful trader …has to reverse his natural impulses… He must fear that his loss may develop into a bigger loss, and hope that his profit may become a big profit” (Reminiscences of a Stock Operator).

It needs a change of mind-set to be comfortable taking losses

The “natural impulse” is deeply engrained in us by our culture. Losing is bad, winning is good. Losing money is bad, making money is good. So what happens when we show a paper loss on a trade? We are conditioned into hating to realise that loss, so we rationalise with all sorts of reasons for not doing so: and the awful result is that we hold onto an increasing loss until we are forced out when it becomes unbearable. And what happens when we see a paper profit is that we are conditioned into wanting to realise the profit. This is the way we are: it needs a change of mind-set to be different, which is why there are so few successful traders. How can the right thing to do have any– thing to do with whether our position shows a profit or a loss? Price knows nothing about our position.

Actually, that’s a good question. We can answer it with another. Isn’t it in fact more likely that if a position shows a profit, it’s a “good” position, which should therefore be held; and if it shows a loss, it’s a “bad “ position

which should therefore be abandoned? Either way, it’s OK to take a loss. Every great trader agrees.

“Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss –that is what does the damage to the pocketbook and to the soul.” –  Jesse Livermore. “He [Michael Marcus] also taught me one other thing that is absolutely

critical: You have to be willing to make mistakes regularly; there is nothing wrong with it.” –  Bruce Kovner*.

“If you have a loss on a trade after a week or two, you are clearly wrong.” – Richard Dennis*.

“I really don’t care about the mistake I made three seconds ago in the market… If you have a losing position that is making you uncomfortable, the solution is very simple: get out, because you can always get back in. There is nothing better than a fresh start.” – Paul Tudor Jones*.

“You have to learn how to lose; it is more important than learning how to win.” – Mark Weinstein*.

One could go on, and on.

Get the Measure of RISK

I don’t know how many of us have had a truly traumatic experience in trading financial markets. Jessie Livermore had not one but many, that would have turned most people’s hair white. Perhaps it was inevitable therefore that he never really learned about risk. Few of us do.

Ed Seykota, who admits Livermore’s beneficial influence on him, delivered this terrible judgement on the great plunger’s experience –though not as terrible as the terminal judgement delivered by the revolver: “I feel it was a function of his psychology… To emulate his experience… you would probably need to over trade and have wipeouts, while you simultaneously fired up your emotions with the burning desire to “win it right back”. Acting out this drama could be exciting. However it also seems terribly expensive. One alternative is to keep bets small and then to keep reducing bets during equity drawdowns. That way you approach your safe money asymptotically and have a gentle financial letdown.”

All great traders seem to have suffered at least one really traumatic experience in the early days: one was usually enough. Market risk is something, it seems, which simply cannot be understood except through vivid first-hand experience. Perhaps nothing important can.

There are two ways of looking at risk. There’s the objective way, which you can put into numbers. For instance if you take on an exposure of 50% of your funds in a position which can move 10% against you –your risk in

that position is 5%: if your exposure is 300%, your risk is 30%. Well, 5% is one thing and 30% is another. Interestingly, 5% is about the most that any very successful trader seems to be prepared to commit to a single position. The maximum figure for a cautious and very diversified fund such as Mint is 1 %. Says Michael Marcus: “ Always bet less than 5% of your money on anyone idea; that way you can be wrong 20 times; it will take you a long time to lose your money.” (Market Wizards).

The other way of looking at risk is the subjective way: it’s the risk you feel, as opposed to the risk you run. There is a risk that each one of us can handle and there is a risk we cannot handle. Understanding risk on this level is knowing where the dividing line comes between what we can handle and what we cannot handle. And all the great traders seem to agree that their own learning process has been all one way. The longer they trade, the more they have found that their results improve with reducing their bets.

Give us a couple of winning trades and we soon convince ourselves that we are heroes and can handle bigger bets. But not so. As soon as we increase the size of our bets, we lose our nerve. We grab small profits, and get rattled by random adverse fluctuations. We forget the reason why we made the trade, and rationalise new ones. We buy high and sell low .In short, we fall to pieces like the golfer with putting nerves. “When you up your volume, you will lose” says Peter Steidlmayer bluntly.

The stories of the hyper-successful traders are all the same in one respect. They spent their first few years finding out what risk they could handle –and the rest of their careers trading broadly within their capacities. Some traders never find their capacities. Markets that offer gearing (leverage) like the currency markets and futures markets bring out the “gambler” in people. This is the character inside us that is forever “reaching for the card that is so high and wild he’ll never need to draw another” , as the Leonard Cohen song puts it: or indeed “reaching for the sky just to surrender” –for surrender is what all gamblers have to do in the end, in financial markets. Successful traders (and successful poker players) are not gamblers: they’re probability players. If this sounds trite, I probably haven’t expressed it is well as some traders have.

Bruce Kovner: “First, I would say that risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade* is my second piece of advice. Whatever you think your position ought to be, cut it at least in half. My experience with novice traders is that they trade 3 to 5 times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 per cent risks.

Paul Tudor Jones: “The most important rule of trading is to play great

defence.”

Larry Hite: “So the very first rule we live by at Mint is: Never risk more than 1 percent of total equity on any trade Risk is a no-fooling around game If you do not manage risk, eventually they will carry you out.”