Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

Reindeer Capital

  • Invest in stocks which are
    1. Blessed by market
    2. Show Linear growth. Not too much velocity
    3. Reacts well to going to round numbers: $20, $30
    4. Is not volatile based on macro economic trends
    5. Move higher on good news, such as a favorable earnings report or the announcement of a new product, and not give much ground on negative news. If the stock responds poorly to negative news then it hasn’t been blessed
  • Buy on extreme weakness and sell on extreme strength. The only way to identify extremes is to get a feel for the sentiment, whether it is euphoria or pessimism. Then you have to act on it quickly, because there are often abrupt peaks and bottoms

  • More Tips:
    • Be patient—wait for the opportunity
    • Trade on your own ideas and style
    • Never trade impulsively, especially on other people’s advice
    • Don’t risk too much on one event or company
    • Stay focused, especially when the markets are moving
    • Anticipate, don’t react
    • Listen to the market, not outside opinions
    • Think trades through, including profit/loss exit points, before you put them on
    • If you are unsure about a position, just get out
    • Force yourself to trade against the consensus
    • Trade pattern recognition
    • Look past tomorrow; develop a six-month and one-year outlook
    • Prices move before fundamentals
    • It is a warning flag if the market is not responding to data correctly
    • Be totally flexible; be able to admit when you are wrong
    • You will be wrong often; recognize winners and losers fast
    • Start each day from last night’s close, not your original cost
    • Adding to losers is easy but usually wrong
    • Force yourself to buy on extreme weakness and sell on extreme strength
    • Get rid of all distractions
    • Remain confident—the opportunities never stop
  • If a stock’s fundamentals look sound, the stock and sector are acting well technically, and the general market tone is improving, I may put on a position and stay with it as long as these factors don’t deteriorate significantly

  • Not appreciating how drastically a bear market can change the balance between return and risk. For example, say you like a pharmaceutical company because you have done thorough research that leads you to believe there is an 80 percent probability that the FDA will approve their drug application. In the current bear market environment, even if you are right about the odds, the trade may be a bad bet because the stock might go up only 5 percent with a favorable ruling, but go down 50 percent with an unfavorable ruling

Steve Watson

  • Questions and answers
    • What else do you look for when you buy a stock?
      • A low price and the prospect for imminent change are the two key components. Beyond that, it also helps if there is insider buying by management, which confirms prospects for an improvement in the company outlook
    • Let’s say a stock is trading in the 8 to 12 P/E range and you like the fundamentals. How do you decide when to buy it? Obviously, you’re not using any technical analysis for timing, since you don’t even look at charts
      • You need a catalyst that will make the stock go higher
    • How many positions do you have at one time?
      • Over a hundred. We won’t let any single position get very large. Our largest holding will be about 3 percent of assets, and even that is rare. For shorts, our maximum position will be half that large
    • How do you select your short positions?
      • We certainly look for the higher-priced stocks—companies trading at thirty to forty times earnings, or stocks that have no earnings. Within that group, we seek to identify those companies with a flawed business plan
    • Give me an example of a flawed business plan.
      • My favorite theme for a short is a one-product company because if that product fails, they have nothing else to fall back on. It’s also much easier to check out sales for a one-product company. A perfect example is Milestone Scientific. The company manufactured a product that was supposed to be a painless alternative to dental novocaine shots. It sounded like a great idea, and originally we started looking at the stock as a buy prospect. One of our analysts went to a dentistry trade show and collected a bunch of business cards from attending dentists. The primary Wall Street analyst covering the stock assumed every dental office would be buying five of these instruments, and he projected unbelievably huge earnings. I visited the company in New Jersey. There were three people sitting in rented offices who were outsourcing everything. We started calling dentists and found the product didn’t work as well as advertised; it wasn’t entirely painless, and it also took longer than novocaine to take effect. Another crucial element was that the company sold the product with a money-back guarantee. They booked all their shipments as revenues and left themselves out on a limb in terms of product returns. We also talked to the manufacturer to whom the company was outsourcing their production and found out the number of units actually shipped as well as their future production plans. We could see that the orders were slowing down dramatically on the manufacturing side. The differences between reality and the Wall Street research report were about as far apart as I have ever seen
    • It sounds like an important element in your decision to short this stock was to have everyone in the office sample their product. Any other examples of short ideas that were derived by “consumer research”?
      • [He searches his memory and then laughs.] One of our shorts was Ultrafem. It was a one-product company that was trading at over a $100 million capitalization. The product was a substitute for feminine pads that used what the company termed “a soft cup technology.” The company had put out press releases trumpeting the superiority of their product to conventional alternatives. I called the manufacturer and got them to send me five free samples, which I gave to five women friends. After they tried it, they all came back to me with virtually the same response: “You’ve got to be kidding!” I shorted the stock. The stock was trading in the twenties when I conducted my “market research;” it’s now trading at three cents with a market capitalization of $260,000
    • How do you time your shorts? Certainly there are a lot of overpriced stocks that just get more overpriced.
      • The timing is definitely the tough part. That is why we spread our short position across so many stocks and use rigorous risk control on our shorts. I don’t mind if I have a long position that goes down 40 percent, as long as I still believe that the fundamentals are sound. If a short goes 20 to 30 percent against us, however, we will start to cover, even if my analysis of the stock is completely unchanged. In fact, I will cover even if I am convinced that the company will ultimately go bankrupt. I have seen too many instances of companies where everything is in place for the stock to go to zero in a year, but it first quintupled because the company made some announcement and the shorts got squeezed. If that stock is a 1 percent short in our portfolio, I’m not going to let it turn into a 5 percent loss. We’ve had a lot of short positions that we closed out because they went against us and that later on collapsed. But we are much more concerned about avoiding a large loss than missing a profit opportunity
  • Watson begins his investment selection process by focusing on stocks that are relatively low priced (low price/earnings ratio), a characteristic that limits risk. A low price is a necessary but not sufficient condition. Many low-priced stocks are low for a reason and will stay relatively depressed. The key element of Watson’s approach is to anticipate which of these low-priced stocks are likely to enjoy a change in investors’ perceptions. In order to identify potential impending changes that could cause a shift in market sentiment, Watson conducts extensive communication with companies and their competitors, consumers, and distributors. He is also a strong proponent of such commonsense research as trying a company’s product, or in the case of a retailer, visiting its stores. Finally, Watson looks for insider buying as a confirmation condition for his stock selections

  • Shorting is considered a high-risk activity and is probably inappropriate for the average investor. Nevertheless, Watson demonstrates that if risk controls are in place to avoid the open-ended losses that can occur in a short position, shorting can reduce portfolio risk by including positions that are inversely correlated with the rest of the portfolio. On the short side, Watson seeks out high-priced companies that have a flawed business plan—often one-product companies that are vulnerable either because the performance of their single product falls far short of promotional claims or because there is no barrier to entry for competitors

  • Watson achieves risk control through a combination of diversification, selection, and loss limitation rules. He diversifies his portfolio sufficiently so that the largest long holdings account for a maximum of 2 to 3 percent of the portfolio. Short positions are capped at about 1.5 percent of the portfolio. The risk on long positions is limited by Watson’s restricting the selection of companies from the universe of low-priced stocks. On the short side, risk is limited by money management rules that require reducing or liquidating a stock that is moving higher, even if the fundamental justification for the trade is completely unchanged

  • Watson has maintained the pig-at-the-trough philosophy he was exposed to at Friess Associates. He is constantly upgrading his portfolio—replacing stocks with other stocks that appear to have an even better return/risk outlook. Therefore, he will typically sell a profitable long holding even though he expects it to go still higher, because after a sufficient advance, he will find another stock that offers equal or greater return potential with less risk. The relevant question is never, “Is this a good stock to hold?” but rather, “Is this a better stock than any alternative holding that is not already in the portfolio?”

Dana Galante

  • Questions and answers
    • How do you select the stocks you short?
      • I look for growth companies that are overvalued—stocks with high P/E [price/earnings] ratios—but that by itself is not enough. There also has to be a catalyst
    • Give me an example of a catalyst
      • An expectation that the company is going to experience a deterioration in earnings
    • How do you anticipate a deterioration in earnings?
      • One thing I look for is companies with slowing revenue growth who have kept their earnings looking good by cutting expenses. Usually, it’s only a matter of time before their earnings growth slows as well. Another thing I look for is a company that is doing great but has a competitor creeping up that no one is paying attention to. The key is anticipating what is going to affect future earnings relative to market expectations.
    • In essence, you look for a high P/E stock that has a catalyst that will make the stock go down
      • Right, but there is another key condition: I won’t short a stock that is moving straight up. The stock has to show signs of weakening or at least stalling. When a company blames the price decline in its stock on short sellers, it’s a red flag
    • Other red flags?
      • Lots of management changes, particularly a high turnover in the firm’s chief financial officer. Also, a change in auditors, can be a major red flag
    • It sounds as if high receivables is a major indicator for you
      • Yes, it’s one of the screens we look at
    • What are some of the other screens?
      • We also screen for revenue deceleration, earnings deceleration, high P/Es, high inventories, and some technical indicators, such as stocks breaking below their fifty-day moving average
  • Galante’s methodology can be very useful as a guideline for which stocks to avoid or liquidate. The combination of factors Galante cites include:
    • Very high P/E ratio
    • A catalyst that will make the stock vulnerable over the near term
    • An uptrend that has stalled or reversed
    • All three of these conditions must be met. Investors might consider periodically reviewing their portfolios and replacing any stocks that meet all three of the above conditions with other stocks. By doing so, investors could reduce the risk in their portfolios
    • In addition, Galante cites a number of red flags that attract her attention to stocks as potential short candidates. By implication, any of these conditions would be a good reason for investors who own the stock to seriously consider liquidating their position
    • These red flags include:
      • High receivables
      • Change in accountants
      • High turnover in chief financial officers
      • A company blaming short sellers for their stock’s decline
      • A company completely changing their core business to take advantage of a prevailing hot trend

Mark D Cook

  • In contrast to the conventional wisdom, which advises looking for trades that offer a profit potential several times as large as the risk, most of Cook’s trading strategies seek to make one dollar for every two dollars risked. This observation provides two important lessons, neither of which is that using a wider risk level than the profit objective is a generally attractive approach

  • First, looking at the probability of winning is every bit as essential as looking at the ratio of potential gain to risk. As Cook demonstrates, a strategy can lose more on losing trades than it gains on winning trades and still be a terrific approach if its probability of winning is high enough. Conversely, a strategy could make ten times as much on winning trades as it gives up on losing trades and still lead to financial ruin if the probabilities are low enough. Consider, for example, betting continuously on the number seven in roulette: when you win, you will win thirty-six times what you bet, but if you play long enough, you are guaranteed to lose all your money because your odds of success are only one in thirty-eight

  • Second, in choosing a trading approach, it is essential to select a method that fits your personality. Cook is happy to take a small profit on a trade but hates to take even a small loss. Given his predisposition, the methodologies he has developed, which accept a low return/risk ratio on each trade in exchange for a high probability of winning, are right for him. But these same methods could be very uncomfortable, and hence unprofitable, for others to trade. Trading is not a one-size-fits-all proposition; each trader must tailor an individual approach

  • Personal problems can decimate a trader’s performance. Consider, for example, Cook’s uncharacteristic large losses during his knee injury and his father’s heart attack. The moral is: If you are experiencing physical or emotional distress, either stop trading altogether, or reduce your trading activity to a level at which you can’t do much damage. If Cook himself is guilty of any serious trading sin during the past decade, it is failing to heed this advice—a mistake he is determined not to repeat

  • Most aspiring traders underestimate the time, work, and money required to become successful. Cook is adamant that to succeed as a trader requires a complete commitment. You must approach trading as a full-time business, not as a part-time interest. Just as in any entrepreneurial venture, you must have a solid business plan, adequate financing, and a willingness to work long hours. Those seeking shortcuts need not apply. And even if you do everything right, you should still expect to lose money during the first few years—losses that Cook views as tuition payments to the school of trading. These are cold, hard facts that many would-be traders prefer not to hear or believe, but ignoring them doesn’t change the reality

Ahmet Okumus

  • Questions and answers
    • What is the specific checklist you use before buying a stock?
      • The stock must meet the following criteria:
        1. The company has a good track record in terms of growing their earnings per share, revenues per share, and cash flow per share
        2. The company has an attractive book value [the theoretical value of a share if all the company’s assets were liquidated and its liabilities paid off] and a high return on equity
        3. The stock is down sharply, often trading near its recent low. But this weakness has to be due to a short-term reason while the long-term fundamentals still remain sound
        4. There is significant insider buying or ownership
        5. Sometimes a company having a new management team with a good track record of turning companies around may provide an additional reason to buy the stock
    • What are the trading rules you live by?
      • Do your research and be sure you know the companies that you are buying
      • Buy low
      • Be disciplined, and don’t get emotionally involved
  • Okumus has developed a trading style that assures he will miss 80 to 90 percent of the winning stocks he identifies and typically realize only a small portion of the advance in the stocks he does buy. He also brags that he has never owned a stock that has made a new high. These hardly sound like characteristics of a great trading approach. Yet these seeming flaws are actually essential elements of his success. Okumus has only one overriding goal: to select individual trades that will have a very high probability of gain and a very low level of risk. To achieve this goal he has to be willing to forgo many winners and leave lots of money on the table. This is fine with Okumus. His approach has resulted in over 90 percent profitable trades and a triple-digit average annual return

  • Okumus’s bread-and-butter trade is buying a stock with sound fundamentals at a bargain price. He looks for stocks with good growth in earnings, revenues, and cash flow, and significant insider buying or ownership. Strong fundamentals, however, are only half the picture. A stock must also be very attractively priced. Typically, the stocks Okumus buys have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value. Very few stocks meet Okumus’s combination of fundamental and price criteria. The majority of the stocks that fulfill his fundamental requirements never decline to his buying price. Out of the universe of ten thousand stocks Okumus surveys, he holds only about ten in his portfolio at any given time

  • One element of market success frequently cited by Market Wizards, both in this volume and its two predecessors, is the age-old trading adage: Cut your losses short. Yet Okumus’s methodology seems to fly in the face of this conventional wisdom. Okumus does not believe in liquidating a stock position because it shows a loss. In fact, if a stock he buys moves lower, he may even buy more. How can Okumus be successful by doing the exact opposite of what so many other great traders advise? There is no paradox. There are many roads to trading success, although none are particularly easy to find or to stay on. Cutting losses is important only because it is a means of risk control. While all successful traders incorporate risk control into their methodology, not all use cutting losses to achieve risk control. Okumus attains risk control by using an extremely restrictive stock selection process: He buys only financially sound companies that have already declined by well over 50 percent from their highs. He has extreme confidence that the stocks he buys have very low risk at the time he buys them. To achieve this degree of certainty, Okumus passes up many profitable trading opportunities. But because he is so rigorous in his stock selection, he is able to achieve risk control without employing the principle of cutting losses short

  • One technique Okumus uses to enhance his performance is the sale of out-of-the-money puts on stocks he wishes to own. He sells puts at a strike price at which he would buy the stock anyway. In this way, he at least makes some profit if the stock fails to decline to his buying point and reduces his cost for the stock by the option premium received if it does reach his purchase price

  • Okumus is very disciplined and patient. If there are very few stocks that meet his highly selective conditions, he will wait until such opportunities arise. For example, at the end of the second quarter in 1999, Okumus was only 13 percent invested because, as he stated at the time, “There are no bargains around. I’m not risking the money I’m investing until I find stocks that are very cheap.”

Mark Minervini

  • The main points of this doctrine include:
    • Rigorously control your losses
    • Develop a method that fits your own personality, and master that one style
    • Do your own research, act on your own ideas, and don’t be influenced by anyone else’s opinion
    • Have a contingency plan for every possible event, which includes how to get back into a trade if you are stopped out and when to take profits if the trade goes in your direction
    • Maintain absolute discipline to your plan—no exceptions!
  • One exercise that Minervini did that proved extraordinarily helpful to him was to analyze his past trades. The insights of this analysis changed his trading style forever and helped him to make the transition from marginal performance to spectacular success. In his own case, Minervini found that by capping the maximum loss on his trades, he could dramatically increase his overall returns, even after allowing for winning trades that would have been eliminated by this rule. This discovery allowed him to make a lot more profit with much less aggravation. Other traders and investors may find that a similar comprehensive analysis of their past trades reveals patterns that point the way to improve their own performance

  • Interestingly, the methodology that Minervini eventually developed was precisely the opposite of his instinctive approach as a novice, which was buying low-priced stocks that were making new lows. Success required not merely the adaptability to modify his initial approach, but also the flexibility to acknowledge that his original ideas were completely wrong. The lesson is that early failure does not preclude long-term success, as long as one is receptive to change

Michael Masters

  • Masters’s approach can be summarized as a four-step process:
    1. Learn from experience. For any trade that is instructive (winner or loser), write down what you learned about the market from that trade. It doesn’t make any difference whether you keep a trader’s diary or use the back of business cards, as Masters does; the important thing is that you methodically record market lessons as they occur
    2. Develop a trading philosophy. Compile your experience-based trading lessons into a coherent trading philosophy. Two points should be made here. First, by definition, this step will be unachievable by beginners because it will take the experience of many trades to develop a meaningful trading philosophy. Second, this step is a dynamic process; as a trader gathers more experience and knowledge, the existing philosophy should be revised accordingly
    3. Define high-probability trades. Use your trading philosophy to develop a methodology for identifying high-probability trades. The idea is to look for trades that exhibit several of the characteristics you have identified as having some predictive value. Even if each condition provides only a marginal edge, the combination of several such conditions can provide a trade with a significant edge
    4. Have a plan. Know how you will get into a trade, and know how you will get out of the trade. Many investors make the mistake of only focusing on the former of these two requirements. Masters not only has a specific method for selecting and entering trades, but he also has a plan for liquidating trades. He will exit a trade whenever one of the following three conditions are met: (a) his profit objective for the trade is realized; (b) the expected catalyst fails to develop or the stock fails to respond as anticipated; (c) the stock fails to respond within a predefined length of time (the “time stop” is triggered)

Steve Cohen

Cohen’s economics education at Wharton taught him that 40 percent of a stock’s price movement was due to the market, 30 percent to the sector, and only 30 percent to the stock itself

Dr.Kiev

  • Dr. Kiev’s advice regarding goal achievement in general and trading success in particular can be summarized as follows:
    • Believing makes it possible
    • To achieve a goal, you not only have to believe it is possible, but you also have to commit to achieving it
    • A commitment that promises the goal to others is more powerful than a commitment made to oneself
    • Extraordinary performers—Olympic gold medal winners, super-traders—continually redefine their goals so they are a stretch. Maintaining exceptional performance requires leaving the comfort zone
    • After setting a goal, the trader or athlete needs to define a strategy that is consistent with the target
    • Traders, athletes, and other goal-oriented individuals need to monitor their performance to make sure they are on track with their target and to diagnose what is holding them back if they are not

Wizards lessons

  • There Is No Single True Path

There is no single true path for succeeding in the markets. The methods employed by great traders are extraordinarily diverse. Some are pure fundamentalists; others use only technical analysis; and still others combine the two methodologies. Some traders consider two days to be long term, while others consider two months to be short term. Some are highly quantitative, while other rely primarily on qualitative market decisions

  • The Universal Trait

Although the traders interviewed differed dramatically in terms of their methods, backgrounds, and personalities, there were numerous traits common to many of them. One trait that was shared by all the traders is discipline

Successful trading is essentially a two-stage process:

  1. Develop an effective trading strategy and an accompanying trading plan that addresses all contingencies
  2. Follow the plan without exception. (By definition, any valid reason for an exception—for example, correcting an oversight—would become part of the plan.) No matter how sound the trading strategy, its success will depend on this execution phase, which requires absolute discipline
  • You Have to Trade Your Personality

Cohen emphasizes that it is critical to trade a style that matches your personality. There is no single right way to trade the markets; you have to know who you are. For example, don’t try to be both an investor and a day trader. Choose an approach that is comfortable for you. Minervini offers similar advice: “Concentrate on mastering one style that suits your personality, which is a lifetime process.”

Successful traders invariably gravitate to an approach that fits their personality. For example, Cook is happy to take a small profit on a trade, but hates to take even a small loss. Given this predisposition, the methodologies he has developed, which accept a low return/risk ratio on each trade in exchange for a high probability of winning, are right for him. These same methods, however, could be a mismatch for others. Trading is not a one-size-fits-all proposition; each trader must tailor an individual approach

  • Failure and Perseverance

Although some of the traders in this book were successful from the start, the early market experiences of others were marked by complete failure. Mark Cook not only lost his entire trading stake several times, but on one of these occasions ended up several hundred thousand dollars in debt and a hair away from personal bankruptcy. Stuart Walton wiped out once with money borrowed from his father and several years later came close to losing not only all his trading capital, but also the money he borrowed on a home equity loan. Mark Minervini lost not only all his own money in the markets, but some borrowed money as well

Despite their horrendous beginnings, these traders ultimately went on to spectacular success. How were they able to achieve such a complete metamorphosis? Of course, part of the answer is that they had the inner strength to not be defeated by defeat. But tenacity without flexibility is no virtue. Had they continued to do what they had been doing before, they would have experienced the same results. The key is that they completely changed what they were doing

  • Great Traders Are Marked by Their Flexibility

Even great traders sometimes have completely wrongheaded ideas when they start. They ultimately succeed, however, because they have the flexibility to change their approach. La Rochefoucauld said, “One of the greatest tragedies of life is the murder of a beautiful theory by a gang of brutal facts.” Great traders are able to face such “tragedies” and choose reality over their preconceptions

Walton, for example, started out by selling powerhouse stocks and buying bargain stocks. When his empirical observations of what actually worked in the market contradicted this original inclination, he was flexible enough to completely reverse his approach. As another example, as a novice trader, Minervini favored buying low-priced stocks that were making new lows, an approach that was almost precisely the opposite of the methodology he ended up using

Markets are dynamic. Approaches that work in one period may cease to work in another. Success in the markets requires the ability to adapt to changing conditions and altered realities. Some examples:

  • Walton adjusts his strategy to fit his perception of the prevailing market environment. As a result, he might be a buyer of momentum stocks in one year and a buyer of value stocks in another. “My philosophy,” he says, “is to float like a jellyfish, and let the market push me where it wants to go.”
  • Even though Lescarbeau has developed systems whose performance almost defy belief, he continues his research to develop their replacements so that he is prepared when market conditions change
  • Fletcher’s primary current strategy evolved in several stages from a much simpler earlier strategy. As competitors increase in the current approaches he is utilizing, Fletcher is busy developing new strategies
  • Cohen says, “I’m always learning, which keeps it exciting and new. I’m not doing the same thing that I was doing ten years ago. I have evolved, and will continue to evolve.”

  • It Requires Time to Become a Successful Trader

Experience is a minimum requirement for success in trading, just as it is in any other profession, and experience can be acquired only in real time. As Cook says, “You can’t expect to become a doctor or an attorney overnight, and trading is no different.”

  • Keep a Record of Your Market Observations

Although the process of gaining experience can’t be rushed, it can be made much more efficient by writing down market observations instead of depending on memory. Keeping a daily diary in which he recorded the recurrent patterns he noticed in the market was instrumental to Cook’s transition from failure to great success. All of the many trading strategies he uses grew out of these notes. Masters jots down observations on the backs of his business cards. A compilation of these notes provided the basis for his trading model

  • Develop a Trading Philosophy

Develop a specific trading philosophy—an integration of market concepts and trading methods—that is based on your market experience and is consistent with your personality (item 3). Developing a trading philosophy is a dynamic process—as you gather more experience and knowledge, the existing philosophy should be revised accordingly

  • What Is Your Edge?

Unless you can answer this question clearly and decisively, you are not ready to trade. Every trader in this book has a specific edge. To offer a few examples:

  • Masters has developed a catalyst-based model that identifies high probability trades
  • Cook has identified price patterns that correctly predict the short-term direction of the market approximately 85 percent of the time
  • Cohen combines the information flow provided by the select group of traders and analysts he has assembled with his innate timing skills as a trader
  • A tremendous investment in research and very low transaction costs have made it possible for Shaw’s firm to identify and profit from small market inefficiencies
  • By combining carefully structured financing deals with hedging techniques, Fletcher implements transactions that have a high probability of being profitable in virtually any scenario
  • Watson’s extensive communication-based research allows him to identify overlooked stocks that are likely to advance sharply well before those opportunities become well recognized on Wall Street

  • The Confidence Chicken-and-Egg Question

One of the most strikingly evident traits among all the market wizards is their high level of confidence. This leads to the question: Are they confident because they have done so well, or is their success a consequence of their confidence? Of course, it would hardly be surprising that anyone who has done as extraordinarily well as the traders in this book would be confident. But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much a contributing factor to their success as a consequence of it. To cite only a few of the many possible examples:

  • When Watson was asked what gave him the confidence to pursue a career in money management when he had no prior success picking stocks, he replied, “Once I decide I am going to do something, I become determined to succeed, regardless of the obstacles. If I didn’t have that attitude, I never would have made it.”
  • Masters, who launched his fund when he was an unemployed stockbroker with virtually no track record, responded to a similar question, “I realized that if somebody could make money trading, so could I. Also, the fact that I had competed successfully at the highest levels of swimming gave me confidence that I could excel in this business as well.”
  • Lescarbeau’s confidence seemed to border on the irrational. When asked why he didn’t delay a split with his partner, who was the money manager of the team, until he had developed his own approach, Lescarbeau replied, “I knew I would come up with something. There was absolutely no doubt in my mind. I had never failed to succeed at anything that I put my mind to, and this was no different.”

An honest self-appraisal in respect to confidence may be one of the best predictors of a trader’s prospects for success in the markets. At the very least, those who consider career changes to become traders or risking a sizable portion of their assets in the market should ask themselves whether they have absolute confidence in their ultimate success. Any hesitation in the answer should be viewed as a cautionary flag

  • Hard Work

The irony is that so many people are drawn to the markets because it seems like an easy way to make a lot of money, yet those who excel tend to be extraordinarily hard workers—almost to a fault. Consider just some of the examples in this book:

  • As if running a huge trading company were not enough, Shaw has also founded a number of successful technology companies, provided venture capital funding and support to two computational chemistry software firms, and chaired a presidential advisory committee. Even when he is on a rare vacation, he acknowledges, “I need a few hours of work each day just to keep myself sane.”
  • Lescarbeau continues to spend long hours doing computer research even though his systems, which require very little time to run, are performing spectacularly well. He continues to work as if these systems were about to become ineffective tomorrow. He never misses a market day, to the point of hobbling across his house in pain on the day of his knee surgery so that he could check on the markets
  • Minervini works six-day workweeks, fourteen-hour trading days, and claims not to have missed a market day in ten years, even when he had pneumonia
  • Cook continues to do regular farm work in addition to spending fifty to sixty hours a week at trading. Moreover, for years after the disastrous trade that brought him to the brink of bankruptcy, Cook worked the equivalent of two full-time jobs

Bender not only spends a full day trading in the U.S. markets, but then is up half the night trading the Japanese stock market

  • Obsessiveness

There is often a fine line between hard work and obsession, a line that is frequently crossed by the market wizards. Certainly some of the examples just cited contain elements of obsession. It may well be that a tendency toward obsessiveness in respect to the markets, and often other endeavors as well, is simply a trait associated with success

  • The Market Wizards Tend to Be Innovators, Not Followers

To list a few examples:

  • When Fletcher started his first job, he was given a desk and told to “figure it out.” He never stopped. Fletcher has made a career of thinking up and implementing innovative market strategies
  • Bender not only developed his own style of trading options but created an approach that sought to profit by betting against conventional option models
  • Shaw’s entire life has been defined by innovation: the software company he launched as a graduate student; his pioneering work in designing the architecture of supercomputers; the various companies he founded; and his central role in developing the unique complex mathematical trading model used by D. E. Shaw
  • By compiling detailed daily diaries of his market observations for over a decade, Cook was able to develop a slew of original, high-reliability trading strategies
  • Minervini uncovered his own menagerie of chart patterns rather than using the patterns popularized in market books
  • By jotting down all his market observations, Masters was able to design his own catalyst-based trading model
  • Although he was secretive about the details, based on their incredible performance alone, it is quite clear that Lescarbeau’s systems are unique

  • To Be a Winner You Have to Be Willing to Take a Loss

In Watson’s words, “You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.”

  • Risk Control

Minervini believes that one of the common mistakes made by novices is that they “spend too much time trying to discover great entry strategies and not enough time on money management.” “Containing your losses,” he says, “is 90 percent of the battle, regardless of the strategy.” Cohen explains the importance of limiting losses as follows: “Most traders make money only in the 50 to 55 percent range. My best trader makes money only 63 percent of the time. That means you’re going to be wrong a lot. If that’s the case, you better make sure your losses are as small as they can be.”

Risk control methods used by the traders interviewed included the following:

  • Stop-loss points. Both Minervini and Cook predetermine where they will get out of a trade that goes against them. This approach allows them to limit the potential loss on any position to a well-defined risk level (barring a huge overnight price move). Both Minervini and Cook indicated that the stop point for any trade depends on the expected gain—that is, trades with greater profit potential will use wider stops (accept more risk)
  • Reducing the position. Cook has a sheet taped to his computer reading: GET SMALLER. “The first thing I do when I’m losing,” he says, “is to stop the bleeding.” Cohen expresses the virtual identical sentiment: “If you think you’re wrong, or if the market is moving against you and you don’t know why, take in half. You can always put it on again. If you do that twice, you’ve taken in three-quarters of your position. Then what’s left is no longer a big deal.”
  • Selecting low-risk positions. Some traders rely on very restrictive stock selection conditions to control risk as an alternative to stop-loss liquidation or position reduction
  • Limiting the initial position size. Cohen cautions, “A common mistake traders make…is that they take on too big of a position relative to their portfolio. Then when the stock moves against them, the pain becomes too great to handle, and they end up panicking or freezing.” On a similar note, Fletcher quotes his mentor, Elliot Wolk, “Never make a bet you can’t afford to lose.”
  • Diversification. The more diversified the holdings, the lower the risk. Diversification by itself, however, is not a sufficient risk-control measure, because of the significant correlation of most stocks to the broader market and hence to each other. Also, as discussed in item 52, too much diversification can have significant drawbacks
  • Short selling. Although the common perception is that short selling is risky, it can actually be an effective tool for reducing portfolio risk
  • Hedged strategies. Some traders (Fletcher, Shaw, and Bender) use methodologies in which positions are hedged from the onset. For these traders, risk control is a matter of restricting leverage, since even a low-risk strategy can become a high-risk trade if the leverage is excessive

  • You Can’t Be Afraid of Risk

Risk control should not be confused with fear of risk. A willingness to accept risk is probably an essential personality trait for a trader. As Watson states, “You have be willing to accept a certain level of risk, or else you will never pull the trigger.” When asked what he looks for when he hires new traders, Cohen replies, “I’m looking for people who are not afraid to take risks.”

  • Limiting the Downside by Focusing on Undervalued Stocks

A number of the traders interviewed restrict their stock selection to the universe of undervalued securities. Watson focuses on the stocks with relatively low price/earnings ratios (8 to 12). Okumus buys stocks that have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value

One reason all these traders focus on buying stocks that meet their definition of value is that by doing so they limit the downside. Another advantage of buying stocks that are trading at depressed levels is that the stocks in this group that do turn around will often have tremendous upside potential

  • Value Alone Is Not Enough

It should be stressed that although a number of traders considered undervaluation a necessary condition for purchasing a stock, none of them viewed it as a sufficient condition. There always had to be other compelling reasons for the trade because a stock could be low priced and stay that way for years. Even if you don’t lose much in buying a value stock that just sits there, it could represent a serious investment blunder by tying up capital that can be used much more effectively elsewhere

  • The Importance of Catalysts

A stock can represent great value and still stagnate for years, tying up valuable capital. Therefore, an essential question that needs to be asked is: What is going to make the stock go up?

  • Watson’s stock selection process contains two essential steps. First, the identification of stocks that fulfill his value criteria, which is the easy part of the process that merely defines the universe of stocks in which he prospects for buy candidates. Second, the search for catalysts (recent or impending) that will identify which of these value stocks have a compelling reason to move higher over the near term. To discover these catalysts, he conducts extensive communication with companies, as well as their competitors, distributors, and consumers. By definition, every trade requires a catalyst
  • Masters has developed an entire trading model based primarily on catalysts. Through years of research and observation, he has been able to find scores of patterns in how stocks respond to catalysts. Although most of these patterns may provide only a small edge by themselves, when grouped together, they help identify high-probability trades

  • Most Traders Focus on When to Get in and Forget About When to Get Out

When to get out of a position is as important as when to get in. Any market strategy that ignores trade liquidation is by definition incomplete.

A liquidation strategy can include one or more of the following elements:

  • Stop-loss points
  • Profit objective. A number of traders interviewed (e.g., Okumus, Cook) will liquidate a stock (or index) if the market reaches their predetermined profit target
  • Time stop. A stock (or index) is liquidated if it fails to reach a target within a specified time frame. Both Masters and Cook cited time stops as a helpful trading strategy
  • Violation of trade premise. A trade is immediately liquidated if the reason for its implementation is contradicted. For example, when IBM, which Cohen shorted in anticipation of poor earnings, reported better-than-expected earnings, Cohen immediately covered his position. Although he still took a large loss on the trade, the loss would have been significantly greater if he had hesitated
  • Counter-to-anticipated market behavior
  • Portfolio considerations

Some of these elements may make sense for all traders (e.g., exiting on counter-to-anticipated market behavior); others are very dependent on a trader’s style. For example, the use of stops to limit losses is essential to Minervini, who uses a timing-based methodology, but is contradictory to the approach used by Okumus and Watson, who tend to buy undervalued stocks after very sharp declines. (The latter traders, however, would still use stop-loss strategies for short positions, which are subject to open-ended losses.) As another example, profit objectives, which are an integral part of some traders’ methodologies, could be detrimental to other traders and investors by limiting profit potential

  • If Market Behavior Doesn’t Conform to Expectations, Get Out

A number of traders mentioned that if the market fails to respond to an event (e.g., earnings report) as expected, they will view it as evidence that they are wrong and liquidate their position. When I interviewed Cohen, he was bullish on the bond market, which at the time was in a long-term decline. He gave me a number of reasons why he believed the bond market would witness a substantial rebound in the ensuing months, and he implemented a long position as I sat next to him. The next few days, the bond market did indeed witness a bounce, but the rally soon faltered, with bond prices sliding to new lows. When I spoke to Cohen on a follow-up phone interview a week after my visit to his firm, I asked him whether he was still long the bond market, which he had been so bullish on several weeks earlier. “No,” Cohen replied, “you trade your theory and then let the market tell you whether you are right.”

  • The Question of When to Liquidate Depends Not Only on the Stock but Also on Whether a Better Investment Can Be Identified

Investable funds are finite. Continuing to hold one stock position precludes using those funds to purchase another stock. Therefore, it may often make sense to liquidate an investment that still looks sound if an even better investment opportunity exists. Watson, for example, employs what he calls a pig-at-the-trough philosophy. He is constantly upgrading his portfolio—replacing stocks that he still expects will go higher with other stocks that appear to have an even better return/risk outlook. Thus, the key question an investor needs to ask regarding a current holding is not “Will the stock move higher?” but rather “Is this stock still a better investment than any other equity I can hold with the same capital?”

  • The Virtue of Patience

Whatever criteria you use to select a stock and determine an entry level, you need to have the patience to wait for those conditions to be met. For example, Okumus will patiently wait for a stock to decline to his “bargain” price level, even if it means missing more than 80 percent of the stocks he wants to buy. In mid-1999, Okumus was only 13 percent invested because, as he stated at the time, “There are no bargains around. I’m not risking the money I’m investing until I find stocks that are very cheap.”

  • The Importance of Setting Goals

Dr. Kiev, who has worked with both Olympic athletes and professional traders, is a strong advocate of the power of setting goals. He contends that believing that an outcome is possible makes it achievable. Believing in a goal, however, is not sufficient. To achieve a goal, Kiev says, you need to not only believe in it but also commit to it. Promising results to others, he maintains, is particularly effective

Dr. Kiev stresses that exceptional performance requires setting goals that are outside a trader’s comfort zone. Thus, the trader seeking to excel needs to continually redefine goals so that they are always a stretch. Traders also need to monitor their performance to make sure they are on track toward reaching their goals and to diagnose what is holding them back if they are not

  • This Time Is Never Different

Every time there is a market mania, the refrain is heard, “This time is different,” followed by some explanation of why the particular bull market will continue, despite already stratospheric prices. When gold soared to near $1,000 an ounce in 1980, the explanation was that gold was “different from every other commodity.” Supposedly, the ordinary laws of supply and demand did not apply to gold because of its special role as a store of value in an increasingly inflationary world. (Remember double-digit inflation?) When the Japanese stock market soared in the 1980s, with price/earnings ratios often five to ten times as high as corresponding levels for U.S. companies, the bulls were ready with a reassuring explanation: The Japanese stock market is different because companies hold large blocks of each other’s shares, and they rarely sell these holdings

As this book was being written, there was an explosive rally in technology stocks, particularly Internet issues. Stocks with no earnings, or even a glimmer of the prospect of earnings, were being bid up to incredible levels. Once again, there was no shortage of pundits to explain why this time was different; why earnings were no longer important (at least for these companies). Warnings about the aspects of mania in the current market were mentioned by a number of the traders interviewed. By the time this manuscript was submitted, many of the Internet stocks had already witnessed enormous percentage declines. The message, however, remains relevant because there will always be some market or sector that rekindles the cry, “This time is different.” Just remember: It never is

  • Fundamentals Are Not Bullish or Bearish in a Vacuum; They Are Bullish or Bearish Only Relative to Price

A great company could be a terrible investment if its price rise has already more than discounted the bullish fundamentals. Conversely, a company that has been experiencing problems and is the subject of negative news could be a great investment if its price decline has more than discounted the bearish information. As Galante expressed when asked for her advice to investors, “A good company could be a bad stock and vice versa.”

  • Successful Investing and Trading Has Nothing to Do with Forecasting

Lescarbeau, for example, emphasized that he never made any predictions and scoffed at those who made claim to such abilities. When asked why he laughed when the subject of market forecasting came up, he replied: “I’m laughing about the people who do make predictions about the stock market. They don’t know. Nobody knows.”

  • Never Assume a Market Fact Based on What You Read or What Others Say; Verify Everything Yourself

When Cook first inquired about the interpretation of the tick (the number of New York Stock Exchange stocks whose last trade was an uptick minus the number whose last trade was a downtick), he was told by an experienced broker that if the tick was very high, it was a buy signal. By doing his own research and recording his own observations, he discovered that the truth was exactly the opposite

Bender began his option trading career by questioning the very core premises underlying the option pricing models used throughout the industry. Convinced that the conventional wisdom was wrong, he developed a methodology that was actually based on betting against the implications of the option pricing models in wide use

  • Never, Ever Listen to Other Opinions

To succeed in the markets, it is essential to make your own decisions. Numerous traders cited listening to others as their worst blunder. Walton and Minervini lost their entire investment stake because of this misjudgment. Talking about this experience, Minervini said, “My mistake had been surrendering the decision-making responsibility to someone else.” Watson got off cheap, learning this lesson at the bargain basement price of a blown grade on a class project. Cohen talks about someone he knows that has the skill to be a great trader, but will never be one because “he refuses to make his own decisions.”

  • Beware of Ego

Walton warns, “The odd thing about this industry is that no matter how successful you become, if you let your ego get involved, one bad phone call can put you out of business.”

  • The Need for Self-Awareness

Each trader must be aware of personal weaknesses that may impede trading success and make the appropriate adjustments. For example, Walton ultimately realized his weakness was listening to other people’s opinions. His awareness of this personal flaw compelled him to make sure that he worked alone, even when the level of assets under management would seem to dictate the need for a staff. In addition, to safely vent his tip-following, gambling urges, he set aside a small amount of capital—too small to do any damage—to be used for such trades

Dr. Kiev describes his work with traders as “a dialogue process to find out what [personal flaws are] impeding a person’s performance.” Some examples of these personal flaws he helped traders identify included:

  • a trader whose bargain-hunting predisposition caused him to miss many good trades because he was always trying to get a slightly better entry price;
  • a trader whose scale-down entry approach was in conflict with his experiencing these trades as a loss, even though they were entered in accordance with his plan;
  • a trader who, to his detriment, always kept a partial position after he made the decision to get out because of his anxiety that the stock would go higher after he liquidated

Awareness alone is not enough; a trader must also be willing to make the necessary changes. Cook, who also works with traders, has seen people with good trading skills fail because they wouldn’t deal with their personal weaknesses. One example he offered was a client who was addicted to the excitement of trading on expiration Fridays. Although the trader did well across all other market sessions, these far more numerous small gains were more than swamped by his large losses on the four-per-year expiration Fridays. Despite being made aware of his weakness, the trader refused to change and ultimately wiped out

  • Don’t Get Emotionally Involved

Ironically, although many people are drawn to the markets for excitement, the market wizards frequently cite keeping emotion out of trading as essential advice to investors. Watson says, “You have to invest without emotions. If you let emotions get involved, you will make bad decisions.”

  • View Personal Problems as a Major Cautionary Flag to Your Trading

Health problems or emotional stress can sometimes decimate a trader’s performance. For example, all of Cook’s losing periods (after he became a consistent winning trader) coincided with times of personal difficulties (e.g., a painful injury, his father’s heart attack). It is a sign of Walton’s maturity as a trader that he decided to take a trading hiatus when an impending divorce coincided with a rare losing period. The morale is: Be extremely vigilant to signs of deteriorating trading performance if you are experiencing health problems or other personal difficulties. During such times, it is probably a good idea to cut trading size and to be prepared to stop trading altogether at the first sign of trouble

  • Analyze Your Past Trades for Possible Insights

Analyzing your past trades might reveal patterns that could be used to improve future performance. For example, in analyzing his past trades, Minervini found that his returns would have been substantially higher if he had capped his losses to a fixed maximum level. This discovery prompted a change in his trading rules that dramatically improved his performance

  • Don’t Worry About Looking Stupid

Never let your market decisions be restricted or influenced by concern over what others might think. As a perfect example of the danger of worrying about other people’s opinions, early in his career, Minervini held on to many losing positions long after he decided they should be liquidated because of concern about being teased by his broker

  • The Danger of Leverage

Ironically, even though Mark Cook won on most of his trades in his initial market endeavor, he wiped out because of excessive leverage. If you are too heavily leveraged, all it takes is one mistake to knock you out of the game

  • The Importance of Position Size

Superior performance requires not only picking the right stock, but also having the conviction to implement major potential trades in meaningful size. Dr. Kiev, who sees Cohen’s trading statistics, said that nearly 100 percent of Cohen’s very substantial gains come from 5 percent of his trades. Cohen himself estimates that perhaps only about 55 percent of his trades are winners. Implicit in these statements is that when Cohen bets big, he is usually right. Indeed, his uncanny skill in determining which trades warrant stepping on the accelerator is an essential element in his success

As another example, even though Lescarbeau is a systematic trader, he will occasionally increase the leverage on trades that he perceives have a particularly high likelihood of winning. Interestingly, he has never lost money on one of these trades

The point is that all trades are not the same. Trades that are perceived to have particularly favorable potential relative to risk or a particularly high probability of success should be implemented in a larger size than other trades. Of course, what constitutes “larger size” is relative to each individual, but the concept is as applicable to the trader whose average position size is one hundred shares as the fund manager whose average position size is one million shares

  • Complexity Is Not a Necessary Ingredient for Success

Some of the patterns and indicators that Cook uses to signal trades are actually quite simple, but it is his skill in their application that accounts for his success

  • View Trading as a Vocation, Not a Hobby

As both Cook and Minervini said, “Hobbies cost money.” Walton offered similar advice, “Either go at it full force or don’t go at it at all. Don’t dabble.”

  • Trading, Like Any Other Business Endeavor, Requires a Sound Business Plan

Cook advises that every trader should develop a business plan that answers all the following essential questions:

  • What markets will be traded?
  • What is the capitalization?
  • How will orders be entered?
  • What type of drawdown will cause trading cessation and reevaluation?
  • What are the profit goals?
  • What procedure will be used for analyzing trades?
  • How will trading procedures change if personal problems arise?
  • How will the working environment be set up?
  • What rewards will the trader take for successful trading?
  • What will the trader do to continue to improve market skills?

  • Define High-Probability Trades

Although the methodologies of the traders interviewed differ greatly, in their own style, they have all found ways of identifying high-probability trades

  • Find Low-Risk Opportunities

Many of the traders interviewed have developed methods that focus on identifying low-risk trades. The merit of a low-risk trade is that it combines two essential elements: patience (because only a small portion of ideas will qualify) and risk control (inherent in the definition)

  • Be Sure You Have a Good Reason for Any Trade You Make

As Cohen explains, buying a stock because it is “too low” or selling it because it is “too high” is not a good reason. Watson paraphrases Peter Lynch’s principle: “If you can’t summarize the reasons why you own a stock in four sentences, you probably shouldn’t own it.”

  • Use Common Sense in Investing

Taking a cue from his role model, Peter Lynch, Watson is a strong proponent of commonsense research. As he illustrated through numerous examples, frequently, the most important research one can do is simply trying a company’s product or visiting its mall outlets in the case of retailers

  • Buy Stocks That Are Difficult to Buy

Walton says, “One of the things I like to see when I’m trying to buy stocks is that they become very difficult to buy. I put an order in to buy Dell at 42, and I got a fill back at 45. I love that.” Minervini says, “Stocks that are ready to blast off are usually very difficult to buy without pushing the market higher.” He says that one of the mistakes “less skilled traders” make is “wait[ing] to buy these stocks on a pullback, which never comes.”

  • Don’t Let a Prior Lower-Priced Liquidation Keep You from Purchasing a Stock That You Would Have Bought Otherwise

Walton considers his willingness to buy back good stocks, even when they are trading higher than where he got out, as one of the changes that helped him succeed as a trader. Minervini stresses the need for having a plan to get back into a trade if you’re stopped out. “Otherwise,” he says, “you’ll often find yourself…watching the position go up 50 percent or 100 percent while you’re on the sidelines.”

  • Holding on to a Losing Stock Can Be a Mistake, Even If It Bounces Back, If the Money Could Have Been Utilized More Effectively Elsewhere

When a stock is down a lot from where it was purchased, it is very easy for the investor to rationalize, “How can I get out now? I can’t lose much more anyway.” Even if this is true, this type of thinking can keep money tied up in stocks that are going nowhere, causing the trader to miss other opportunities. Talking about why he dumped some stocks after their prices had already declined as much as 70 percent from where he got in, Walton said: “By cleaning out my portfolio and reinvesting in solid stocks, I made back much more money than I would have if I had kept [these] stocks and waited for a dead cat bounce.”

  • You Don’t Have to Make All-or-Nothing Trading Decisions

As an illustration of this advice offered by Minervini, if you can’t decide whether to take profits on a position, there’s nothing wrong with taking profits on part of it

  • Pay Attention to How a Stock Responds to News

Walton looks for stocks that move higher on good news but don’t give much ground on negative news. If a stock responds poorly to negative news, then in Walton’s words, “[it] hasn’t been blessed [by the market].”

  • Insider Buying Is an Important Confirming Condition

The willingness of management or the company to buy its own stock may not be a sufficient condition to buy a stock, but it does provide strong confirmation that the stock is a good investment. A number of traders cited insider buying as a critical element in their stock selection process(e.g., Okumus and Watson)

Okumus stresses that insider buying statistics need to be viewed in relative terms. “I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant.” Okumus also points out the necessity of making sure that insider buying actually represents the purchase of new shares, not the exercise of options

  • Hope Is a Four-Letter Word

Cook advises that if you ever find yourself saying, “I hope this position comes back,” get out or reduce your size.

  • The Argument Against Diversification

Diversification is often extolled as a virtue because it is an instrumental tool in reducing risk. This argument is valid insofar as it generally unwise to risk all your assets on one or two equities, as opposed to spreading the investment across a broader number of diversified stocks. Beyond a certain minimum level, however, diversification may sometimes have negative consequences. Okumus, for example, explains why he limits his portfolio to approximately ten holdings as follows: “Simple logic: My top ten ideas will always perform better than my top hundred.”

The foregoing is not intended as an argument against diversification. Indeed, some minimal diversification is almost always desirable. The point is that although some diversification is beneficial, more diversification may sometimes be detrimental. Each trader needs to consider the appropriate level of diversification as an individual decision

  • Caution Against Data Mining

If enough data is tested, patterns will arise simply by chance—even in random data. Data mining—letting the computer cycle through data, testing thousands or millions of input combinations in search of profitable patterns—will tend to generate trading models (systems) that look great, but have no predictive power. Such hindsight analysis can entice the researcher to trade a worthless system. Shaw avoids this trap by first developing a hypothesis of market behavior to be tested rather than blindly searching the data for patterns

  • Synergy and Marginal Indicators

Shaw mentioned that although the individual market inefficiencies his firm has identified cannot be traded profitably on their own, they can be combined to identify profit opportunities. The general implication is that it is possible for technical or fundamental indicators that are marginal on their own to provide the basis for a much more reliable indicator when combined

  • Past Superior Performance Is Relevant Only If the Same Conditions Are Expected to Prevail

It is important to understand why an investment (stock or fund) outperformed in the past. For example, in the late 1990s a number of the better performing funds owed their superior results to a strategy of buying the most highly capitalized stocks. As a result, the high-cap stocks were bid up to extremely high price/earnings ratios relative to the rest of the market. A new investor expecting these funds to continue to outperform in the future would, in effect, be making an investment bet that was dependent on high-cap stocks becoming even more overpriced relative to the rest of the market

As columnist George J. Church once wrote, “Every generation has its characteristic folly, but the basic cause is the same: people persist in believing that what has happened in the recent past will go on happening into the indefinite future, even while the ground is shifting under their feet.”

  • Popularity Can Destroy a Sound Approach

A classic example of this principle was provided by the 1980s experience with portfolio insurance (the systematic sale of stock index futures as the value of a stock portfolio declines in order to reduce risk exposure). In the early years of its implementation, portfolio insurance provided a reasonable strategy for investors to limit losses in the event of market declines. As the strategy became more popular, however, it set the stage for its own destruction. By the time of the October 1987 crash, portfolio insurance was in wide usage, which contributed to the domino effect of price declines triggering portfolio insurance selling, which pushed prices still lower, causing more portfolio selling, and so on. It can even be argued that the mere knowledge of the existence of large portfolio insurance sell orders below the market was one of the reasons for the enormous magnitude of the October 19, 1987, decline

  • Like a Coin, the Market Has Two Sides—But the Coin Is Unfair Just as you can bet heads or tails on a coin, you can go long or short a stock

Unlike a normal coin, however, the odds for each side are not equal: The long-term uptrend in stock prices results in a strong negative bias in short selling trades. As Lescarbeau says, “Shorting stocks is dumb because the odds are stacked against you. The stock market has been rising by over 10 percent a year for many decades. Why would you want to go against that trend?” (Actually, there is a good reason why, which we will get to shortly.) Another disadvantage to the short side is that the upside is capped. Whereas a well-chosen buy could result in hundreds or even thousands of percent profit on the trade, the most perfect short position is limited to a profit of 100 percent (if the stock goes to zero). Conversely, whereas a long position can’t lose more than 100 percent (assuming no use of margin), the loss on a short position is theoretically unlimited

Finally, with the exception of index products, the system is stacked against short selling. The short seller has to borrow the stock to sell it, an action that introduces the risk of the borrowed stock being called in at a future date, forcing the trader to cover (buy in) the position. Frequently, deliberate attempts to force shorts to cover their positions (short squeezes) can cause overvalued, and even worthless, stocks to rally sharply before collapsing. Thus, the short seller faces the real risk of being right on the trade and still losing money because of an artificially forced liquidation. Another obstacle faced by shorts is that positions can be implemented only on an uptick (when the stock trades up from its last sale price)—a rule that can cause a trade to be executed at a much worse price than the prevailing market price when the order was entered

  • The Why of Short Selling

With all the disadvantages of short selling, it would appear reasonable to conclude that it is foolhardy ever to go short. Reasonable, but wrong. As proof, consider this amazing fact: fourteen of the fifteen traders interviewed in this book incorporate short selling! (The only exception is Lescarbeau.) Obviously, there must be some very compelling reason for short selling

The key to understanding the raison d’être for short selling is to view these trades within the context of the total portfolio rather than as stand-alone transactions. With all their inherent disadvantages, short positions have one powerful attribute: they are inversely correlated to the rest of the portfolio (they will tend to make money when long holdings are losing and vice versa). This property makes short selling one of the most useful tools for reducing risk

To understand how short selling can reduce risk, we will compare two hypothetical portfolios. Portfolio A holds only long positions and makes 20 percent for the year. Portfolio B makes all the same trades as Portfolio A, but also adds a smaller component of short trades. To keep the example simple, assume the short positions in Portfolio B exactly break even for the year. Based on the stated assumptions, Portfolio B will also make 20 percent for the year. There is, however, one critical difference: the magnitude of equity declines will tend to be smaller in Portfolio B. Why? Because the short positions in the portfolio will tend to do best when the rest of the portfolio is declining

In our example, we assumed short positions broke even. If a trader can make a net profit on short positions, then short selling offers the opportunity to both reduce risk and increase return. Actually, short selling offers the opportunity to increase returns without increasing risk, even if the short positions themselves only break even. * How? By trading long positions with greater leverage (using margin if the trader is fully invested)—a step that can be taken without increasing risk because the short positions are a hedge against the rest of the portfolio

It should now be clear why so many of the traders interviewed supplement their long positions with short trades: It allows them to increase their return/risk levels (lower risk, or higher return, or some combination of the two)

If short selling can help reduce portfolio risk, why is it so often considered to be exactly the opposite: a high-risk endeavor? Two reasons. First, short trades are often naively viewed as independent transactions rather than in the context of the total portfolio. Second, the open-ended loss exposure of short positions can indeed lead to enormous risk. Fortunately, however, this risk can be controlled, which brings us to our next point

  • The One Indispensable Rule for Short Selling

Although short selling will tend to reduce portfolio risk, any individual short position is subject to losses far beyond the original capital commitment. A few examples:

  • A $10,000 short position in Amazon in June 1998 would have lost $120,000 in seven months
  • A $10,000 short position in Ebay in October 1998 would have lost $230,000 in seven months
  • A $10,000 short position in Yahoo! in January 1997 would have lost $680,000 in two years

As these examples make clear, it takes only one bad mistake to wipe out an account on the short side. Because of the theoretically unlimited risk in short positions, the one essential rule for short selling is: Define a specific plan for limiting losses and adhere rigorously to it

The following are some of the risk-control methods for short positions mentioned by the interviewed traders:

  • A short position is liquidated when it reaches a predetermined maximum loss point, even if the trader’s bearish analysis is completely unchanged. As Watson says, “I will cover even if I am convinced that the company will ultimately go bankrupt…I’m not going to let [a 1 percent short in the portfolio] turn into a 5 percent loss.”
  • A short position is limited to a specific maximum percentage of the portfolio. Therefore, as the price of a short position rises, the size of the position would have to be reduced to keep its percentage share of the portfolio from increasing
  • Short positions are treated as short-term trades, often tied to a specific catalyst, such as an earnings report. Win or lose, the trade is liquidated within weeks or even days

  • Identifying Short-Selling Candidates (or Stocks to Avoid for Long-Only Traders)

Galante, whose total focus is on short selling, looks for the following red flags in finding potential shorts:

  • high receivables (large outstanding billings for goods and services);
  • change in accountants;
  • high turnover in chief financial officers;
  • a company blaming short sellers for their stock’s decline;
  • a company completely changing their core business to take advantage of a prevailing hot trend

The stocks flagged must meet three additional conditions to qualify for an actual short sale:

  • very high P/E ratio;
  • a catalyst that will make the stock vulnerable over the near term;
  • an uptrend that has stalled or reversed

Watson’s ideal short-selling candidate is a high-priced, one-product company. He looks for companies whose future sales will be vulnerable because their single or primary product does not live up to promotional claims or because there is no barrier to entry for competitors

  • Use Options to Express Specific Price Expectations

Prevailing option prices will reflect the assumption that price movements are random. If you have specific expectations about the relative probabilities of a stock’s future price movements, then it will frequently be possible to define option trades that offer a higher profit potential (at an equivalent risk level) than buying the stock

  • Sell Out-of-the-Money Puts in Stocks You Want to Buy

This is a technique used by Okumus that could be very useful to many investors, but is probably utilized by very few. The idea is for an investor to sell puts at a strike price at which he would want to buy the stock anyway. This strategy will assure making some profit if the stock fails to decline to the intended buying point and will reduce the cost for the stock by the option premium received if it does reach the intended purchase price

For example, let’s say XYZ Corporation is trading at $24 and you want to buy the stock at $20. Typically, to achieve this investment goal, you would place a buy order for the stock at a price limit of $20. The alternative Okumus suggests is selling $20 puts in the stock. In this way, if the stock fails to decline to your buy price, you will at least make some money from the sale of the $20 puts, which by definition will expire worthless. If, on the other hand, the stock declines to under $20, put buyers will exercise their option and you will end up long the stock at $20, which is the price that you wanted to buy it at anyway. Moreover, in this latter event, your purchase price will be reduced by the premium collected from the sale of the options

  • Wall Street Research Reports Will Tend to Be Biased

A number of traders mentioned the tendency for Wall Street research reports to be biased. Watson cites the bias due to investment banking relationships—analysts will typically feel implicit pressure to issue buy ratings on companies that are clients of the firm, even if they don’t particularly like the stock

  • The Universality of Success

This chapter was intended to summarize the elements of successful trading and investing. I believe, however, that the same traits that lead to success in trading are also instrumental to success in any field. Virtually all the items listed, with the exception of those that are exclusively market-specific, would be pertinent as a blueprint for success in any endeavor

Options—Understanding the Basics

There are two basic types of options: calls and puts. The purchase of a call option provides the buyer with the right—but not the obligation—to purchase the underlying stock (or other financial instrument) at a specified price, called the strike price or exercise price, at any time up to and including the expiration date. A put option provides the buyer with the right—but not the obligation—to sell the underlying stock at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, whereas selling a put is a bullish trade.) The price of an option is called premium. As an example of an option, an IBM April 130 call gives the purchaser the right to buy 100 shares of IBM at $130 per share at any time during the life of the option

The buyer of a call seeks to profit from an anticipated price rise by locking in a specified purchase price. The call buyer’s maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price were above the prevailing market price. For example, if IBM were trading at $125 when the 130 option expired, the option would expire worthless. If at expiration the price of the underlying market was above the strike price, the option would have some value and would hence be exercised. However, if the differenct between the market price and the strike price was less than the premium paid for the option, the net result of the trade would still be a loss. In order for a call buyer to realize a net profit, the difference between the market price and the strike price would have to exceed the premium paid when the call was purchased (after adjusting for commission cost). The higher the market price, the greater the resulting profit

The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Like the call buyer, his maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the market price by an amount greater than the premium of the put at purchase (after adjusting for commission cost). Whereas the buyer of a call or put has limited risk and unlimited potential gain, the reverse is true for the seller. The option seller (often called the writer ) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position at the strike price if an option is exercised. For example, if a call is exercised, the seller must assume a short position in the underlying market at the strike price (because, by exercising the call, the buyer assumes a long position at that price). The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call provides the most attractive trading opportunity. However, if the trader expected a large price decline, he would be usually better off going short the underlying market or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market. Some novices have trouble understanding why a trader would not always prefer the buy side of the option (call or put, depending on market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurrence, (i.e., prices in the vicinity of the market price when the option trade occurs) would result in a net gain to the option seller. Roughly speaking, the option buyer accepts a large probability of a small loss in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain. In an efficient market, neither the consistent option buyer nor the consistent option seller should have any significant advantage over the long run

The option premium consists of two components: intrinsic value plus time value. The intrinsic value of a call option is the amount by which the current market price is above the strike price. (The intrinsic value of a put option is the amount by which the current market price is below the strike price.) In effect, the intrinsic value is that part of the premium that could be realized if the option were exercised at the current market price. The intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic value, a trader could buy and exercise the option and immediately offset the resulting market position, thereby realizing a net gain (assuming that the trader covers at least transaction costs)

Options that have intrinsic value (i.e., calls with strike prices below the market price and puts with strike prices above the market price) are said to be in the money. Options that have no intrinsic value are called out of the money options. Options with a strike price closest to the market price are called at the money options

An out of the money option, which by definition has an intrinsic value equal to zero, will still have some value because of the possibility that the market price will move beyond the strike price prior to the expiration date. An in the money option will have a value greater than the intrinsic value because a position in the option will be preferred to a position in the underlying market. Why? Because both the option and the market position will gain equally in the event of a favorable price movement, but the option’s maximum loss is limited. The portion of the premium that exceeds the intrinsic value is called the time value

The three most important factors that influence an option’s time value are the following:

  1. Relationship between the strike price and market price. Deeply out of the money options will have little time value, since it is unlikely that the market price will move to the strike price—or beyond—prior to expiration. Deeply in the money options have little time value because these options offer positions very similar to the underlying market—both will gain and lose equivalent amounts for all but an extremely adverse price move. In other words, for a deeply in the money option, risk being limited is not worth very much because the strike price is so far from the prevailing market place
  2. Time remaining until expiration. The more time remaining until expiration, the greater the value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specified amount prior to expiration
  3. Volatility. Time value will vary directly with the estimated volatility (a measure of the degree of price variability) of the underlying market for the remaining life span of the option. This relationship results because greater volatility raises the probability of the intrinsic value increasing by any specified amount prior to expiration. In other words, the greater the volatility, the greater the probable price range of the market. Although volatility is an extremely important factor in the determination of option premium values, it should be stressed that the future volatility of a market is never precisely known until after the fact. (In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the implied volatility

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