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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Ironically, I actually ended up losing money on the trade==== And youre saying that 20 percent is that type of number? ==== Thats my hypothesis. Obviously, I cant really prove it. ==== Do you use your statistical studies of the normal duration and magnitude of price moves to set targets either in terms of price or time? ==== Absolutely not. To use extent and duration profiles to predict exact market turning points would be like an insurance company telling you when and how you will die on the day you buy your policy. They dont have to do that to make a profit. All they need to do to make a profit is to know what the odds are. ==== How then do you analyze a situation in which a market has reached the median age of historical upmoves? ==== Once a price move exceeds its median historical age, any method you use to analyze the market, whether it be fundamental or technical, is likely to be far more accurate. For example, if a chartist interprets a particular pattern as a top formation, but the market is only up 10 percent from the last relative low, the odds are high that the projection will be incorrect. However, if the market is up 25 to 30 percent, then the same type of formation should be given a great deal more weight. ==== When you miss a major turning point, such as the October 1974 low you mentioned before (which was the low point of the market since that time), how do you eventually get back into the market? ==== Markets go up in stepwise fashion. I wait until a situation arises that looks like theres another major relative low. In the case of 1974,1 went long the world on December 6. That day proved to be the exact bottom of the market. Ironically, I actually ended up losing money on the trade. ==== Before I ask you to explain that apparent paradox, first tell me what made you so sure that it was the bottom of the market. ==== To begin, there was a Dow Theory buy signal-the Dow Jones Industrial index had made a new low, but the Transportation index and the S&P 500 had not. In addition, the volume on the break to new lows was relatively light. Also, we had been in a bear market for a long time, and bearish sentiment was pervasive. Finally, bad news was starting to lose its impact on the market-bearish news stories would come out, and stocks would essentially lie flat. ==== Now tell me how you managed to lose money buying the December 1974 low. ==== I had an incredibly profitable year up to that point. I took one-third of my profits for the year and bought out-of-the-money calls expiring in January. As one example, at the time, Kodak was trading at 64, and I bought the January 70 calls, which were trading near 1. On January 27, which was the expiration day of the January option series, Kodak had rebounded to 69. The calls obviously went out worthless. One week later, Kodak was trading at 80. The same type of experience was repeated in a dozen other positions. ==== So your mistake was buying options that were too far out of the money and too short in duration? ==== They werent too far out of the money. My mistake was that I didnt allow enough time until expiration. This episode preceded my study on the duration and magnitude of historical price moves, which we discussed earlier. After I completed my study in 1976,1 realized that the second legs of bull markets tend to be relatively extended. Im certain that if I encountered a similar situation after 1976,1 would have bought the April options instead of the January options. But atthe time, I simply didnt have enough knowledgeabout the probabilities of various market moves. ==== How did you eventually get back into the market? ==== I got long in February 1975 and did very well. By the way, that was very hard to do because I was getting back into the market at a point at which stock prices were trading much higher than when my options expired worthless in January. ==== I dont completely understand your statistical study of the longevity of price moves. It appears that weve been in an extended bull market since 1982, which at the time of this interview [April 1991] would make the current bull market nine years old. Doesnt that place the age of this bull market off the charts in terms of your historical studies? Wouldnt you have been inclined to look for a major top far too prematurely? ==== I look at it from a completely different perspective. By my definitions, the bull market that began in 1982 ended in November 1983. ==== How do you objectively make those kinds of classifications? ==== What defines an uptrend? One essential criterion is that you do not take out a prior major relative low. The bear phase that lasted from June 1983 to July 1984 consisted of two major downswings-that is, you took out a prior major relative low. Also, by my definitions, to qualify as a bear market, the price move must last a minimum of six months and be equal to at least 15 percent. Both of these conditions were met by the price decline from the June 1983 high to the July 1984 low. Thus, in terms of all my criteria, the price upmove that began in July 1984 marked the beginning of a new bull market. ==== By your classification, when did the bull market that began in July 1984 end? ==== In my view, that bull market ended in October 1989, making it the second longest bull market since 1896 (the start of my statistical survey). The bull market didnt end in August 1987 because the subsequent price break lasted only three months. Therefore, although that price decline was extraordinarily sharp, it did not meet the minimum time duration definition for a bear market, namely, six months from top to bottom. ==== Is there anything you consider unique about your money management approach? ==== Yes, I analyze risk by measuring the extent and duration of price swings. For example, if the market has risen 20 percent in roughly 107 days, even if Im still extremely bullish Ill have a maximum position size of 50 percent, because statistically weve reached the median historical magnitude and duration of an upmove. ==== In other words, you vary the size of the bet relative to your perception of the market risk. Do you do anything differently in terms of cutting loses? ==== Losses are always predetermined so that I can measure my risk. ==== By predetermined you mean that you decide where youre getting out before you get in? ==== Exactly. Let me give you an example to illustrate why this principle is so important. Take the typical trader who gets a call from his broker. Listen, his broker says, I have some information from a reliable source that stock XYZ is going to be a takeover play. Its only trading at $20; it could go up to $60! The trader buys the stock, and two weeks later its trading at $18. The action just doesnt seem right, so he promises himself to get out when hes even. The next week the stock is down to $17. Now hes beginning to feel a little bit concerned. Ill get out on the first rally, he vows to himself. One week later the stock is down to $15, and the trader, who has bought the stock on margin, suddenly realizes hes lost half his money. Two days later the stock is at $14, and he calls up his broker in a state of desperation and exclaims, Get me out! He gets filled at $13, and thats the bottom of the market. Sound familiar? Think about the psychological process involved. At the beginning, the trader fell for the lure of making easy money. When the stock declined to $18, he felt a little anxious. When it fell to $17, he felt the onset of panic. When the stock slid to $15, it was pure panic. When he finally got out, he felt a sense of relief-which is somewhat ironic since he had just lost 70 percent of his money. Theres nothing logical about this process. Its all an emotional pitfall. Planning where to get out before putting on the trade is a means of enforcing emotional discipline. ==== Is predetermining an exit point something that youve done for the last few years? ==== No, thats something that Ive done since my first day in the business. Ive always had a point where I knew that I was getting out. ==== Does taking a loss have an emotional impact on you? ==== None. Taking a loss never affects me, but I dont take big losses. ==== Never? Wasnt there ever any instance in which you deviated from your risk control guidelines? ==== Well, actually, there was one instance in November 1984. That situation was dramatic because it ended up costing me over $1 million. At the time, the Fed was easing, and I was convinced that we were in a bull market. The market had started to sell off because Congress was considering a change in the tax code. However, when the newspapers reported that (he proposed change in the tax code would be revenue neutral, I decided to go long. 1 put on a huge position because I trade at my biggest when Im making money, and I had experienced a great year up to that point. I was long the world-two legal-size pages of positions. My smallest position was one hundred options and my biggest position-Im not exaggerating-was two thousand options. What I failed to realize was that, even though the proposed change in the tax code was revenue neutral, the plan called for taking money from corporations and giving it to individuals. When youre long stocks, you dont want any plan that takes money away from corporations [he laughs]. When the market went down four days in a row, I knew I was wrong. I wanted to be out. The market just kept on falling. On the sixth straight down day, I got out. If I had sold after the fourth down day, my loss would have been only half as large. ==== I thought you had a rule about getting out? ==== I did. My rule would have had me out on the fourth day. ==== So you violated your rule? ==== Yes, but it wasnt a matter of my hoping that the market would go up. The reason that I didnt get out was that the decline seemed extremely overdone. My plan was still to liquidate, but to wait for the first day the market rallied. ==== Did you end up getting out at the bottom? ==== No, the market actually declined for nine consecutive days. ==== What lesson did you learn from that experience? ==== Whenever theres a tax proposal, or some other major legislative uncertainty, I now get flat immediately. The market will always run to the sidelines until it knows what will happen. ==== Is there any more general lesson that would apply? ==== Yes, when youre trading at your biggest, you should be making money instantaneously. ==== In other words, when you have a large position, you should cut your bet size quickly unless that position starts making money right at the start? ==== Exactly. When youre trading large, you need to have an especially short fuse in regard to cutting losses. My goal on Wall Street was never to get rich but to stay in business. Theres a big difference. If youre out of the business, you can never get rich. Thats why you have to be especially cautious when youre trading a larger position size. |
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