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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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They don't approach trading as a business==== Why do most people lose money in the market? ==== I know this will sound like a cliche, but the single most important reason that people lose money in the financial markets is that they dont cut their losses short. It is a curiosity of human nature that no matter how many books talk about this rule, and no matter how many experts offer this advice, people still keep making the same mistake. ==== What other mistakes do people make? ==== They don't approach trading as a business. Ive always viewed trading as a business. ==== Can you elaborate on your business plan for trading? ==== I view the objectives in trading as a three-tiered hierarchy. First and foremost is the preservation of capital. When I first look at a trade, I dont ask, What is the potential profit I can realize? but rather, What is the potential loss I could suffer? Second, I strive for consistent profitability by balancing my risk relative to the accumulated profits or losses. Consistency is far more important than making lots of money. Third, insofar as Im successful in the first two goals, I attempt to achieve superior returns. I do this by increasing my bet size after, and only after, periods of high profitability. In other words, if I have had a particularly profitable recent period, I may try to pyramid my gains by placing a larger bet size assuming, of course, the right situation presents itself. The key to building wealth is to preserve capital and wait patiently for the right opportunity to make the extraordinary gains. ==== What is your opinion about chart analysis? ==== Ive made too much money trading on technical observations to dismiss technical analysis as many pure fundamentalists do. However, I do believe that technical analysis is insufficient as a sole method of analyzing and trading the market. Back in 1974,1 was approached by a technical analyst who talked a convincing game about how he could help improve my trading. I hired him as an advisor on a trial basis for S125 a week. I also offered to pay him a percentage 6T the profits on his recommendations. Well, this fellow was very industrious. He worked sixteen-hour days and analyzed his charts in ways that I still dont understand. However, whenever I asked him for a specific recommendation, he would show me the chart and say things like, This stock might be forming a top. He could never give me a straight answer when I asked him if I should buy or sell. My most distinct memory about him is that his shirtsleeves were frayed and he ate homemade tuna fish sandwiches for lunch. ==== Do you use chart analysis? ==== Yes, but I like to keep it simple. My primary methodology is a three-step process to define important trend changes. Let me take the example of trying to identify a top in a rising market. The first step is waiting for the uptrend line to be broken. ==== In my experience, I have not found trend lines to be particularly reliable. ==== It is essential that you draw the trend line correctly. Most people draw trend lines incorrectly. ==== What is the correct way of drawing a trend line? ==== In the case of an uptrend line, you draw the line from the lowest low to the highest low immediately preceding the highest high, making sure that the connecting point you select does not result in the trend line passing through any prices between the two points. ==== I interrupted you. You said you used a three-step process of chart analysis. What are the remaining two steps? ==== Once the trend line is broken, I then look for an unsuccessful test of the recent high. This failure may take the form of prices reversing below the previous high or, in some instances, prices might actually penetrate the previous high by a modest amount and then break. In the case where prices penetrate the previous high, a pullback below that high would serve as confirmation of a failed test of the high. The third and final confirmation of a trend change would be the downside penetration of the most recent relative low. ==== In the second criterion you mentioned-the failed test of the previous high-you indicated that sometimes the rebound will fall short of the high and sometimes it will penetrate the high before prices break. Is the pattern more reliable if the previous high is penetrated before prices pull back? ==== As a matter of fact, yes. In fact, this one pattern alone can sometimes catch the virtual exact high or low. In my view, these types of price failures are probably the most reliable and important chart patterns. The reason these types of failures often mark major turning points is related to the mechanics of the trading floor. Many traders tend to set their stops at or near the previous high or low. This behavioral pattern holds tme for both major and minor price moves. When there is a heavy concentration of such stops, you can be reasonably sure that the locals on the floor are aware of this information. There will be a tendency for the locals to buy as prices approach a concentration of buy stops above the market (or to sell if the market approaches heavy sell stops below the market). The locals try to profit by anticipating that the activation of a large pocket of stops will cause a minor extension of the price move. They will then use such a price extension as an opportunity to liquidate their positions for a quick profit. Thus, its in the interest of the locals to try to trigger heavy concentrations of stop orders. In cases where there are valid fundamental reasons for the continuation of a price move beyond the previous high (or low), the move will tend to extend. However, if the move to a new high (or low) was largely caused by local trading activity, once the stop orders are filled, prices will tend to reverse, falling back below the prior high (or rebounding above the prior low). In effect, the triggering of the stops represents the markets last gasp. The process I have just described applies to an open outcry type of market, such as futures. However, a similar process also operates in specialist-type markets, such as the stock exchange. The specialist trades one stock or several stocks. Its the specialists job to make a market in these stocks. For providing this service, the specialist is paid a flat fee per hundred shares traded. Obviously, its in his interest to have prices move to the levels that will result in the execution of the largest amount of orders. These points will normally be prices just above the prior high or just below the prior low. Also, keep in mind that the specialist has the advantage of knowing ahead of time the location of all the orders for his stock. In addition, the locals on the stock exchange floor will have a similar type of interest in triggering stops as do the locals on, say, the futures market exchanges. The primary point Im trying to make is that key chart patterns are often based on the activity of the professionals on the floors. ==== Do you use any technical indicators? ==== I use them as a secondary type of input. In the stock market, the one indicator I give the greatest weight is the two-hundred-day moving average. I wouldnt recommend this indicator as a sole input for making trading decisions, but it does add a bit of usefiil information to sup plement other methods and forms of analysis. In fact, one study I saw demonstrated that by simply using the two-hundred-day moving average on the Dow Jones stocks, an investor could have earned an average annual return of 18 percent over the fifty-year survey period-approximately double the return that would have been realized by a straight buy-and-hold method. ==== I know that youre a self-taught student in economics, having read scores or possibly even hundreds of books on the subject. Has this study been a purely intellectual endeavor, or does it yield some practical benefits in terms of trading? ==== There have been a number of incidents in which I believe my knowledge of economics and economic history helped me profit from the markets. A classic example occurred when Francois Mitterrand, a selfproclaimed socialist, won a surprise victory in the 1981 French presidential election. In his campaign, Mitterrand had promised to nationalize segments of industry and to introduce massive social welfare programs. I understood that the economic implications of Mitterrands programs would spell disaster for the French franc. I immediately sold the franc, which was then trading at approximately a four-to-one exchange rate to the dollar. I covered that position a mere three weeks later when the franc was trading at six to one to the dollar. In my view, that trade was about as close as you can get to a sure thing. Incidentally, the franc eventually sank to a ten-to-one rate against the dollar. ==== Probably your best-publicized market call was a prediction for a major top in the stock market, which you made in Barron`s in September 1987-one month before the crash. What made you so confident about an impending collapse in stock prices? ==== At me August 1987 high, the stock market had gained nearly 23 percent in ninety-six days. These figures were almost exactly in line with the historical medians for the magnitude and duration of intermediate bull market moves. This consideration was only a cautionary note. If all the other factors were positive, then fine. However, to recall an analogy I used earlier, this market was no Jack LaLanne. In August, the Dow Jones Industrial index made a new high, but the advance/decline ratio did not-a bearish divergence. The price/earnings ratio at the time was at its highest level in twentyfive years. Government, corporate, and consumer debt were at record levels. Virtually any indicator you looked at was screaming caution against the possibility of an impending collapse. ==== Were you short going into the October 19 crash? If so, what considerations did you use to actually time your entry into the market? ==== The first major timing signal came on October 5, when I read Fed Chairman Greenspans comment in the Wall Street Journal, in which he was quoted as saying that interest rates could become dangerously high if inflation fears were to mushroom in the financial markets. Although Greenspan indicated that he felt such concerns were unwarranted, he also hinted that the discount rate might have to be raised to alleviate such worries. On October 15, Dow Theory gave a sell signal, and I initiated my short position. The straw that broke the camels back was Secretary of State James Bakers dispute with Germany, in which he urged Germany to stimulate its economy. When Germany refused to cooperate, Baker made a weekend announcement that the United States was prepared to let the dollar slide. In my opinion, theres no doubt that this statement was the trigger for the October 19 stock market collapse. An unknown devaluation of a currency is not something that any foreign investor wants to live with. What does slide mean? Five percent? Ten percent? Twenty percent? How much are you going to let it slide? Investors who hold dollar-denominated securities are going to sell until they know what slide means. At that point, I was absolutely convinced that the stock market was going to collapse because of this unknown dollar devaluation. On Monday morning, I immediately added to my short position, even though the Dow Jones index opened over 200 points lower. ==== I know that you also caught the October 1989 minicrash. Was the analysis process similar to that in October 1987? ==== Very much so. In October 1989, the market had been up for 200 days without an intermediate downtrend [by Sperandeos definition, a decline of fifteen days or longer], versus a historical median of 107 days. Moreover, the market was up over 24 percent, and my historical studies had shown that seven out of eight times when the market was up by that amount, a correction eventually occurred that carried prices back below that point. In other words, the odds for the market continuing to move higher were very low. Consequently, I was out of longs and very attuned to signs that the market was ready to die. Statistically, this market was like an eighty-seven-year-old. ==== Any final words? ==== Being involved in this business requires tremendous dedication and desire. However, you shouldnt make trading your whole life. You have to take time off. You need to spend time with loved ones. You need to balance your life. When I did my exhaustive study on historical stock trends, my daughter, Jennifer, was in her preschool years. Thats a critical age for the child in terms of development and a wonderful age for parents to enjoy their children. Unfortunately, I was so involved with my project that when I came home from work, I would eat and immediately head for my study. When my daughter wandered into my office, I had no time to share with her. It was a mistake that I regret to this day. Some traders make this business their entire life and, as a result, they may make more money, but at the expense of living a more rounded, balanced, and satisfying life. One way or another, it all comes down to odds. Unless you can find some way to get the odds in your favor, trading, like any other 50/50 game with a cost to play (commissions and execution slippage in this case), will eventually be a losing proposition. Sperandeo has taken the definition of odds to an actuarial-like extreme. Just as insurance companies guarantee that the odds are in their favor by classifying policyholders according to risk, Sperandeo categorizes the stock market by risk. When it comes to the stock market, he can tell the difference between a twenty-year-old and an eighty-year-old. Another somewhat related element behind Sperandeos success is that he varies his bet size considerably. When he implements a position in a market that he perceives to be in the beginning stages of a new trend and various indicators confirm the trade, he will tend to trade much larger than in situations where these conditions are lacking. In this way, Sperandeo places his largest bet when he estimates that the odds are most favorable. (Incidentally, this strategy is essentially the key to success in games such as blackjack; see the Hull interview.) Sperandeo emphasizes, however, that when trading large, it is essential that the market go immediately in your favor; otherwise, the position should be pared down quickly. This measure is essential to ensure financial survival when you are wrong in a situation that you thought was highly favorable. While his view is hardly universal, Sperandeo downplays the significance of intelligence to trading success. Based on his experience in training thirty-eight traders, Sperandeo concluded that intelligence was virtually irrelevant in predicting success. A far more important trait to winning as a trader, he says, is the ability to admit mistakes. He points out that people who tie their self-esteem to being right in the markets will find it very difficult to take losses when the market action indicates that they are wrong. One sacred cow that Sperandeo believes is really a bum steer is the standard advice to use a buy-andnold strategy in the stock market. Sperandeo provides some examples of very extended periods in which such a strategy would have been disastrous. |
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