Trader’s Narrative

I’m going to tell you exactly how you can become a successful trader. But a word of caution. You are probably not going to like the answer. I’m not going to sell you a course or a ’system’ or anything like that. So if that disappoints you, simply skip this and go read something else.

For the few who will actually read on, here is the definitive guide to trading mastery & success:

Most people approach this subject by looking for certain types of skills, qualities or personalities that would allow someone to excel at trading. We know that analytical, as well as, critical thinking skills are important, so is a competitive streak and a friendly relationship with numbers and probabilities helps of course. Many successful traders also excel at games which involve patterns and probabilities like poker and chess. But obviously, not everyone who has these characteristics or all who are great poker players, for example, are in turn successful traders.

So what is really the key to performance?

Although I knew the answer intuitively, it wasn’t until I read Malcolm Gladwell’s book, Outliers: The Story of Success that it was spelled out for me. By the way, I highly recommend you add this to your reading list because it will explain many seemingly disparate questions: the North, South cultural divide in the US, why Asians are much better at math, why the school year doesn’t last 12 months, etc. Anyway, getting back on point, most relevant to us, in Outliers, Gladwell explores the 10,000 hour principle: to achieve world class success in any field requires an investment of at least 10,000 hours of your time.

Of course, Gladwell didn’t invent this, as a gifted writer he brings to life the dry, academic insights gleaned by others. In essence, the 10,000 hour principle is a confirmation of the maxim made famous by Edison: genius is 1% inspiration, 99% perspiration. If you’re interested in the research, you should check out The Cambridge Handbook of Expertise and Expert Performance edited by Dr. K. Anders Ericsson, from Florida State University.

Think of a person who is considered a ‘genius’ in their field. Let’s take Mozart or Picasso. If you explore each of their lives, you soon realize that talent and practice become so enmeshed that it is impossible to separate the two. Both masters were engaged in their art at a very young age and practiced feverishly. By the time they were young adults they had done more work in their field than the average composer or artist does in a lifetime. When they hit their stride as adults, they were just warming up! They then went on to heights of accomplishment which dazzle us to this day.

Tick, Tock…
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So putting it plainly, to become a successful trader, you need to invest at least 10,000 hours of your time doing just that… trading. Of course, that means that you’ll also have to think about trading to come up with ideas, read about the current market, learn about market history to put the present in context, learn different ways of analyzing the market like technical analysis, tape reading, sentiment, etc. There’s a lot there but you need to put in those hours before you can expect success.

It might help to think about this in another way. Do you expect a thoracic surgeon to saunter through one seminar on biology then flip through Gray’s Anatomy casually and then pick up a scalpel and save people’s lives? would you want yourself or your loved ones to be his patient?

So do you then see the fallacy in assuming that simply by taking one trading course and reading a few books on trading you will make money from trading next month?

What does 10,000 hours look like?

There are 250 trading days in a year and 7.5 hours in a regular trading day, so in a year there are 1,875 potential trading hours. But you also have to consider that it isn’t possible to stay glued to the screen for the whole day (nor advisable!) and that beyond the market hours, you need to do homework both before and after.

But assuming that you put in 8 hours, either trading or thinking and analyzing… then in a year you’ve got 2,000 hours. Which means that in 5 years you’ll have 10,000 hours.

What if you were really dedicated and put in 10 hours a day? and your Saturdays? then it would only take you 3 years to get to 10,000 hours.

And here’s the problem. Most people don’t want to do this. It is hard. It is frustrating. It is grueling. The average person doesn’t want to work hard, they don’t want to put in the hours, so not surprisingly, the results they get are also average (or below average). Extraordinary achievement requires extraordinary effort, fueled by passion and a smattering of innate talent.

In Jack Schwager’s must read “Market Wizard” series of books, he profiles extraordinary traders. Read their stories and you’ll soon find the thread that runs through all of them. These are traders that work hard. They think about the market, they are so creative that they actually come up with novel indicators that often bear their names. These are not your average traders because their dedication to the craft is anything but average.

Even if they start out putting in some hours, most people give up. They quit well before the 10,000 hours have accumulated. That’s why you need passion. For without it, can you imagine doing anything for 10,000 hours?

Let’s face it, if you don’t like something, you have trouble getting yourself motivated for 30 minutes. You procrastinate, negotiate and come up with all sorts of tricks to not do it. So obviously the prerequisite is that you have a passion for trading. Going through 10,000 hours is the best way to discover if you do. If you do, those 10,000 hours will fly by but if you hate it, they’ll seem like a century.

There are other variables: luck and talent. By luck I mean, when you have finished putting in your hours, are you trading in an easy environment where the wind is at your back? or in a devastating market condition that grinds even hardened professionals to a nub?

Imagine if you started trading in the early 1990’s just as ECNs and more open market regulations allowed for all sorts of easy arbitrage, or if you entered trading during the bull market in the mid 1990’s. You might think that this would be a disadvantage since it would make trading appear too easy but that is only true for those that approach it with that mindset. To you, who put in 10,000 hours, that is not the case, in fact, just as you hit your stride and flex your new found skills, there is an amazingly lucrative market condition ready for you.

And by talent I mean an innate skill. What people call those who are a ‘natural’. Although they do exist, the only way it can be leveraged to leapfrog the rest is through consistent practice. Even if you have a ‘gift’, unless you develop it, others who simply put in more effort will over take you, eventually.

Let’s take an example so I can illustrate what I mean exactly. The name Steve A. Cohen should be familiar to you. If not, he is probably one of the most successful traders in modern times. There is very little known about him or his eponymous firm, SAC Capital Advisors, except that it is a force to be reckoned with. SAC regularly trades ~3% of the NYSE volume and since inception in 1992, has returned 40% to investors. This is even more astounding when you consider that SAC now manages billions of dollars in assets and that its performance fee is 50% with a 3% fixed management fee (as opposed to the standard 2/20 structure in the industry).

So how did Cohen get so good? Was he just a natural? is he a trading genius? To try to answer that, let’s rewind to 1956 when he was born in Great Neck, NY and then go forward a few years to find him as a young boy at the dinner table.

Cohen’s father, who worked in the garment industry was passionate about sports and he shared this with his son, poring over the scores and highlights after dinner. You could say that Steve’s love for the stock market was stoked by his father’s love for sports and especially sports scores. Steve was fascinated to discovered that there was another section in the paper with similar rows of numbers that changed daily and that they represented prices. Soon these new set of numbers became much more fascinating to him than sports score. By the time he was 13 he would regularly drop by the local brokerage office and watch the tape. In the few interviews he has given, he has mentioned again and again that what he does today has its roots in the simple act of watching the tape scroll by when he was a teenager.

Later Cohen attended Wharton, graduating with a degree in economics. While there, he was so taken with stocks that he traded between classes. Also, like many other master traders, Cohen was a great poker player. The story of Cohen’s first day at his first ‘real job’ is well known as it has been told and retold so many times it has gained a folkloric status: when Cohen was 22 he was hired by Gruntal & Co. and on his first day he made $8,000. Soon he was clearing $100,000 a day for the firm and in 1984 was given his own trading group, which he ran until he started his own firm.

Now, when most people hear the story of Cohen’s first day, their eyebrows shoot up and they attribute it to pure talent. But when you consider that Cohen was watching the tape since he was 13 and that he was trading throughout his teenage years and college, then it isn’t that surprising, is it? This by no means discounts his accomplishment but rather it puts it in the proper context.

By the time he started trading on Wall St. with Gruntal, he had approximately 9 years of experience (from 13 to 22). He quickly ramped up the hours - you can just imagine how many he racked up as a professional trader running his own group! - and within a few years had double or triple the requisite 10,000 hours.

When he started SAC Capital with $25 million in 1992, Cohen was 36 - which means that he had been trading almost continuously for 13 years. And a large proportion of those years was spent in such an intense and concerted effort, day in and day out, that it bordered on a fanatical zeal to perfect his craft. Is it surprising then, that he is one of the best?

As you’d expect, Cohen is not motivated by money but trades because it is what he loves. If he were motivated by wealth, he would have been able to stop and enjoy a life of leisure a long, long time ago.

What is Your Plan?
Because of the obvious realities of life for most, it is much easier to go through your 10,000 hours when you are young. You don’t have other responsibilities which can get in the way, you have lots of mental and physical energy and stamina, you are able to concentrate and learn very fast, and you have an open and inquisitive mind that hasn’t been polluted by dogmas.

But other than those advantages, there is nothing really that can stop you, no matter how old you are, from becoming a master trader… if you have the passion for it. Because that is what will motivate you to put in the requisite 10,000+ hours of apprenticeship. Add to that a favorable market environment and maybe a little talent, and a pinch of luck and who knows? Maybe the next generation will be reading about your accomplishments in the next series of Market Wizard books.

If you enjoyed this, then you might also enjoy:

• Two Most Powerful Principles of Personal Development
• How to Fail As a Trader in 10 Easy Steps
• Psychology of Risk

Coming at the heels of such massive financial frauds as Madoff and Stanford, (as well as previous hedge fund collapses like Bayou) “Hedge Fund Operational Due Diligence” is well timed.

The recent batch of fraud dwarfs the largest trading losses in history, combined, and makes it crystal clear why all investors should take due diligence extremely seriously. The author, Jason Scharfman, previously at Graystone Research (a division of Morgan Stanley), is now at Corgentum, a full service hedge fund operational risk consultancy practice.

What is operational due diligence? Usually when we think of the risks involved with a hedge fund, the first we think of are related to the market. That is, how much an investment in them can depreciate as a result of trading losses. And although this is very important, there are two more areas of risk: credit and operational.

Credit is the risk associated with a counter-party being unable to meet their obligations (cough AIG cough). Operational due diligence encompasses a broad array of risks, including more ‘human’ frailties, such as internal controls, internal/external fraud, as well as business disruptions due to external or internal factors.

This is the risk that almost every single Madoff investor ignored - that says a lot because these were, by definition “sophisticated” but they ignored all the operational red flags and handed over millions of dollars.

Scharfman’s book explains not only how to diagnose and analyze the operational risks that may be present in a hedge fund, but how to continue to monitor them. This book is invaluable if you are running or thinking of starting a hedge fund, want to invest in one (or already have) or if you work in the field of asset management.

Because it is a thorough and exhaustive exposition, going through just about everything like a manual, it makes for an excellent reference resource. While the topic can be rather dry, Scharfman brings it to life by using nuanced hypothetical scenarios which read like stories (Chapter 5).

For example, would you or should you allocate money to a hedge fund if the head trader or manager has a criminal record? How would you treat this if the manager was pro-active in mentioning it? and not? what if it was not related to financial fraud?

If you’re impatient, you can skip to Chapter Six, which has the “Ten Tips for Performing an Operational Due Diligence”:

1. Avoid meeting with the wrong people or the wrong group
2. Get out of the conference room
3. Little white lies can turn into big problems
4. Be wary of phantomware
5. Focus on documentation and negotiation
6. Read the fine print (financial statement notes, etc.)
7. Reference checking: importance of in-sample and out-of-sample references
8. Credit analysis: are funds financially viable?
9. Long-term planning: Key staff retention, succession planning, and more
10. Growth Planning: is the manager proactive or reactive?

There has always been a struggle between hedge fund managers and investors. One side wants to disclose as little as possible, to protect proprietary strategies. And the other wants as much disclosure as possible to protect their assets. There has been an uneasy relationship between the two parties because of this. The trend is now shifting to more transparency not only because of the large fraud cases that have come to light but also because of a diminishing source of funds. Investors have a stronger position to make more demands for disclosure. And with Scharfman’s book, even the smaller investors have a blueprint to follow.

There’s a lot more in the book, of course, but that should give you enough to whet your appetite. You can purchase it at Amazon, or your favorite book seller (it is published by Wiley, a specialist in finance books).

Or be one of my lucky readers to win a free copy of Hedge Fund Operational Due Diligence. To enter for the chance to receive a copy of Jason Scharman’s book for free, just drop me a comment below. Make sure you write your email correctly (so I can contact you when you win the random draw!).

Way back in May 2008 I wondered: Will Sprott IPO Mark Top Of Commodity Bull Market?

Yes. Yes, it did.

For those unfamiliar with them, Sprott is a boutique asset manager in Canada. The IPO of Sprott was an accurate tell for the commodity market top because of the firms expertise in and their cheerleading of the commodities markets.

You had to ask yourself this simple question: If they believed that the bull market in commodities would continue, why would they sell such a highly leveraged asset as their equity?

The dashed line is the CRB Index, the most popular measure of the commodities markets and the solid line is the price of Sprott (SII) on the Toronto Stock Exchange. It closed the first day at around $10 a share but fell immediately. It approached that high again to put in a double top and started to fall in lock step with the CRB index. In mid-November 2008 it traded below $2.50 - less than a 25% of the IPO initial price.

Another case of watching what others are doing and not necessarily saying. In general, you want to always be wary of whatever Wall St. sells. They aren’t doing it out of the kindness of their hearts or to be charitable.

This market ‘tell’ was one of the reasons why I was bearish on commodities and for the most part it was the right posture. The only exception lately of course has been the gold market which has surprisingly revived to once again gain the $1000/oz. level. I’ll come back to the gold market another time since it deserves more attention.

Here’s this past week’s sentiment overview:

AAII Sentiment
The weekly AAII sentiment survey showed that 33% of respondents are bulls, up 8% points from last week. And 39% are bears, down 5% points from last week. Nothing really exciting here.

But something else that the American Association of Individual Investors monitors is how their members allocate assets within their portfolio: stocks, bonds, and cash. As you would expect, right now the average investor is shell-shocked and feeling risk averse. After dipping below the 2002 bear market low, their allocation to stocks has recovered slightly to appx. 45%.

Instead of seeking the shelter of cash, the average investor as measured by AAII, is plowing the money they took out of equities into bonds. So much so that right now they are allocating the most they have been since 1994. So consider this extreme bullishness in bond sentiment to be yet another rationale for a bubble in bonds.

Investors Intelligence
From the other sentiment survey, the newsletter editors continue to be an ambivalent lot for the most part. This week’s sentiment survey conducted by ChartCraft had 32.3% bulls and 38.7% bears. The bears are reasserting themselves but it is still too close for anything resembling a signal for contrarians.

OEX Put Call Ratio
Both of the options sentiment ratios that I usually monitor (CBOE put call ratio and the ISE sentiment index) are not telling us much right now. Fortunately, the OEX put call ratio is different. Although it is not as well known as the other two, I mentioned it before back on October 23rd, 2008: What’s up with this crazy options market?

Right now, this option sentiment ratio is even lower than it was then. In fact, right now the OEX put call ratio (10 day moving average) is lower than it has been for the past 20+ years. If you really wanted to find a lower reading, it would have to be Black Monday 1987.

Since the OEX options market is considerably smaller and it is generally believed that it is the playground of the ’smart money’, it is not interpreted as a contrarian signal when we have a preponderance of call buying, as we do now.

Hulbert Newsletter Sentiment
According to Mark Hulbert, the Hulbert Newsletter Sentiment Index (HSNSI) reacted quite unexpectedly to the Geithner press conference. Even though the market fell, HSNSI rose from -7.2% last week to +2%!

Mutual Fund Cash Positions
The more cash mutual funds hold in their portfolios, the more pessimistic the asset managers are. And more importantly, the more ammunition there is to continue the next bull market (when it starts).

From 2001 to mid 2007, mutual fund cash holdings continued to decrease - reaching an all time low at around 3.5%. As a result of the current bear market, the cash reserves have been increasing and are now around 5.2%.

But as Jason Goepfert brought to light, comparing the amount of cash over time isn’t very useful because at different times there are differing monetary conditions (interest rates, inflation, etc.). So he came up with a way to strip away these variables to allow for a historic comparison to be made. You can find his paper on this in the Free Trading Resource section (Charles H. Dow Awards folder).

Right now this standardized measure is showing that current mutual fund cash reserves are at higher comparable levels than the last bear market. But not as high as the early 1990’s.

Magazine Cover Indicator
Thanks to a reader from Germany for pointing out an interesting magazine cover indicator across the pond. Focus Money’s current cover (on the left) shows a very dark map of the world with the word “VORSICHT” in red - meaning: Caution! or Danger!. And below it, ‘Weltwirtschaftskrise’, literally meaning ‘world economic crisis’ but mostly used to refer to the Great Depression of the 1930’s.

The previous weeks’ covers weren’t much more cheerful either. They promoted ’safe’ investments like gold, bonds, convertibles, fixed income funds, etc. Since Focus Money is usually a very cheerful and optimistic publication that pushes stocks, this is a rare occurrence. And it is even more significant when you consider that the last time Focus Money had such somber covers guiding readers away from risk was back in February of 2003.

Hedge Fund Exposure
According to data from Carpenter Analytics, hedge fund exposure is slightly net short, as it has been from early 2008. This correct net posture is not surprising when you consider the depth of resources and talent at their disposal. However, the current net short exposure is very small compared to what we saw in the same measure in the last bear market. On the plus side, hedge funds are now much less short than they were during the waterfall declines of 2008.

Congratulations to Norman, the winner of my latest trading book giveaway!

Thank you to all who entered. I wish I could give each of you a prize as well. Since I can’t do that, with the permission of the publisher, I’m going to do an extra bonus draw for a second winner as well.

That way, two of my readers can enjoy Hedge Fund Trading Secrets Revealed” by Robert Dorfman.

One of the reasons that I enjoy writing this blog is the ability to be able to help others out there who are interested to learn more about trading and investing. These book reviews and giveaways are a great way to do that so look forward to more of them.

Keep watching because I already have two other books on deck and once I am finished reading and putting up a review for them, I’ll be doing a draw for them as well.

To keep the karma leveling up, all of the winners of the book giveaways will write their own reviews once they are done so you can get their perspectives as well.

If you have any suggestions for a book that you’d like to nominate as a candidate, by all means, drop me a comment below. I try to keep up to date on high quality books but with the amount that keeps getting written every year, it is difficult to not miss a few gems.