Hedge Fund Market Wizards

Author

Jack D. Schwager

Genre

Investing

Last Read

August 14, 2019

Cover

Stars

★★★★★

“Fascinating insights into the hedge fund traders who consistently outperform the markets, in their own words From bestselling author, investment expert, and Wall Street theoretician Jack Schwager comes a behind-the-scenes look at the world of hedge funds, from fifteen traders who've consistently beaten the markets.”

I read this book pre-Kindle, so do not have Kindle highlight notes, but I have added the ‘40 Market Wizard Lessons’ below, which is a good summary.

Highlights

1. There Is No Holy Grail in Trading: Many traders mistakenly believe that there is some single solution to defining market behavior. Not only is there no single solution to the markets, but those solutions that do exist are continually changing. The range of the methods used by the traders interviewed in this book, some of which are even polar opposites, is a testament to the diversity of possible approaches.
2. Find a Trading Method That Fits Your Personality: Traders must find a methodology that fits their own beliefs and talents. A sound methodology that is successful for one trader can be a poor fit and a losing strategy for another trader.
1. O’Shea - “If I try to teach you what I do, you will fail because you are not me. If you hang around me, you will observe what I do, and you may pick up some good habits. But there are a lot of things you will want to do differently. A good friend of mine, who sat next to me for several years, is now managing lots of money at another hedge fund and doing very well. But he is not the same as me. What he learned was not to become me. He became something else. He became him.”
3. Trade Within Your Comfort Zone: If a position is too large, the trader will be prone to exit good trades on inconsequential corrections because fear will dominate the decision process. As Clark advises, you have to “trade within your emotional capacity.” Similarly, Vidich warns, “Limit your size in any position so that fear does not become the prevailing instinct guiding your judgment.”
4. Flexibility Is an Essential Quality for Trading Success: Highly skilled traders will not only liquidate their positions if they believe they made a mistake, but will actually reverse those positions. Mai’s best trade of 2011 came from shorting dry bulk shippers, a trade idea that, ironically, originated with the premise that these companies represented a buying opportunity. However, when in doing his research Mai realized that he was not only wrong, but that he had it exactly backward, he reversed his original trading plan. Clark emphasizes that good traders can change their minds in an instant.
5. The Need to Adapt: It would be nice to believe that if you can find a trading methodology that works and also have the discipline to apply it consistently, then trading success is assured. Unfortunately, the real world is a bit more difficult. Platt, whose firm BlueCrest trades both discretionary and systematic strategies, believes that systematic approaches must continually be revised or else they will degrade. He describes the process as “a research war.”
6. Don’t Confuse the Concepts of Winning and Losing Trades with Good and Bad Trades: A good trade can lose money, and a bad trade can make money. Even the best trading processes will lose a certain percentage of the time. There is no way of knowing a priori which individual trade will make money. As long as a trade adhered to a process with a positive edge, it is a good trade, regardless of whether it wins or loses, because if similar trades are repeated multiple times, they will come out ahead.
7. Do More of What Works and Less of What Doesn’t: This core advice offered by Clark may sound obvious, but the reality is that many traders violate this principle. It is quite common for a trader to be good at one type of trade, but to degrade performance by also engaging in trades without any clear edge, whether due to boredom or other reasons.
8. If You Are Out of Sync with the Markets, Trying Harder Won’t Help: When trading is going badly, trying harder is often likely to make matters even worse. If you are in a losing streak, the best action may be to step away from the markets.
9. The Road to Success Is Paved with Mistakes: Dalio strongly believes that learning from mistakes is essential to improvement and ultimate success. Each mistake, if recognized and acted on, provides an opportunity for improving a trading approach. Most traders would benefit by writing down each mistake, the implied lesson, and the intended change in the trading process.
10. Wait for High-Conviction Trades
11. Trade Because of Perceived Opportunity, Not Out of the Desire to Make Money: Toward the end of 2010, out of a desire to reach his minimum profit target for the year, Benedict took marginal trades he otherwise would not have taken. These trades resulted in net losses and, as a consequence, Benedict ended up even further from his intended target.
12. The Importance of Doing Nothing: For some traders, the discipline and patience to do nothing when the environment is unfavorable or opportunities are lacking is a crucial element in their success.
13. How a Trade Is Implemented Can Be More Important Than the Trade Itself: The trade was highly successful, not because the underlying premise was correct, which it was, but rather because of the way the trade was implemented. If O’Shea had gone short the stock index instead, he would have been correct on his call, but most likely would have lost money by being stopped out during the steep bear market rally in equities.
1. i.e. how you express the view matters more than the view
14. Trading Around a Position Can Be Beneficial: Most traders tend to view trades as a two-step process: a decision when to enter and a decision when to exit. It may be better to view trading as a dynamic rather than static process between entry and exit points.
15. Position Size Can Be More Important Than the Entry Price: Too many traders focus only on the entry price and pay insufficient attention to the size of the position. Trading too large can result in good trades being liquidated at a loss because of fear. On the other hand, trading larger than normal when the profit potential appears to be much greater than the risk is one of the key ways in which many of the Market Wizards achieve superior returns.
16. Determining the Trade Size: What is the optimal trade size? There is a mathematically precise answer: The Kelly criterion (described in Chapter 6) will provide a higher cumulative return over the long run than any other strategy for determining trade size. The problem, however, is that the Kelly criterion assumes that the probability of winning and the ratio of the amount won to the amount lost per wager are precisely known. Although this assumption is valid for games of chance, in trading, the probability of winning is unknown and, at best, can only be estimated. If win/loss probabilities can be reasonably estimated, then the Kelly criterion can provide a starting point for determining trade size.
17. Vary Market Exposure Based on Opportunities: Exposure levels and even the direction of exposure should vary based on opportunities and perceived relative value. For example, depending on whether stock prices appear to be cheaply or expensively priced, Claugus will vary his net exposure range from 110 percent long to 70 percent short.
18. Seek an Asymmetric Return/Risk Profile: Mai structures his trades to be right skewed—that is, the maximum loss is limited, but the upside is open-ended. One common way of achieving this type of return/risk profile is by being a selective buyer of options—buying options when there is a perceived greater-than-normal probability of a large price move.
1. Platt achieves right-skewed asymmetry at the portfolio level through the risk control process, which strictly limits each trader’s maximum loss from the starting allocation each year, but does not raise the risk cutoff level if the trader generates profits during the year. In this way, the portfolio maximum loss is tightly curtailed, but the upside potential is open ended.
19. Beware of Trades Borne of Euphoria: Caution against placing impulsive trades influenced by being caught up in market hysteria. Excessive euphoria in the market should be seen as a cautionary flag of a potential impending reversal.
20. If You Are on the Right Side of Euphoria or Panic, Lighten Up: Parabolic price moves in either direction tend to end abruptly and sharply. If you are fortunate enough to be on the right side of a market in which the price move turns near vertical, consider scaling out of the position while the trend is still moving in your direction.
21. Staring at the Screen All Day Can Be Expensive: Clark believes that watching every tick can lead to both overtrading and an increased chance of liquidating good positions.
22. Just Because You’ve Heard It 100 Times Doesn’t Make It Less Important: Risk Control Is Critical
1. Risk limits on individual trades
2. Exposure reduction thresholds
3. Position size adjustments for changes in volatility
4. Trade-dependent risk controls
23. Don’t Try to Be 100 Percent Right: Vidich advises that instead of making an all-or-nothing decision, traders should liquidate part of the position. Taking a partial loss is much easier than liquidating the entire position and will avoid the possibility of riding the entire position for a large loss.
24. Protective Stops Need to Be Consistent with the Trade Analysis: O’Shea explains that too many traders set stops based on their pain threshold rather than as points that disprove their trade premise. Because traders can’t stand the pain of a larger loss, they tend to set stops too close—that is, at a point at which they would still believe in the trade.
25. Constraining Monthly Losses Is Only a Good Idea if It Is Consistent with the Trading Strategy: Greenblatt asserts that value investors must maintain a longer-term perspective and not be swayed by interim losses, providing the fundamentals haven’t changed. For longer-term investors, such as Taylor and Greenblatt, monthly loss constraints would be in conflict with their strategy.
26. The Power of Diversification: Dalio calls diversification the “Holy Grail of investing.” He points out that if assets are truly uncorrelated, diversification could improve return/risk by as much as a factor of 5:1.
27. Correlation Can Be Misleading: Although being cognizant of correlation between different markets is crucial to avoiding excessive risk, it is important to understand that correlation measures past price relationships. It is only relevant if there is reason to believe that the past correlation is a reasonable proxy for future correlation. Some market correlations are stable, but others can vary widely and even change sign.
28. The Price Action in Related Markets Can Sometimes Provide Important Trading Clues: Although the price action in other markets can be important, there are no set rules in how such price action should be interpreted. Sometimes, one market may tend to lead another. In other situations, two markets may move in tandem, but then begin to move independently, a price behavior change that may provide price directional clues.
29. Markets Behave Differently in Different Environments: Any analysis of fundamental factors that assumes a static relationship between economic variables and market prices will be doomed to failure because markets behave differently in different environments. As Dalio points out, the same fundamental conditions and government actions will have different price consequences in a deleveraging environment than in a recession.
30. Pay Attention to How the Market Responds to News: A counter-to-anticipated response to market news may be more meaningful than the news item itself. Platt recalls a trade in which there was a continuing stream of adverse news. He repeatedly expected to lose money after each news item, and yet the market did not move against him. Platt read the inability of the market to respond to the news as confirmation of his trade idea, and he quadrupled his position, turning it into one of his biggest winners ever.
31. Major Fundamental Events May Often Be Followed by Counterintuitive Price Movements
32. Situations Characterized by the Potential for a Widely Divergent Binary Outcome Can Often Provide Excellent Buying Opportunities in Options: Option prices are primarily determined by models that assume that large price movements are unlikely. In circumstances when the fundamentals suggest a significant potential for either a large price gain or a large price loss, option prices often fail to reflect the abnormally large probability of such outsized price movements. Examples of this principle include Greenblatt’s option trade in Wells Fargo and Mai’s option trade in Capital One.
33. A Stock Can Be Well-Priced Even if It Has Already Gone Up a Lot: Many traders miss participating in the best opportunities because they can’t bring themselves to buy a stock or market that has already seen a large upmove. What matters, however, is not how much a stock has gone up, but rather how well a stock is priced relative to its future prospects.
34. Don’t Make Trading Decisions Based on Where You Bought (or Sold) a Stock: The market doesn’t care where you entered your position. When Vidich felt that a stock that had just fallen all the way back to where he had bought it was going lower, he just got out, not letting his entry level affect the trading decision.
35. Potential New Revenue Sources That Are More Than a Year Out May Not Be Reflected in the Current Stock Price: Claugus likes to look for situations where a company will recognize new revenue sources one or more years out because such future potential earnings are frequently not adequately discounted, or discounted at all, by the current stock price.
36. Value Investing Works: Greenblatt has demonstrated that value investing works both through a long career as a highly successful trader using value principles and through rigorous computer-based research. The catch is that although value investing works over the long term, there are times when it works poorly. However, as Greenblatt points out, this periodic underperformance is actually the reason why value investing is able to maintain its edge. If it worked all the time, it would attract enough followers so the edge would disappear.
37. The Efficient Market Hypothesis Provides an Inaccurate Model of How the Market Really Works: Prices are not always near fair value. Sometimes, prices will be much too high based on the prevailing information, and sometimes they will be much too low. Greenblatt quotes the metaphor originally used by Benjamin Graham, in which he compares the market to a highly erratic business partner who is sometimes willing to sell shares to you at absurdly low prices and sometimes willing to buy shares from you at ridiculously high prices.
38. It Is Usually a Mistake for a Manager to Alter Investment Decisions or the Investment Process to Better Fit Investor Demands
39. Volatility and Risk Are Not Synonymous: Low volatility does not imply low risk and high volatility does not imply high risk. Investments subject to sporadic large risks may exhibit low volatility if a risk event is not present in the existing track record. For example, the strategy of selling out-of-the-money options can exhibit low volatility if there are no large, abrupt price moves, but is at risk of asymptotically increasing losses in the event of a sudden, steep selloff.
40. It Is a Mistake to Select Managers Based Solely on Past Performance