Market Wizards: Interviews with Top Traders

Jack D. Schwager

• Publisher: Wiley
• Year: 2016
• Print ISBN: 9781592802975
• eBook ISBN: 9781118538715
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

THE INVESTMENT CLASSIC

"I've read Market Wizards at several stages of my career as it shows the staying power of good down-to-earth wisdoms of true practitioners with skin in the game. This is the central document showing the heuristics that real-life traders use to manage their affairs, how people who do rather than talk have done things. Twenty years from now, it will still be fresh. There is no other like it."
—NASSIM N. TALEB, former derivatives trader, author of The Black Swan, and professor, NYU-Poly

" Market Wizards is one of the most fascinating books ever written about Wall Street. A few of the 'Wizards' are my friends—and Jack Schwager has nailed their modus operandi on the head."
—MARTIN W. ZWEIG, PhD, Editor, The Zweig Forecast

"It is difficult enough to develop a method that works. It then takes experience to believe what your method is telling you. But the toughest task of all is turning analysis into money. If you don't believe it, try it. These guys have it all: a method, the conviction, and the discipline to act decisively time after time, regardless of distractions and pressures. They are heroes of Wall Street, and Jack Schwager's book brings their characters vividly to life."
—ROBERT R. PRECHTER, JR., Editor, The Elliott Wave Theorist

Part I

Futures and Currencies

Taking the Mystery Out of Futures

Of all the markets discussed in this book, the futures market is probably the one least understood by most investors. It is also one of the fastest growing. Trading volume in futures has expanded more than twentyfold during the past twenty years. In 1988, the dollar value of all futures contracts traded in the U.S. exceeded $10 trillion!* Obviously, there is a lot more than pork belly trading involved here.

Today’s futures markets encompass all of the world’s major market groups: interest rates (e.g., T-bonds), stock indexes (e.g., the S&P 500), currencies (e.g., Japanese yen), precious metals (e.g., gold), energy (e.g., crude oil), and agricultural commodities (e.g., corn). Although the futures markets had their origins in agricultural commodities, this sector now accounts for only about one-fifth of total futures trading. During the past decade, the introduction and spectacular growth of many new contracts has resulted in the financial-type markets (currencies, interest rate instruments, and stock indexes) accounting for approximately 60 percent of all futures trading. (Energy and metal markets account for nearly half of the remaining 40 percent.) Thus, while the term commodities is often used to refer to the futures markets, it has increasingly become a misnomer. Many of the most actively traded futures markets, such as those in the financial instruments, are not truly commodities, while many commodity markets have no corresponding futures markets.

The essence of a futures market is in its name: Trading involves a standardized contract for a commodity, such as gold, or a financial instrument, such as T-bonds, for a future delivery date, as opposed to the present time. For example, if an automobile manufacturer needs copper for current operations, it will buy its materials directly from a producer. If, however, the same manufacturer was concerned that copper prices would be much higher in six months, it could approximately lock in its costs at that time by buying copper futures now. (This offset of future price risk is called a hedge.) If copper prices climbed during the interim, the profit on the futures hedge would approximately offset the higher cost of copper at the time of actual purchase. Of course, if copper prices declined instead, the futures hedge would result in a loss, but the manufacturer would end up buying its copper at lower levels than it was willing to lock in.

While hedgers, such as the above automobile manufacturer, participate in futures markets to reduce the risk of an adverse price move, traders participate in an effort to profit from anticipated price changes. In fact, many traders will prefer the futures markets over their cash counterparts as trading vehicles for a variety of reasons:

1. Standardized contracts—Futures contracts are standardized (in terms of quantity and quality); thus, the trader does not have to find a specific buyer or seller in order to initiate or liquidate a position.

2. Liquidity—All of the major futures markets provide excellent liquidity.

3. Ease of going short—The futures markets allow equal ease of going short as well as long. For example, the short seller in the stock market (who is actually borrowing stock to sell) must wait for an uptick before initiating a position; no such restriction exists in the futures markets.

4. Leverage—The futures markets offer tremendous leverage. Roughly speaking, initial margin requirements are usually equal to 5 to 10 percent of the contract value. (The use of the term margin in the futures market is unfortunate because it leads to tremendous confusion with the concept of margins in stocks. In the futures markets, margins do not imply partial payments, since no actual physical transaction occurs until the expiration date; rather, margins are basically good-faith deposits.) Although high leverage is one of the attributes of futures markets for traders, it should be emphasized that leverage is a two-edged sword. The undisciplined use of leverage is the single most important reason why most traders lose money in the futures markets. In general, futures prices are no more volatile than the underlying cash prices or, for that matter, many stocks. The high-risk reputation of futures is largely a consequence of the leverage factor.

5. Low transaction costs—Futures markets provide very low transaction costs. For example, it is far less expensive for a stock portfolio manager to reduce market exposure by selling the equivalent dollar amount of stock index futures contracts than by selling individual stocks.

6. Ease of offset—A futures position can be offset at any time during market hours, providing prices are not locked at limit-up or limit-down. (Some futures markets specify daily maximum price changes. In cases in which free market forces would normally seek an equilibrium price outside the range of boundaries implied by price limits, the market will simply move to the limit and virtually cease to trade.)

7. Guaranteed by exchange—The futures trader does not have to be concerned about the financial stability of the person on the other side of the trade. All futures transactions are guaranteed by the clearinghouse of the exchange.

Since by their very structure, futures are closely tied to their underlying markets (the activity of arbitrageurs assures that deviations are relatively minor and short lived), price moves in futures will very closely parallel those in the corresponding cash markets. Keeping in mind that the majority of futures trading activity is concentrated in financial instruments, many futures traders are, in reality, traders in stocks, bonds, and currencies. In this context, the comments of futures traders interviewed in the following chapters have direct relevance even to investors who have never ventured beyond stocks and bonds.

*This is a rough but conservative estimate based on 246 million contracts traded and assuming an average contract value well over $40,000. (Excluding short-term interest rate futures, such as Eurodollars, single contract values ranged from about $11,000 for sugar at 10¢/Ib. to $150,000 for the S&P 500 at an index value of 300.)

The Interbank Currency Market Defined

The interbank currency market is a twenty-four-hour market which literally follows the sun around the world, moving from banking centers in the U.S. to Australia, to the Far East, to Europe, and finally back to the U.S. The market exists to fill the need of companies to hedge exchange risk in a world of rapidly fluctuating currency values. For example, if a Japanese electronics manufacturer negotiates an export sale of stereo equipment to the U.S. with payment in dollars to be received six months hence, that manufacturer is vulnerable to a depreciation of the dollar versus the yen during the interim. If the manufacturer wants to assure a fixed price in the local currency (yen) in order to lock in a profit, he can hedge himself by selling the equivalent amount of U.S. dollars in the interbank market for the anticipated date of payment. The banks will quote the manufacturer an exchange rate for the precise amount required, for the specific future date.

Speculators trade in the interbank currency market in an effort to profit from their expectations regarding shifts in exchange rates. For example, a speculator who anticipated a decline in the British pound against the dollar would simply sell forward British pounds. (All transactions in the interbank market are denominated in U.S. dollars.) A speculator who expected the British pound to decline versus the Japanese yen would buy a specific dollar amount of Japanese yen and sell an equivalent dollar amount of British pounds.

Michael Marcus

Blighting Never Strikes Twice

Michael Marcus began his career as a commodity research analyst for a major brokerage house. His near-compulsive attraction to trading led him to abandon his salaried position to pursue full-time trading. After a brief, almost comical, stint as a floor trader, he went to work for Commodities Corporation, a firm that hired professional traders to trade the company’s own funds. Marcus became one of their most successful traders. In a number of years, his profits exceeded the combined total profit of all the other traders. Over a ten-year period, he multiplied his company account by an incredible 2,500-fold!

I first met Marcus the day I joined Reynolds Securities as a futures research analyst. Marcus had accepted a similar job at a competing firm, and I was assuming the position he had just vacated. In those early years in both our careers, we met regularly. Although I usually found my own analysis more persuasive when we disagreed, Marcus ultimately proved right about the direction of the market. Eventually, Marcus accepted a job as a trader, became very successful, and moved out to the West Coast.

When I first conceived the idea for this book, Marcus was high on my list of interview candidates. Marcus’ initial response to my request was agreeable, but not firm. Several weeks later, he declined, as his desire to maintain anonymity dominated his natural inclination to participate in an endeavor he found appealing. (Marcus knew and respected many of the other traders I was interviewing.) I was very disappointed because Marcus is one of the finest traders I have been privileged to know. Fortunately, some additional persuasion by a mutual friend helped change his mind.

When I met Marcus for this interview, it had been seven years since we had last seen each other. The interview was conducted in Marcus’ home, a two-house complex set on a cliff overlooking a private beach in Southern California. You enter the complex through a massive gate (“amazing gate” as described by an assistant who provided me with driving directions) that would probably have a good chance of holding up through a panzer division attack.

On first greeting, Marcus seemed aloof, almost withdrawn. This quiet side of Marcus’ personality makes his description of his short-lived attempt to be a floor trader particularly striking. He became animated, however, as soon as he began talking about his trading experiences. Our conversation focused on his early “roller coaster” years, which he considered to be the most interesting of his career.

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How did you first get interested in trading futures?

I was something of a scholar. In 1969, I graduated from Johns Hopkins, Phi Beta Kappa, near the top of my class. I had a Ph.D. fellowship in psychology at Clark University, and fully expected to live the life of a professor. Through a mutual friend, I met this fellow named John, who claimed he could double my money every two weeks, like clockwork. That sounded very appealing [he laughs]. I don’t think I even asked John how he could do it. It was such an attractive idea that I didn’t want to spoil things by finding out too many facts. I was afraid I would get cold feet.

Weren’t you skeptical? Didn’t he sound too much like a used car salesman?

No, I had never invested in anything, and I was very naive. I hired John, who was a junior at my school, to be my commodity trading advisor at $30 a week. Occasionally, I threw in free potato chips and soda. He had a theory that you could su...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Preface
• Acknowledgments
• Prologue
• My Own Story
• Part I: Futures and Currencies
• Part II: Mostly Stocks
• Part III: A Little Bit of Everything
• Part IV: The View From The Floor
• Part V: The Psychology of Trading
• Appendix 1: Program Trading and Portfolio Insurance
• Appendix 2: Options—Understanding the Basics
• Glossary