Introduction

About the book

Hedge Fund Market Wizards is another great book written by best selling author Jack Schwager who is an investment expert and Wall Street theoretician. It gives you a behind-the-scenes look at the world of hedge funds from fifteen traders who have consistently beaten the markets. This book provides a rare insight into the trading philosophy and successful methods employed by some of the most profitable individuals in the hedge fund business.

About the author

Jack D. Schwager is a recognized industry expert on futures and hedge funds and the author of a number of widely acclaimed financial books, including Hedge Fund Market Wizards. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. He is also an advisor to MarkeTopper Securities, an India-based quantitative trading firm. His prior experience also includes over twenty years as a director of futures research for some of Wall Street's leading firms.

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Colm O’Shea: Know When Its Raining

The common outlook of a successful global macro manager is a trader who is capable of forecasting major trends in world markets through skilful research and understanding. O’Shea underlines that his edge is recognizing what has happened and not forecasting what will happen. 

He believes that trying to pick a major turning point is extremely difficult and trying to do so is a losing strategy. Instead, he waits till events occur to confirm a trading belief. For example, he felt that unreasonable risk-taking from 2005 to 2007 had magnified various markets beyond practical levels and left the financial markets susceptible to a major selloff. However, instead of forecasting turning points, he was trading according to the widespread market facts and had bullish positions. He did not shift to a bearish position until an event confirmed that the markets were about to roll over. The event was that the liquidity in the money market was fading away in August 2007. There was no need to forecast anything, but to recognize the implication of an event that was ignored by many. 

O’Shea believes that trade implementation is more important than the trade idea. He strives to execute a trade in such a way that it generates the best return-to-risk and limits losses when the trade is wrong. 

Flexibility is an important quality to successful trading. It is essential for a trader not to get attached to a notion and should always be ready to get out of a trade if the price action is conflicting with the trading belief. 

In April 2009, O’Shea was very negative about the financial prospect. However, the market price action was inconsistent with his bearish belief. Thus, he developed a completely different theory that seemed to fit the situation- the markets marked the beginning of an Asia-led economic recovery. 

Both equity and commodity markets ventured on a multiyear rally and his original market expectation would have been disastrous. He was flexible enough to realise his mistake and act upon it allowing him to generate profits.

O’Shea believes that the best way to trade a market bubble is to take part on the long side to earn from the excessive euphoria. To try to pick a top is almost impossible and prone to large losses. It is easier to trade from the long side because the uptrend in a bubble is often steady, while the downtrend can be highly volatile due to bubble burst. 

There are two important components to trade the long side of a bubble successfully. First, it is important to launch a trade early in the bubble stage. Second, the long position should be structured to limit the loss because bubbles are subject to sharp and abrupt downside reversals.

For this reason, instead of being outright long in a bubble market, O’Shea would take positions like long call, in which maximum risk is the option premium paid. 

Macro trades are generally based on a fundamental view. However, it is not necessary to always have a reason for the trade. Sometimes when the fundamental reason is not evident, the market price action indicates something important going on. 

Long Term Capital Markets (LTCM- a hedge fund) demise had strongly impacted the markets. O’Shea adjusted his positions because he inferred that the market action magnitude was indicating an important fundamental development. He recalled the concept of investing first and investigating later.

O’Shea also emphasised the importance of discipline while managing money. He explains that money management discipline could also be ineffective if it is not compatible with the trade analysis. 

Many traders set stops at painful price levels instead of setting them at levels that disapprove of the original assumption. Despite getting stopped, they believe that their original presumption was correct and tempt to again get into a trade, only to mounting losses.

O’Shea’s advice is to first decide where you are wrong and then set a stop. If the stop indicates an uncomfortable loss, then keep the position size smaller accordingly.

One common principle that underlies almost all the trades is that they are structured to be right-skewed. This means, the maximum loss is limited, but the upside is unlimited. Long options, long Credit Default Swaps (CDS) & long TED spreads (difference between the three-month Treasury bill and the three-month LIBOR based in U.S. dollars) are all examples of trades where the maximum loss is restricted. 

Ray Dalio : The Man Who Loves Mistakes

Dalio strongly believes in diversification. He calls the improvement of return/risk by adding uncorrelated assets the “Holy Grail of investing.”

To determine the dependence or independence of two assets, most people focus on correlation as the main tool. However, Dalio believes that the correlation between assets varies and depends on prevailing situations. Hence it can be misleading and unsuitable for designing a diversified portfolio.

For example, generally, gold and bonds are inversely related because inflation is bullish for gold and negative for bonds. This is because higher inflation usually means a higher rate of interest. However, an easy money policy will reduce interest rates because of which bond prices will increase. At the same time, it will increase long term suspicion of currency depreciation which will increase gold prices. Hence, both gold and bonds will move higher together during the early phase of the deleveraging cycle which is exactly opposite to their natural relationship.

Dalio believes drivers that affect a position are causes whereas correlations are the outcomes. To construct a diversified portfolio, it is important to select assets that have different drivers rather than just being uncorrelated.

Markets behave differently in distinct environments. A fundamental model that presumes fixed relationships between the market and other economic variables, is faulty because those relations can drastically change in different situations. Dalio asserts that a logical fundamental approach must be broad enough to encompass both temporal and geographical environments. He believes that this is the only approach to build an adequately strong fundamental model.

Like many other market wizards, Dalio too insists on keeping a trading journal. Keeping a note of trading mistakes serves as a future reminder and strengthens the lesson learnt from it. Mistakes provide an opportunity to learn from them and improve to achieve success. It is an essential part of continuous improvement as a trader and also for any other attempt.

Larry Benedict : Beyond Three Strikes

The identity of Benedict’s technique is that he looks at markets in the connection of the price action in other markets. Markets are correlated, but these correlations change drastically with time. There are times when the S&P moves along with T-bonds, and at times follows crude oil prices. Benedict closely watches these inter-market relationships minute by minute. 

For example, if two markets are positively correlated, Benedict may short the market that seems to have run up in excess, using a long position in the correlated market to hedge himself.

The timing of such positions will depend on the prevalent price levels of each market. It will not be simultaneous necessarily, either on entry or on exit. 

When short, the selection and execution of actual trades will be highly inconsistent, depending on multiple considerations and experience. The process is entirely voluntary and not formulated.

However, traders must use this approach according to their individual trading style and personal observation. 

There are two main elements of Benedict’s risk management approach. First, he limits the portfolio risk to a small fixed amount of 2.0 % to 2.5 %. Second, when this downside limit is reached, he reduces his position size and trades smaller quantities until he profits again. A portfolio risk level of 2.5 % may be extremely difficult for many traders, but the main idea of setting a predefined loss has extensive relevance. Also, when trading isn't going well, curtailing exposure is a rational action for discretionary traders. 

Trades should be encouraged by opportunity. Traders should be cautious against trading out of money-making desire.

Scott Ramsey: Low-Risk Futures Trader

A valuable lesson that Ramsey delivers is that integrating fundamental analysis can benefit technically-oriented traders greatly. It is not about executing a complicated fundamental analysis for price projections. It is about understanding the key fundamental drivers that determine the market direction.

Once the fundamental opinion is ascertained, Ramsey uses technical analysis to verify his scheduled plan. The objective is to identify the fundamental factors that can drive the market in one direction and then use technical analysis to trade in the same direction.

Fundamentals can also be used as a contradictory indicator. Ramsey looks for situations where the common market perception is contrary to the market action. He always goes long on the strongest market in a sector and short one the weakest one. However, novice traders make the mistake of doing exactly the opposite. They end up buying the laggers in a sector wrongly assuming that they have not moved yet and hence they will move potentially with less risk.

While looking for a reversal, he focuses on establishing a position in the market that delayed the most during the previous price move.

Ramsey is very attentive about price movements in related markets. When a market fails to respond according to the expectations in a correlated market, it indicates inherent strength or weakness. For example, in September 2011, equity prices rallied, but commodity prices weakened, after moving together for years. Ramsey interpreted the failure of commodity prices as an indication of impending weakness. Thereafter, commodity prices sank further.

The distinctive feature of his trading is his rigid risk control approach. From the point of entry, he usually risks 0.1% on each trade. Once he has moved ahead on trade, he allows more space for risk. This method ensures that losses on new trades are moderate.

Ramsey is susceptible to substantial loss after profiting largely from winning trades. He monitors his position multiple times at night even when he is on a holiday. Successful trading needs dedication. Such a commitment should not be a burden because trading is a passion and not a job. 

Jaffray Woodriff: The Third Way

In Woodriff’s view, there are four important ideas about trading systems:

• It is possible to find systems that work better than the most common approaches of following trend or countertrend.
• Data mining methods can be applied to search huge quantities of data to find useful patterns without necessarily falling victim to curve fitting. Although, most people trying to do so will misapply the technique and end up finding past patterns that worked very well, but fail in actual trading.
• Old price data, even greater than thirty years, can be nearly as meaningful as recent data.
• Systems that work well across many markets are more likely to continue than systems that do well in specific markets. It is important to develop systems that work broadly instead of market-specific systems.

The core of Woodriff’s risk management technique comprises adjusting position sizes according to the change in overall volatility. It is also relevant to in line with changing overall volatility—has applicability to a lot of traders, even those who don’t use a systematic approach. 

When the market is more volatile, Woodriff trades a smaller quantity of the asset. 

Woodriff uses the average dollar range in contract value for adjusting portfolio exposure. With this approach, he could maintain his portfolio volatility close to the target level, despite widely deviating volatility over the past 20 years.

Almost like all successful traders, Woodriff too developed a methodology that suited his personality. He deeply felt the need to develop an approach that was different from what everyone else was doing. He developed it but also understood it very early when the method didn’t suit him. 

He asks traders to look where others don’t and adjust position sizes to general risk to target specific volatility. They should also pay careful attention to transaction costs as well.

Edward Thorp: The Innovator

For Edward Thorp, both gambling and investing are quite similar because both are based on probability and finding the edge can be done analytically. 

Thorp flouted the basic prejudices in both investing and gambling. He applied similar kinds of scientific and mathematical reasoning to each venture. The same principles and risk management is relevant to the trading lessons that he used in the markets. 

Winning against a roulette was earlier considered impossible mathematically. Thorp focussed on predicting the most probable ending zone for the ball. This different approach helped him create an edge of 44%. The comprehensive lesson is that what seems impossible sometimes is entirely possible if addressed with a different approach. This applies to trading as well. If the market cannot be beaten with conventional strategies, it is better to try unconventional ones.

Another important method apart from entry is altering the position size. The sizing should be smaller for lower probability trades and larger for higher probability ones. This can change a losing strategy into a winning one. 

Confidence is applicable not only in defining the trade size but also on reasonable risk management. It is sound advice to bet within your comfort zone. Emotions influence trading decisions and prove to be deadly. 

Many traders believe that there is a single remedy to define market behaviour and continuously try to find that Holy Grail of trading strategies. If it was true, then trading would become as simple as operating a money machine. However, there is no such single solution. For being successful, traders have to adapt themselves to changing market situations. It is not a fixed process but a dynamic one. 

The initial concept of Thorp’s approach was to balance long stock positions that had declined the most with short stock positions that had advanced the most to ensure that the portfolio’s net exposure was close to zero. However, when the return/risk started to erode, he shifted to a variant strategy that incorporated sector neutrality to market neutrality. When sector-neutral arbitrage also started losing its edge, he switched to another variant that neutralized the portfolio to the various factors. By the time the third repetition was altered, the original version had degraded considerably. This continuous adaptation and alteration helped Thorp to maintain a strong and consistent return/risk.

The Kelly criterion by John Kelly (a mathematical formula that helps investors and gamblers calculate what percentage of their money they should allocate to each investment or bet) can be useful to determine the optimal size of a trade. It can be mathematically illustrated and will generate a higher return in the long run than any other strategy. However, this model assumes that the winning probability and the ratio of profit/loss per bet are literally known. This assumption holds true for games but in trading, winning probability is not known and can be guessed with a broad degree of error. 

There is an upright penalty for overestimating the probability and ratio, when the Kelly criterion is used. The negative impact of overvaluing the size is twice as large as the negative impact of underrating it. Hence, if the accurate probabilities of winning are not known then the bet size should be significantly smaller than the full Kelly amount.

Moreover, even if the assumption is correct, the resulting equity surge would be volatile beyond people’s comfort level. The high volatility has important practical indications as well. Higher the volatility of the equity, the greater the chance of renouncing the approach during the decline.

Thorp suggests that even if the probability of winning can be estimated, using half Kelly is a better option. When the estimate is correct, even half the size will be a better option than full. However, if the estimation is subject to wide error, then even half size would be too large, and the Kelly criterion would be of limited use.

Jamie Mai: Seeking Asymmetry

Mai’s investment strategy has five main pillars:

1. Finding mispricings in a conceptually priced world. Prices, specifically for derivatives, are based on standard pricing assumptions which may be inappropriate according to the prevailing market conditions. When these assumptions are unjustified, it creates mispricings and trading opportunities. Mai strives to identify these trade opportunities.
2. Selecting trades in which the probability is considerably inclined to a positive result. As a rule, if the trade succeeds, Cornwall expects that the estimated gain multiplied by the probability of a positive result must be at least twice as large as the estimated loss. These profits and losses and their probabilities must be based on subjective measures. The rigid criterion for qualifying trades will lead to a concentrated portfolio. Generally, Mai has only 15 to 20 independent risks at any one time. Although his portfolio is very concentrated, he constructs his trades asymmetrically to constrain the downside when he is wrong.
3. Implementing trades asymmetrically. Mai structures a trade where the downside is limited and the upside is open-ended. One broad way of achieving such a return/risk profile is by being an option buyer (of course, when there is a mispricing).
4. Waiting for high-conviction trades. Mai is patient enough to wait for a trading opportunity that meets his guidelines. This trait improves the return/risk of a trade.
5. Using cash to target portfolio risk because the portfolio mostly consists of derivatives. Mai holds a large cash component in the portfolio (commonly, 50% to 80%). He targets his desired risk level by altering this cash component. 

Option prices are determined by pricing models using certain assumptions. These models provide relatively good approximations. However, sometimes those assumptions are inappropriate for a prevailing market situation. Mai recognized five such assumptions that are not valid at times.

1. Normal distribution of prices- Options pricing is based on the assumption of a normal distribution. This indicates that the probability of extreme moves on either side is abysmally low. However, in some cases, large price moves are more likely than suggested by the normal distribution. In such situations, options are likely to be mispriced, especially OTM calls/puts. This mispricing creates profit opportunities. Another implication of a normal distribution is that it assumes equal probabilities for an up move/down move. Although this assumption may be acceptable, there are times when a market is more likely to go up by a given percentage than down by the same or vice versa. In such situations, the odds of a big price upswing are quite greater than the odds of an equivalent decline. The conclusion is that many times the market price is wrong and such situations provide trade opportunities.

2. The forward price is a true forecaster of the future mean— This assumption implies that options are going to be priced with probabilities centered at the corresponding forward price. However, sometimes when the forward price is far from the present price, it should not be reasonable to assume that a price change adequate to the difference between the forward and damage is the presumably market outcome. Frequently, there is also good reason to assume that some price between the forward and price is more likely than the forward price. If this can be true, out-of-the-money options (puts if the forward price is higher and calls if it's lower) could also be underpriced.

3. Volatility is a measure of the square root of time—This assumption in option pricing is logical only for short periods. For longer time intervals this assumption may understate probable volatility, especially if current volatility is low, for two reasons. First, the longer the period, volatility will be more likely to return to the mean from current low levels. Second, longer periods allow more trend opportunities that result in larger price moves than indicated by the volatility assumption.

4. In calculating volatility, the trend can be avoided—Option pricing models calculate the probability of price moves based on time and volatility. Trend is not part of the calculation. The implied belief is that the daily price direction change is random. Hence, a trending market can result in price moves that would be considered unlikely by the pricing model. If there is a reason to anticipate a trend, then OTM options will be underpriced. 

5. Existing correlations are good predictors of future correlations—Some market correlations like gold and platinum, tend to be fairly consistent, whereas other market pairs like the Australian dollar and Swiss franc may show inconsistent correlation patterns. Trades based on correlation will tend to presume that future correlation will be equal to the past correlation. Such a belief may be invalid for markets that have a varying correlation.

One of the great myths is relating risk with volatility, which is wrong for several reasons. First, the most important risks don’t reflect in the track record and hence are not shown by volatility. For example, a portfolio of illiquid positions may have low volatility during a risk-on period. However, it may have a large risk if market opinion shifts to risk-off. The other side of the coin is that large, abrupt gains may sometimes increase volatility but the theoretical risk is limited. 

Flexibility is one of the distinctive features of Market Wizards. Mai habitually changes his view as demanded by the research. A good trader will always get out of a position when he realizes a mistake. Great traders are skilled at taking an opposite position when they discover their original idea was wrong.

Michael Plat: The Art & Science of Risk Control

Risk control is one of the most important factors for successful trading and Michael Plat masters that art. Risk management begins with trade implementation. 

Expecting that interest rates will decrease; Platt will affirm a trading theme in a way that minimizes risk compared to the same return potential. Thus, he rarely implements directional trades as absolute long or short positions. Plat usually trades long options or complex spread structures that provide the same return, but with restricted risk.

In spite of limiting loss, Platt gets out of a trade if he feels uncomfortable. He also sets a time limit for his trades. If a trade doesn't work within a logical time, he just liquidates it. 

A 3% loss is enough to accelerate a 50% reduction in a trader’s funding. This strict rule helps to prevent a trader from losing more than 5% of his initial stake.

The key is that this risk rule pertains to a trader’s opening stake. Thus, it motivates traders to be very careful at the beginning, being highly selective in their trades and tightly curbing the loss. As traders move ahead, their cushion widens because their trading profit enhances the preliminary 3% loss allowance. 

Practically, the trader allocation risk control strategy ensures capital protection, while at the same time keeping upside potential open-ended. Effectively, it is an asymmetric risk management strategy.

Risk control is important for many reasons, like avoiding abnormal losses, minimizing emotional distress, and restricting the adverse impact of compounding. Large percentage losses require significantly greater percentage profits to breakeven- If you lose 50% of your capital, you will require a 100% profit to reach the old levels Losing trades creates a mental constraint for the trader and often results in missed winning trade opportunities. 

According to Platt, trading follows the 80/20 rule. 80% of a trader’s profits comes from 20% of the trades. If the psychological side-effect of a loss results in missing a trade in the 20%, it can be a big deal.

Platt is very attentive towards the market response to the news. He refers to an intriguing observation in which there was a stream of adverse news, negative for his position. However, the market did not move against him. Platt was able to infer the market's inability to respond to the news. This was a confirmation of his trade idea and he increased his position four times. It turned out to be one of his biggest wins ever. 

Steve Clark: Do More Of What Works And Less of What Doesn’t

Clark’s core recommendation to traders is that they should accomplish more of what works and less of what doesn’t. It may seem unnecessary to state this because it sounds so prudent. However, many traders fail to stick to this strikingly obvious principle. 

Some traders who are good at taking well planned longer-term positions, end up taking short-term trades based on impulses in which they have no edge. Other traders with effective systems get bored of the computerized approach and take discretionary decisions that reduce their overall performance. Traders must figure out what they are best in and focus on those trades. 

One useful exercise traders should do is to evaluate their past trades by splitting winners and losers. This analysis often reveals trading patterns. When the gaining and losing trades are identified, Clark’s advice comes into the picture. Doing more of what works and less of what doesn't. 

Clark also warns traders against diversifying away from their expertise. Some traders succeed because they are good at doing a particular type of trade. This success often encourages traders to get into other areas in which they do not have an edge. 

Traders try to focus mostly on the entry point of a trade. However, entry size is more important than entry price because uncomfortable trade size may compel a trader to exit the trade on a trivial negative price move. 

One way of realizing that the position is too large is if one wakes up thinking about it. Trading size should be small enough so that fear does not overcome judgement. In Clark’s words, one must trade within his/her emotional capacity. 

The position size also needs to be adjusted as per the changing market environment. If the market volatility increases drastically, traders will have to reduce their normal exposure levels likewise, or else their risk will increase dramatically.

Flexibility is another basic quality for successful trading. If the piece action is inconsistent with the trade assumption, good traders are competent to change their mind instantly. 

Almost all traders experience situations when they are out of sync with the markets. It is better to get out of all trades and take a holiday in those times. This break will interrupt the negative spiral which can weaken confidence. When resuming trading, they should trade smaller quantities until their confidence is regained. 

Martin Taylor: The Tsar Has No Clothes

Martin Taylor looks for three essential characteristics while selecting emerging market equities: 

1. Favourable macro-outlook—There are two main ways in which Taylor’s macro assessment affects the portfolio. First, he concentrates longs in the countries that have the most positive fundamentals. Second, the global macro climate can influence the net exposure of the total portfolio. 

2. Supportive secular trend—Taylor looks for situations in which there is a strong fundamentally based temporal trend that supports the trade. 

3. Good company—Taylor looks for companies that have attractive growth outlooks and are reasonably priced relative to expected earnings. He avoids low-beta stocks despite their good values.

Investors often tend to miss the best stocks because they can’t persuade themselves to buy a stock that has already ascended a lot. How well a stock is priced relative to its prospects matters and not how much it has gone up.

Your net exposure should match your comfort level. For example, if you are uneasy being entirely out of the market, then a flat position may be riskier than a fair long position. This is because you will be more likely to be a victim of false rallies. Taylor believes that because of some long exposure during the volatile period of 2008 to 2009, his potential losses were reduced even though the market collapsed. 

Another benefit of trading within a comfort zone is that smaller net exposure may generate better returns. 

Taylor believes that a fixation with monthly returns can adversely impact long-term investment decisions. When he is strongly confident that a stock will move higher over the long term, then, reducing exposure during temporary weakness to restrict the monthly loss would be a mistake. 

Taylor believes the best opportunities are those where you can identify a potential trend that the market does not acknowledge because it is concluding history instead of looking forward. Investors often make mistakes by associating manager performance in a given year with manager skill. In some examples, more skilled managers underperform because they deny participating in market bubbles. In fact, during market bubbles, the most unwise managers emerge as best performers.

Taylor underperformed in 1999 because he thought it was outrageous to buy tech stocks at their exaggerated price levels. However, this same investment decision was one of the main reasons for his strong outperformance in the following years when these stocks slid extensively.

Tom Claugus: A Change Of Plans

Claugus provides an important lesson that is both market-specific and also has general importance for all investors: Alter exposure based on opportunity. When stock prices are near the lower end of the long-term price range, Claugus will hold a maximum long position. Contrarily, when prices are near the upper end of the range, he will hold a maximum short position. Altering the net exposure based on the current opportunity provides a considerable improvement in an investment approach. 

While selecting individual stocks, Claugus looks for companies that will profit from a future development that is not being priced in the current market environment. The origin of the improvement can take many forms like expected new sources of production, new technology, an anticipated increase in asset value, etc. He believes that if a revenue source is more than a year away, the market will frequently fail to allocate a significant value to it. Fundamental screens will fail to recognize these stocks because the source of the bullish potential is not reflected in existing statistics.

Traders make a mistake of judging trades as right or wrong, based on the outcome. A losing trade may reflect a valid trading decision. They have to accept that a certain percentage of good trades will lose money.

As long as a profitable strategy is executed according to plan, a trade loss does not indicate a trading mistake.

On the other hand, a winning trade can be a poor trading decision. 

Trading is a matter of probabilities. No matter how effective a trading strategy is, it will be wrong a certain percentage of the time. Traders confuse the ideas of winning and losing traders with good and bad trades.

Discover the ease of stock investing with Tom Claugus: A Change of Plans. Enroll now for our 'Stock Investing Made Easy' course!

A bad trade can make money and a good trade can lose money. A good trade pursues a strategy that will be profitable with a reasonable risk, if repeated multiple times, although it can lose money on an individual trade. A bad trade follows a process that will lose money if repeated multiple times but may make money on an individual trade.

Joe Vidich: Harvesting Losses

Traders face a common dilemma when the market moves against their position. Vidich offers a solution to this situation. He advises traders not to try to be cent per cent right. While facing a losing position, he begins by liquidating a part of it. Taking a partial loss is more convenient than liquidating the whole position. Instead of delaying, it helps traders to act. Liquidating gradually helps mitigate the damage. 

Traders make a common mistake of letting greed influence their position beyond comfort level. When positions are large, the trading decisions are fear-driven instead of judgement and experience.

Flexibility is an important trait of successful traders. Vidich is bullish on energy markets but he does not let his view influence his trading decision. In 2008, when there was an excessive upside in prices, he gradually moved from a long position to a short one. Thereafter, crude oil prices collapsed to $90, he again moved to the long side of energy equity. However, he soon discovered that the change in market sentiment and fundamentals indicated lower prices and again switched to the short side. He was flexible enough to change his trading opinion and turned a devastating loss into a massive profit.

Trading decisions should not be taken based on the entry of the position. When a stock had fallen to the price where Vidich entered and was going lower, he immediately got out of the trade.

While controlling losses, there will be times when the market will just turn around after your stop-loss is hit. This annoying experience cannot be avoided while effectively managing risk and hence you should get used to it.

Vidich is very disciplined in cutting losses because of which his maximum drawdown has been in single digits. He was always ready to accept that he would liquidate losing position just before the markets turned around. This approach helped him to achieve this impressive risk control.

Kevin Daly: Who Is Warren Buffet?

Music is the space between the notes. Similarly, there is space in between investments. These spaces are the times one is out of the market and it is crucial for successful investment. 

In spite of being mostly a net long equity investor, Kevin Daly accomplished cumulative gross returns of more than 800% during those 12 years when the broad equity market indexes were nearly flat. He managed to achieve this because of superior stock selection and also by not participating in the market at the wrong times. Sometimes, being out of the market is important to succeed. 

When the environment is adverse or when there is a lack of opportunity, one must have patience to stay on the sidelines and not take the sub optimal trades. Daly had to be patient for more than two years during the 2000 to 2002 bear market.

His stock investing method and philosophy can be outlined as follows:

• Stick to the businesses you understand.
• Find companies in that business that are undervalued compared to their similar competitors. 
• Book profits when prices move up to the fair valuation stage.
• When the market turns stormy, it is better to ascend into a cash refuge. 
• Stick to the vital system and never take flyers.
• Investments should be treated as a business and not as a gamble. 

$50 million is a small size by the standard of a fund manager. However, Daly manages this small size only because he understands the advantage of managing smaller assets. This is one reason why he has made virtually no effort to raise additional assets. 

Individual investors have an important advantage over large hedge fund managers. It is difficult for large fund managers to enter and liquidate positions without incurring substantial slippage costs. Also, as the assets managed grow, the world of possible opportunities shrinks. 

He has seen many managers who did extremely well while trading smaller asset levels, but experienced significant deterioration in performance when they expanded their assets beyond the optimal level required for their method. They should be disciplined to turn down additional assets when they believe it would deter their performance. It is an important component in longer-term success.

Jimmy Balodimas: Stepping In Front Of Freight Trains

Jimmy Balodimas’s style is so highly individualistic, so dependent on inherent talent, and so poorly compatible to most traders that, they would be better off doing the exact opposite than trying to imitate his approach. 

Three lessons can be extracted from Balodimas’s story that is more generally applicable without potential toxic side effects:

The need to adapt— While the commonality of human nature provides elements of consistency in market behaviour across time, markets also change, and successful traders adapt to that change. In Balodimas’ case, he noticed that the greater level of market participation by hedge funds was resulting in smoother price moves for individual stocks and much fewer pullbacks, particularly intraday. This structural change made it more difficult for Balodimas to neutralize losses from being too early in a position with profits from trading around the position. It became more important not being too early on trades. Balodimas responded by keeping positions smaller until there was a market change that gave him a high degree of confidence that a turning point was imminent. The idea that trading methods need to be adjusted to changing market conditions is an important concept that can be applied to a trader’s approach.

Trading around a position— A key element in Balodimas’s trading approach is adjusting position size in contrast to market fluctuations. For instance, if he is short, he will reduce his position on price breaks and rebuild his position on rallies. Balodimas is so competent at trading around positions that he often generates net profits even when the net price movement of a stock counters his position. The potential drawback is that a retracement to the re-entry level may not occur, in that case profits will be realized on a smaller position. On the positive side, if the liquidated portion of the position is re-entered at a better price, total profits will be enhanced, and perhaps even more importantly, the ability to hold the position will be improved. Whether trading around positions is beneficial or detrimental shall be highly contingent on the individual trader. 

Avoid euphoria—  His last advice to traders would be to sell into panic rallies. Very few traders have the natural timing skill and emotional strength to pull this off successfully. Those who are on the right side of a market must book partial or total profits while the market is in a state of panic. They should not wait for the reversal which can be both extreme and abrupt.  

Balodimas has been through multiple bull and bear market phases, averaging hundreds of trades a day. The markets he predicts are major tops and bottoms which consistently trend for a long time once they change. Despite this consistent pattern, he only trades a small part of the emerging trend. He feels he could improve his performance by simply trading these markets for a longer time.

The point is that even the best traders may not be implementing their strategies in the best way. A trader should consider whether the trading method assigned is best aligned with his edge.

Balodimas was extremely dedicated as a trader and used to work long hours with full obsession. However, this level of success was only possible because of his inherent skill, that gives him a sense of what markets will do. 

There is no single true path that leads to successful trading. Striving traders should understand that the quest is in finding an approach that fits their personality. Jimmy Balodimas found an approach that suits his personality—independent, strong, contrarian, and very comfortable with risk. However, the same approach could be disastrous for most other traders who have different comfort levels in trading style. 

You cannot succeed in the market by duplicating someone else’s approach because the chances are remote that their method will fit your personality. The answer lies not in copying but in finding your own approach.

Joel Greenblatt: The Magic Formula

There are three main lessons that Greenblatt provides about value investing:

• Value investing works
• Value investing doesn’t work all the time
• Point no. 2 is one of the reasons why point no. 1 is true

Investing in good businesses that are cheaply priced will outperform the market over the longer term. This value edge doesn't go away because the underperformance period can be long and severe enough to discourage investors from sticking to the approach. 

Although many managers understand the superiority of value investing, they too face trouble using such an approach because of the shortening time horizons in sustaining unsatisfactory performance. The institutions have become increasingly likely to reclaim investments from below average managers. This means that managers who stick to a value approach tend to lose significant assets at some point. The inability of investors and managers to invest with a long-term horizon establishes the opportunity for time arbitrage. It is an edge in an investing approach that needs the long-term holding commitment periods.

Greenblatt believes the efficient market hypothesis gives an erroneous model of how the market really works. According to him, a more appropriate model is that prices trade around fair value, but broad divergences occur because of large swings in investor sentiments. 

He believes that the biggest mistakes investors make while selecting managers is using past performance as the guide. He speaks of practical data demonstrating that there is no meaningful correlation between past and future manager performance. He suggests that managers should be selected on the basis of their investment process and not returns.

Greenblatt believes that stock indexes are a better investment choice than mutual funds because of their lower fees and more tax-efficient structure. Despite these advantages, Greenblatt thinks that most popular stock indexes are structurally flawed. 

His Wells Fargo trade demonstrates the concept that options can be underpriced in situations in which the fundamentals command a high chance of a large gain or loss. This means it has a binary outcome scenario. In this trade, it was uncertain whether Wells Fargo would survive a serious real estate downturn. Even if they did, its fee income indicated a far higher price. This binary outlook made a long-term long option position an extremely impressive trade. The broad lesson is that options are mainly priced off of mathematical models that do not consider certain fundamentals. 

He advises managers to guard against letting assets size grow to the point where it hinders performance. The first ten years of Gotham Capital exhibit an impressive track record. Greenblatt could have easily grown his fund by multiples, accumulating heavy management fees in the process. Rather, he chose to return all assets to investors to keep the size small enough so that it did not impede the ability to execute the strategy or hamper performance.

Conclusion

This book is incredible for anyone who wants to dig deeper into how the wizards perform. Jack Schwager has listed all the lessons offered by the successful people who are interviewed in this book and here are a few of them:

• There is no holy grail or single solution to trading.
• Do what you’re comfortable with and find a method that suits your personality .
• Do not mistake winning and losing money with good and bad trades.
• Realize the power of risk control and diversification.
• Be flexible and adaptive to the continuous changes in the market.
• Always look for an infinite upside coupled with minimal downside in all trades.
• The way of trade implementation is more important than the trade idea.
• Markets behave differently in different situations.

The list of similar kinds of lessons goes on providing crucial points for beginners to understand how investments work. Readers looking to develop their trading skills will certainly have a lot to learn from this book!