Introduction

About the book

Stock Market Wizards by Jack Schwager is a collection of interviews with traders who have turned scanty sums into great fortunes. By reading this book, you can extract tremendous knowledge. It taps into the minds of the successful traders and reveals the secret of their astounding success.
This book also reveals the psychology and mechanics behind the trading world. 

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.

Buy the book

The book is a collection of interviews with those traders who achieved phenomenal success in stock trading and disclose useful insights so that you can become successful in trading. We highly recommend you to read the entire book. (affiliate link)

Buy from Amazon

Stuart Walton: Back From The Abyss

Stuart Walton was not keen to be a trader. From being a cartoonist to a journalist, he finally landed on the equity desk.

He believed in giving 100% energy and enthusiasm to the market. After losing money because of tips and opinions, he decided to work all alone. He realized the importance of trading without any influence. 

Walton believed that trading was the best way of business to acquire the comforts of life.

On several occasions, he lost nearly all his money due to emotional trading decisions.

All trading that he does now involves gut feeling. He believes that luck does play a part but one has to work to put himself in the position to be lucky.

He finds good companies that have an advantage in the market. The advantage could be because of good expected earnings or any other reason. These stocks can be identified by their behaviour. For some reason, the market blesses some stocks, while it doesn't go to other stocks, no matter how cheap they are.

He insists that finding the hardest thing is the right thing to do. For e.g. buying a high-flying stock or selling a stock that went down considerably.

To evaluate stocks, he follows only 25% of fundamentals and 25% of technicals to check linearity in its trend. Another 25% is evaluating how a stock responds to different information: macroeconomic events, news flows, etc. He also pays attention to a stock’s reaction when it reaches the round numbers like $20, $30, etc. He also checks how much positivity the stock has and how much ground it gives to negative news.

For e.g., if a stock responds poorly to negative news, then it hasn't been favoured by the market.

The last 25% is his gut feeling for the direction of the market as a whole.

His average holding position of a stock is that of a few weeks. He might trade in and out of the stock twice in the same day or maybe multiple times in a week just to ensure he is in the right trade. If he is not comfortable about it, he squares off the position.

He defines a trade to be successful if he has been able to catch a major part of the move, even if it is in several parts.

He feels that a sound strategy will work as long as you stick to it.

He strongly recommends keeping your egos aside, no matter how successful you are because it can put you out of business. Making mistakes is fine because it makes you realize that they can recur and helps you become more careful. Getting involved in illiquid stocks is another mistake people tend to make according to Walton.

He believes that traits of a successful trader include being unemotional, hardworking, and extremely disciplined. 

The key elements for being successful are persistence, self-awareness, flexibility, and creating your own methodology.

He advises novice traders to either go for it seriously and with full dedication or not go for it at all.

Stuart Walton's story demonstrates that early failure doesn't prevent later success. It also shows the importance of developing your methodology and shutting out all other opinions.

Michael Lauer: The Wisdom Of Value, The Folly Of Fad

Michael Lauer is well known for managing funds with outstanding returns coupled with low risk. Since January 1993, Lauer's flagship fund has realized a net 72% average annual compounded return (CAGR). He has achieved these exorbitant returns keeping losses both small and short-lived.

Lauer believes in concentrating his portfolio into a small number of holdings (fifteen stocks typically account for 75% or more of assets). He believes broad diversification is very mediocre because it makes your performance similar to that of the market. Research shows that 80% of the diversification benefits can be achieved with just 15 different stocks. To achieve the goal of exceptional performance and low correlation, too much diversification is not required.

To cut down the universe of U. S. stocks to a mere fifteen requires a very restrictive selection process. Lauer has six screens that must be met by security to feature on his shortlist:

1. It must be a company/sector that he fully understands.
2. The price of that stock must have declined by more than 50% relative to the market average. This means that the stocks which have experienced wholesale/institutional liquidation are his area of focus.
3. The company must have a reasonable cash flow and a strong balance sheet.
4. There must be either insider buying or a repurchase program or both.
5. The stock must represent convincing value (e.g., price near book value, large revenues relative to total capitalization).
6. There should be a catalyst to ensure that the stock moves shortly. Otherwise, although the preceding four conditions will limit declines, the stock could just sit where it is for years, reserving the capital.

Lauer will typically liquidate his stock despite knowing that it will move higher. This is because he believes that he will get other opportunities for a better risk/return profile.

He goes on to explain that short positions differ from long positions in two ways:

Firstly, the holding period for short positions is much shorter than for long positions (a week compared to three to eighteen months). Stops are employed in short positions to limit losses because of potential upside loss.  

Second, the size of major fund holdings provides important information. For example, if major funds hold a large number of shares and they start liquidating their position, then the stock will probably undergo relative pressure for months.

One similarity between long and short positions is that they both require a catalyst. For short positions, it is a supreme issue because timing is motivated by an expected event (e.g., a disappointing earnings report). 

Lauer explains two more important concepts. First, a great performance requires not only picking the correct stock but also having the conviction to implement trades in meaningful size. For example, a small position in a great stock is just an add-on to one’s mistakes. He firmly believes that any investment approach that depends on stock market direction for profitability is destined to mediocrity. Similarly, any approach that relies on accurate forecasting or involves high expectation stocks is extremely risky. 

He summarizes the market philosophy by saying that the business does not involve investing in great companies but by profiting from inefficiently priced stocks. He explains that the fundamentals are not bullish or bearish in a vacuum; they are bullish or bearish only relative to price. The greatest company in the world may prove to be a terrible investment if its price rise has already over-discounted the bullish fundamentals. Conversely, a company that has been blasted with negative news could be a great buy if its price decline has over-discounted the bearish information.

Steve Watson: Dialing For Dollars

After working as a broker for 2 years, Steve Watson decided to fulfill his goal in stock trading. He attributes his success to his attitude of overcoming obstacles and achieving success through determination.

When it comes to trading, Steve is always willing to accept risk but never willing to take it.

One of the most important lessons that he learnt is to stick to his own beliefs.

While selecting stocks, he talks about two kinds of funds: a micro fund that invests in companies with a market capitalization of under $350 million, and a small-cap fund that invests in companies with a capitalization of $350 million- $1.5 billion.

In both funds, they start by looking for relatively cheap companies—trading between eight to twelve times earnings. Within this group, they try to identify those companies for which investors' perceptions are about to change. For example, these may be companies that are having some trouble now, but their business is about to turn around. They try to be the first ones to find out that information.

Two key components while buying a stock are its low price and the prospect for imminent change. To identify the prospect that will change market sentiments, Watson extensively communicates with companies, their competitors, consumers, and distributors. Beyond that, insider buying by management also helps because it confirms the prospects of improvement.

He mentions that his largest holding is 3% of his assets and that is also very rare. For short positions, his maximum is 1.5%. His total exposure usually is 20-50% net long.

While selecting for short positions, he looks for high-priced shares that are trading at thirty to forty times earnings or stocks that have no earnings. Within that group, he tries to identify those companies with a flawed business plan (like product failure).

He explains that he can hold his position (even if the stock is down 40%) if his fundamentals are sound. However, if a short position goes 20-30% against him, he will start to cover irrespective of the fundamentals.

Watson controls risk through a combination of selection, diversification, and loss limitation rules. Watson is constantly upgrading his portfolio —replacing stocks with other stocks that appear to have an even better return/risk outlook. Therefore, he will sell a profitable long holding after a sufficient price rise even though he still expects it to go higher. He will then find another stock with better return prospects and less risk.

He believes one should do his research and stick to it instead of getting swayed by other people's opinions. Emotional investments are bad decisions according to him. People who are willing to lose money in this business are the ones who become successful.

Dana Galante: Against The Current

Dana Galante realized an average annual compounded return of 15%. This may not sound impressive until one gets to know that Galante is a pure short seller. She achieved her 15% return during a period when the index rose by an annual average of 32%.

Although Galante is a pure short seller, her ideas also hold good for the long-only investors. Her methods provide useful guidance on which stock to liquidate or avoid.

The combination of factors she follows is a very high P/E ratio, a catalyst that will keep the stock exposed in the near term, and a reversed uptrend. All three of these conditions must be met. Investors might consider reviewing their portfolios from time to time and replacing stocks that meet all of the three conditions with other stocks. By doing so, investors can reduce portfolio risk.

In addition to this, Galante also explains several red flags that attract her attention to consider stocks for shorting. Investors can think of liquidating their position if any of these conditions hold. These red flags include:

• high receivables
• change in accountants
• high turnover of chief financial officers
• blaming short-sellers for a stock's decline
• a company changing its core business to take advantage of a prevailing trend

She also evaluates some stocks that break below their fifty-day moving average.

Further, she explains her risk-controlling strategies. If she loses 20% on a single stock, she covers one-third of her position. The maximum allocation given to a single stock is 3% of the portfolio. If due to a price rise, a stock covers a larger percentage of the portfolio, she rebalances it. She believes in controlling risk through diversification. Hence, she has 50-60 stocks in her portfolio from across different sectors.

Mark D Cook: Harvesting S&P Profits

Mark D Cook is passionate about trading, but his love for his market career still stands at third place after family and land. For him, farmland is the ultimate real asset. Hence, he is very enthusiastic about converting his trading profits into real assets.

His early attempts at trading were marked by repeated setbacks; however, he never gave up. Each failure only made him work harder. Finally, after many years of developing a strategy, business plan, and carefully tracking the stock market, his trading became consistently profitable. Discipline has helped him to realize triple-digit returns from the market unfailingly. 

He used a method called Conjunction trade which required two simultaneous conditions to generate a buy signal. The conditions were stock ticks going below -400 and Dow Jones ticks going below -22. He adopted a strategy of selling calls and puts simultaneously (straddles) in high volatility stocks.

He also followed a method of Tick-buy. In this method, whenever the tick went to -1000, he would buy because the market will tend to bounce back.

He believes in increasing his activity rather than exposure. The first thing he does while losing is to reduce the position. He doesn't get out of that trade completely. This compels him to make money in his next trade. The idea behind this is to rebuild confidence.

He advises that hope should not be a part of a trader’s vocabulary (hoping for the trade to work in your favour). Instead, he should immediately reduce or exit his position. 

He also never held his position for more than three days because he believes that holding a position for a longer period than this can diminish returns. Exception being when the cumulative market signals still validate the trade.

Common wisdom suggests looking for trades that offer several times more profit than risk. However, Cook's trading strategies involved making one dollar for every two dollars risked. This observation provides two important lessons: First, looking at the probability of winning is equally important as looking at the ratio of potential gain to risk. 

He explains that a strategy can lose more on losing trades than it gains on winning trades but still can be a great approach if its probability of winning is high enough. 

Conversely, a strategy that can make ten times on winning trades as it gives up on losing trades. Yet, it can lead to financial ruin if the probability of winning is very low. 

He cites an example of continuous betting on number seven in roulette. On winning, it gives thirty-six times the bet but after playing long enough, you tend to lose all the money because the odds of success are only one in thirty-eight.

The second important factor in choosing a trading method that fits your personality.

His method of low return/risk ratio in exchange for a high probability of winning was appropriate for him. However, the same approach can prove to be uncomfortable and unprofitable to others.

He advises traders to stop trading or reduce trading activity if they are experiencing any kind of physical or emotional distress. This will help reduce the damage.

According to Cook, the key to success lies in commitment. Trading must be pursued as a full-time business and not as a part-time interest. One must be prepared for losses and think of it as tuition fees for learning in the school of trading. These are the cold facts that traders must accept.

He believes that gaining proficiency in trading or any other profession requires experience and experience comes with time.

Alphonse “Buddy’’ Fletcher Jr: Win-Win Investing

Alphonse Fletcher Jr gained interest in markets during high school when he worked on developing a program to find winners on the dog race track. During his graduation from Harvard University, he tried to evaluate what would happen if an option price was forced away from its theoretical value by placing large buy or sell orders that moved the market. His results convinced him that he had found a consistent way to capture profits in the options market. However, that idea of making money was the opposite of all the theories he had learnt about the markets.

His analysis implied that it was possible to implement offsetting trades, in which the total position had little or no risk and still provided a profit opportunity. In the real world, such discrepancies might occur because an oversized buy or sell order might knock out a particular option or security. However, in the theoretical model, it will be impossible to show a consistent risk-free opportunity if the efficient market hypothesis is correct. 

His initial success came from a brilliant insight: Whether the markets are efficient or not, if different investors are treated differently, it hints at a profit opportunity. 

He knew that arbitrage will only eliminate opportunities where both parties have the same costs of funds. If, however, one’s cost of funds is significantly higher or lower, then there will be a chance. In a more general sense, the markets might be priced very efficiently if everyone had identical costs of funds, received the same dividend, and had the same transaction costs. 

He explained that the market was pricing options based on a theoretical model that assumed a risk-free rate. For many investors, however, the relevant interest rate was the cost of borrowing, which was higher. For example, the option-pricing model might assume an interest rate of 7% while the investor might have a borrowing cost of 8%. This discrepancy implied a profit opportunity. He used option box spread (a trade that involves implementing four simultaneous and separate option positions) to gain from this inconsistency.

Fletcher attributes his success to the lessons he learnt while working for Elliot Wolk- Never make a bet you can't afford to lose. He still follows the rule of risk aversion. He sticks to the rules of his first job of making significant returns from minimum risk and capital.

He believes some companies have much greater difficulty attracting investment funds than other companies with equivalent long-term fundamentals. By identifying these companies, Fletcher can structure a financing deal that offers these firms funds at a lower cost while at the same time providing him with a high chance of low-risk profit opportunity.

The reason for his success is risk control and innovation.

Although the details of Fletcher's approach are not directly applicable to ordinary investors, the two goals still represent worthy goals for all market participants.

Ahmet Okumus: From Istanbul To Wall Street Bull

Ahmet Okumus was mesmerized by the Istanbul Stock Exchange trading floor at the age of 16. He was so obsessed with it that he began skipping classes for it. He realized that stocks move for a reason and decided to find out that reason.

In 1998, after going wrong in the bear market, he made three changes to his trading rules.

• Not to get involved when there is too much mania because mania cannot be predicted.
• Never have more than 100% net position, either long or short.
• Using options specifically for reducing downside volatility.

He likes to stick to fundamental values. He had a rule that he would buy a stock if it went down to the price limit for 3 consecutive days and then sell it on the first short-term bounce.

His main goal was to select trades with a high probability of gain and low risk. For this, he had to forego many winning stocks but the approach resulted in 90% profitable trades and a triple-digit average annual return.

Okumus started trading in 1992 and managed to earn a whopping 107% of an average annual compounded return by the year 2000.

Okumus's trade involves buying a stock with sound fundamentals at a bargain price. He looks for stocks with good growth in earnings, cash flow, and significant insider buying. Strong fundamentals, however, are only half the picture. A stock must also be very attractively priced. Typically, Okumus buys stocks that have declined 60% or more off their highs and are trading at PE ratios under 12. He also prefers to buy stocks with prices close to book value. Very few stocks meet Okumus's fundamental and price criteria. Thus, he holds only about ten stocks in his portfolio at any given time.

Okumus does not believe in the age-old adage of cutting the losses short. Instead, he buys more if a stock moves lower. Cutting losses is a measure of risk control. Although successful traders incorporate risk control measures in their work, they don't prefer to cut losses for risk control.

Okumus attains risk control by using his above-mentioned extremely restrictive stock selection process. He is confident that the stocks he buys have extremely low risk at that time. To ensure this, Okumus has to give up many profitable trading opportunities. But because he has a stringent stock selection, he can control risk without cutting losses short.

One strategy Okumus uses is a cash-secured put. This strategy involves selling OTM puts of the stocks which he is willing to buy. In other words, selling put options is another way of buying stocks. If the stock price doesn't go down to the OTM strike price, the premium on put sold is earned. Also, if it goes down to the strike price, then he easily buys the stock because at that price (he is willing to buy it at that price anyway). So, by selling puts, he is getting paid by the market while waiting for the stock to come down to his price. For some stocks, it may be possible to make money by selling puts only rather than buying the stock.

His main goal is not to lose money. He thinks making money consistently is good enough. He doesn't believe in going short on an extremely overvalued stock until and unless there is a catalyst for change.

The key elements he follows for trading are discipline, doing good research to know your companies well, and not getting emotionally involved in trades.

Mark Minervini: Stock Around The Clock

Mark Minervini wanted to become a musician. However, in the early 1980’s he got interested in the stock market. He sold his studio and used the proceeds to trade. Initially, he lost everything and realized that depending on others for advice was his worst mistake. So, he began working on an intensive program of research and self-education. After almost a decade he succeeded in developing a well-defined trading process.

He achieved an average annual compounded return of 220% during that period.  His worst performance during that span yielded a 128% gain which most of the traders will be delighted to have as their best performance.

Minervini believes that there is usually a reason for stocks trading low. He prefers buying stocks that are priced at $20 or higher. He never buys stocks that are priced under $12. His basic belief is to expose the portfolio to the best stocks available in the market and also cutting losses quickly when things go wrong.

He also suggests that if investors avoid certain stocks because of high P/E, they tend to miss out on the best market moves.

Minervini also believes in designing your strategy according to your personality.

On identifying the market leaders, he uses relative strength. He looks for stocks that hold up well during a market correction and they are the first ones to rebound when the market comes off a relative low. He has always believed that great trading opportunities are available every day. One has to work on identifying them. 

He shares how losing money for a beginner is the best thing to happen. It teaches one to respect the market.

He suggests that beginners should trade with a small amount of money that they can afford to lose. However, the amount should be big enough to make them feel the pain if it is lost. Paper trading is one of the worst things they can consider doing. What is important is how much profit you earn on winning trades than how much you lose on losing trades. Minervini is profitable only about 50% times, but he profits more than the amount he loses.

While reading several books, he learnt that patience, money management and flexibility are very important for successful trading. Protecting your capital and also your profits should be equally important for you. 

The key to good trading lies in managing the downside. Minervini suggests that if a person wants to be a trader, then he should learn to play poker. Poker provides a good similarity. In poker, previous hands mean nothing and the current hand determines the probability. Similarly, if Minervini gets stopped out of a trade five times, he would still put the same trade sixth time, if it meets his criteria.

He gives a 50-50 weightage to fundamentals and technicals. He never bets on his fundamental ideas without price confirmation. However, he might consider buying a stock with negative fundamentals if its price performance is in the top 2% of the market. The reason being, that the price action may reflect that the stock is discounting a potential change in fundamentals that is not yet evident. Such combinations of strong prices and weak fundamentals are found in companies that are demonstrating a turnaround in operations or which have new technologies which are not yet widely understood.

He prefers looking at a five-year, one-year, and intraday chart for his analysis. He spends a lot of time evaluating when the patterns have worked to figure out how the market can trick investors. After the majority have been fooled, he gets on with the smooth sailing. 

For novice traders, he advises that mistakes are inevitable. However, to prevent mistakes from turning into disasters, they will have to accept losses when they are small.

There must be a plan for every contingency. The most important contingency plan is the one that will limit your loss if you are wrong. Beyond that, there has to be a plan to get back into the trade if you're stopped out.

There should also be a plan for getting out of winning trades. 

He thinks that many amateur investors become careless after gains because they fall into the trap of thinking that they are winning “market’s money” and in no time the market takes it back. It is your money and you will have to protect it. 

Steve Lescarbeau: The Ultimate Trading System

Steve Lescarbeau is known for his systems that are by far the best ones. He invests in mutual funds and has made an average annual compounded return of over 70% with incredible risk control.

He believes the traits needed for comprehensive success are the characteristics that are required to become a successful trader. The key elements required to be victorious are being smart, disciplined, decisive and independent.

Another characteristic of winners in any field is that they are extremely confident. An honest assessment of your confidence level is the best indicator of your potential for accomplishment. Confidence cannot be manufactured. You either have it, or you don't. It can however be acquired by hard work.

Even though Lescarbeau has already developed incredible trading systems, he continues his research without abatement. He doesn't relax, instead ploughs a comfortable approach daily, as if what he is using will cease to work tomorrow. Obsession is one more trait that has helped Lescarbeau to achieve success. He never misses a day from checking markets.

Lescarbeau refused to reveal any details about his trading systems because he believes that when too many people jump on the bandwagon, the market takes it away. In his opinion, if you know what is working for the market then you should keep it to yourself because it won't last forever. It will become obsolete at some point in time.

He uses leverage but never more than 140% of his capital.

He doesn't sell winners and doesn't believe in holding losers. He also doesn't get emotionally involved with his trades.

Lescarbeau has an unfailing sense of discipline. He never holds onto a position once he gets a sell signal. If his system tells him to liquidate, he is out without any second-guessing. The essence of discipline is that there are no exceptions.

Risk control means longevity. A trader like Lescarbeau keeps his losses very low and has a much higher probability of long-term success.

His advice for novice traders is that he doesn't want them to misinterpret activity with accomplishment. They begin trading before having any idea about it. They are active, but they’re not accomplishing anything.

Michael Masters: Swimming Through The Markets

Starting as an unemployed stockbroker, Michael Masters became one of the largest stock traders in America. He realized an average annual compounded return of 86%, with losses in only 3 months. He is a religious man with integrity, morality and determination to succeed. He emphasizes the importance of discipline i.e., cutting losses.

He believes in the approach of portfolio theory. The theory is that you should diversify your portfolio so that you can remove the unsystematic/company-specific risk. That way, if a company blows up, you don't tend to lose. Masters tries to take the unsystematic risk by holding stocks when the unsystematic risk is higher than the systematic risk relatively (at times when the stock's price movement will be influenced more by company-specific events as compared to market movements as a whole).

Another important factor for improving trading is a catalyst. It is an event that has the potential to trigger a stock price of a company by changing the market's perception. 

He uses time stops for his trades. He has a window frame for each trade to work. If anything doesn't happen within that time then that event is not going to be discounted by the market anymore.

Michael Masters’ approach can be summarized as a four-step process:

1. Learn from experience: You should always keep a record of market lessons as they occur. The trade may be a winner or a loser, but you should write down the learning from that trade.

2. Develop a trading philosophy. Compile your experiences of trading lessons into a rational trading philosophy. This cannot be achieved by beginners because it requires experience of many trades to be able to develop a meaningful programme. It is a dynamic process because as more knowledge and experience is gathered, the trader should revise his existing philosophy accordingly.

3. Define high-probability trades. Use that developed methodology to identify high-probability trades. It will help look for trades with predictive value. If individual conditions do not provide an edge, cumulative conditions may provide a significant edge.

4. Have a plan. Know the way of entry and exit for your trade. Masters has a specific way of selecting and entering trades. He also has his plans for liquidating trades. He will exit a trade if any of these conditions are met:

(a) he has realized his profit objective from the trade
(b) the expected catalyst failed to develop or the stock fails to respond as forecasted
(c) the stock fails to respond within a predefined length of time and the "time stop" is triggered.

John Bender: Questioning The Obvious

John Bender believes that the option pricing theory developed by Nobel Prize winner Black Scholes Merton and also used by traders worldwide is fundamentally flawed.

From 1989 to 1995, he realized an average compounded annual return of 187%, while he lost only in three quarters. The worst decline being that of 11%.

He follows a principle: Don't accept anything instead question everything. The principle is relevant not only in trading but in all professions.

One of the basic principles of option theory is that the stock prices on a future date follow a normal distribution. Many traders have improvised this model by adjusting the curve and making its tails fatter because the rare events were much more common than predicted. However, Bender has further gone to question the very premise of using a normal curve as the starting point for describing prices. He has also questioned the usage of a single model to describe the price behaviour of different markets and stocks. By ditching the concept that price movements are random and are normally distributed, he was able to derive much more accurate option pricing models.

Ideally, options should be used to trade when the trader's expectations differ from the theoretical assumptions. For example, if a trader thinks a stock is going to witness a rapid price rise before the option expiration date, then obviously buying the out of the money option might be a better trade than buying the stock itself. This is because OTM call options are relatively cheap. After all, they will have value during expiry only if the stock price rises sharply.

He cites another example to explain further. Assume, there is an upcoming event that can cause the stock price to rise or decline. The chances of the stock price going in both directions are equal. If it is bullish, then the chances of a high price rise are much more than a moderate price rise. However, the standard option pricing model assumes the opposite. It assumes that a moderate price rise is more likely than a high price rise. Hence, if the assumption made by you is correct then it is possible to create an option strategy that will keep the odds in your favour. For e.g., you may sell the ATM call options and use the premium received to buy a larger quantity of OTM call options. If the price declines, then you will tend to break even. If the price rises a little, you will lose moderately and if the price rises sharply, then you will win big. This strategy is known as Call Ratio Back Spread.

He believes that the key to using options effectively is to chalk out your expectations of the probabilities of a stock moving to different price levels. If these expectations differ from the assumptions of standard pricing models, that means there are favourable option bets available. This holds true only if your expectation tends to be more accurate than random guessing.

Claudio Guazzoni: Eliminating The Downside

Claudio Guazzoni started with the simple idea of buying restricted stock at a discounted price. This is how he built his enterprise one deal at a time. He raised his initial stakes from others.

The relevance to investors is not Guazzoni's technique, but rather his premise that "every period has its opportunities where you can find investments that are extremely discounted and have a well-protected downside." 

Guazzoni's strategy of buying restricted stock is a perfect example of the principle that opportunities arise when the market participants are treated differently from one another.

In this case, the owners of restricted stock were not allowed to sell their shares, whereas ordinary investors were allowed. This contrast in the treatment of shareholders provided the opportunity for Guazzoni to buy restricted shares at deep discounts. It may have been a very simple idea but still a highly profitable one. The point is that it is not important to complicate things to achieve success.

Guazzoni's entire career has one theme: looking for undervalued assets. All the strategies he has worked on involved buying undervalued assets. The idea of buying assets at prices below their true value does not only generate profit but also limits the downside risk. According to Guazzoni, his philosophy includes eliminating the downside. If one can eliminate downside risk, he can make money at the end of the year. 

David Shaw: The Quantitative Edge

David Shaw was one of the most brilliant mathematicians, physicists, and computer scientists. His purpose was to combine his quantitative skills to consistently extract profits from the world's financial markets.

He seeks to profit strictly from pricing discrepancies among different securities, avoiding risks associated with directional moves in the market. His trading approach requires highly complex mathematical models, vast computer power, constant monitoring of worldwide markets by a staff of traders, and near-instantaneous, extreme low-cost trade executions, and is beyond the reach of the ordinary investor. 

One concept that came up in this interview was the idea that a market pattern (or inefficiencies) may not be profitable when evaluated individually. However, it can still prove to be a profitable strategy when combined with other patterns. 

Although Shaw ridicules chart patterns and technical indicators, a similar idea holds good that a combination of indicators might be a useful model to trade, even when the individual indicator is worthless when used alone.

This effect would apply to fundamental inputs as well. For example, a researcher might check ten different fundamental factors and finds that none can be used as price indicators. This does not imply that these inputs should be dismissed. Even though the factors don't provide a meaningful prediction as an individual factor, it is very well possible that the combinations of these inputs prove to be a useful price indicator.

Another important principle is that of an appropriate methodology in testing trading ideas. If a trader tries to develop a systematic approach, then he should avoid data mining through computers. This means it should not let the computer run through millions of inputs to give out profitable patterns. He believes such patterns have no predictive power because patterns can even be found in random data.

He avoids this problem of data mining by running a theoretical hypothesis before each computer test and by using rigorous statistical measures to evaluate the importance of the results.

Steve Cohen: The Trading Room

In the seven years of money management till 2001, Steve Cohen has established an average compounded annual return of 45%, with only three losing months. The worst being a tiny 2% decline.

He has a real sense of where the market is headed. This real sense or gut feel is the filtration of experiences and lessons learnt from thousands of trades.

Cohen asserts that all traders make mistakes but they limit the damage. A common mistake made by traders is that they go short with a very big position compared to their portfolio. Hence when the stock goes up, it becomes difficult to handle and they end up panicking. To develop risk control skills, one may take years of experience. 

For novice traders, Cohen advises that it is important that one’s style of trading should match his personality. The trader should know whether he is a day trader or an investor. If he is a day trader, then he should better not try to behave like an investor and vice versa. This is because the market cannot be controlled but their reactions can be. Hence, it is necessary to choose an approach that is comfortable.

Another important piece of advice he offers is that if the market is moving against you or trade is going wrong, and you have no idea of the reason, then it's better to square off half the position.

He believes that a single style or approach cannot provide profitable results over a very long period of time. To become successful, traders will have to learn and adapt continuously. Cohen himself tries to constantly learn about the markets. This helps him to master confining stocks, sectors and trading styles. For him, trading is an evolutionary process.

Ari Kiev M.D.: The Mind Of A Winner

Ari Kiev is neither a Market Wizard nor a trader. Doctor Kiev was the first psychiatrist to be appointed to the U. S. Olympic Sports Medicine Committee during 1977-82.

His advice is extremely important because one of the world’s greatest traders, Steve Cohen attributes his success to Dr Kiev.

He has authored many books including Strategies for Success, The Psychology of Risk and Trading to Win.

Doctor Kiev explains that it is important to have belief in what you are doing. Believing that something is possible makes it achievable. You have to commit to work towards it. If one wants to achieve an exceptional goal, then he will have to move out of his comfort zone.

On winning, he advises traders to first define a target, then construct a strategy that is consistent with that target. A set of discipline and risk management guidelines must be followed. He explains that the objective of setting targets is to create a benchmark for performance evaluation. Then trade, track and evaluate your performance. It will help focus on correct things that are not being done and also on wrong things that are being done. Every individual needs to monitor his performance to make sure he is moving in tandem with his target and if not, then to get diagnosed for what is holding them back. 

Wizard Lessons

The important traits and factors required for successful trading can be summed up as follows:

• There is no single true path.
• Be flexible and trade your personality.
• Develop a trading philosophy and keep track of your market observations.
• Patience, confidence, hard work, and risk control.
• Be an innovator and not a follower.
• Accept losses and limit downside.
• Verify every fact yourself and set a goal.
• Ego and emotions have no place in trading.
• Use common sense and define high probability trades.
• Pay attention to catalysts and insider information.
• Popularity can destroy a sound approach.
• Accept that it takes time to become a successful trader.