Nithin Kamath, co-founder of Zerodha caught up with Jack Schwager for bringing Fundseeder to India and used the opportunity to interview him. Following are the highlights of the interview.
One of the first books that a budding trader or investor reads is Market Wizards. The book consists of a series of interview of professional traders who trade in all financial markets including equities, currencies, commodities and treasury. Most successful traders have Market Wizards at the top of their must read books.
Jack Schwager, the author of the book, has written many books in the Market Wizard series all being interviews of fund managers and traders. Schwager himself has been a trader and a fund manager. Having written a number of bestsellers, Schwager has co-founded Fundseeder which aims at helping fund managers.
Nithin Kamath, co-founder of Zerodha caught up with Schwager for bringing Fundseeder to India and used the opportunity to interview him. Nithin has himself been a stock trader for over a decade before founding Zerodha, India’s first discount brokerage, with over 6 lakh clients and contributing nearly two percent of exchange volume.
Following are the highlights of the interview.
Nithin: You are an author but you have also traded most of your life so, I’m just curious to know the kind of trader you were. Were you actively day trading?
Jack Schwager: Day trading is one thing I’ve never done or been attracted to. I went through different phases. I started out at the very beginning when I didn’t know anything which is not to imply the methodology is wrong, it is just that it was wrong for me trading on the fundamentals in commodities. Eventually when I became familiar with technical analysis and risk management associated with that and I pretty much became a chart oriented trader. I had created some trading systems for a brokerage firm that I was the director of research for. I was even a CTA for a small period as a partner. I was involved with the system trading and trend oriented systematic trading and later on I combined that with some counter trend to lessen the volatility.
There was nothing wrong with the system or the approach but I thought I’d like systematic trading more it would completely remove the emotions. But what I found is that I didn’t like not having the control. So, if you are truly trading a system then you have to stick with the system.
For a system to work correctly, particularly if it is primarily generating its profits by trend following and if it really designed correctly it's going to as a byproduct give you periodic large drawdowns. I was just not comfortable with that, particularly surrendering the decision process to a computer.
So, It was not like you knew where the liquidation signal would come, it could vary so you didn’t really know what the amount of risk would be when things were going bad. So, ultimately I ended up going back to chart analysis with risk management. Chart analysis I should explain is not just a matter if looking for classical chart patterns. It's a matter of that and like I wrote in technical analysis book and the futures book, I consider failures of patterns actually to be more significant than the patterns themselves.
It was also about being willing to trade the counter trend in the sense that where I would have let’s say an objective for a trade where I would think the move was largely done and there would also be other factors that would suggest resistance and you got similar conclusion on 10 years and 1 year charts and maybe had retracements that coincided.
So, when you had multiple factors coincide for a trend running out, not that I was picking a top or a bottom but rather saying that this is a reasonable area for the market to stall and those were also the type of trades I would take.
The one thing they all has in common is that every trade is accompanied by at least in the futures market by a protective stop when I took the trade. So, there was no reason to be concerned about so called selling into a rally and buying into a decline because those trades had every much as the same type of risk protection as if I was going with the trend.
They weren’t so much as trying to pick a top or a bottom but it was simply understanding that all moves has a certain amount of potential and saying this is a reasonable area to look for the trend to stall and at least correct. Sometimes i would go straight into it by looking for signs of the market stalling. So, that’s essentially my pathway and what I ultimately evolved to which is not to say it’s the right but what was comfortable for me.
Nithin: I’ve heard about your transition from being a fundamental trader to becoming a discretionary technical trader because of all the risk management benefits you got from following technical analysis. Can you talk a bit about this?
Jack Schwager: It’s kind of interesting. I am not pushing anything but I've interviewed traders who made millions or hundreds of millions on fundamentals so I am not knocking fundamentals and it’s right for certain kind of people. I’ve seen both kinds, traders who have done tremendously well with fundamentals and traders who done phenomenally well with technical.
But for myself, the problem I always had with fundamentals is that inherently in the approach, the more wrong you are the more sense it makes to add to the position. So, if I think that some market is underpriced let’s say at $6 and I go long because my fundamentals tell me that this is cheap. If this goes to $5.50 and nothing has changed then it logically means that it is an even better deal and that I should buy more and to certainly not get out.
Not only does fundamentals not have any intrinsic risk management, by its very nature anti risk management. Because if you are trying to assign a value to an item and if it is going against with any change and I emphasize without any change in the facts as a fundamental trader your logical step would be to add to a losing position.
This from a risk management perspective isn’t very good. Whereas in technical if you are going with the trend or even against a trend I can say that I can expect the market to fail in this zone and if it goes beyond the zone by a 100 points then my call is wrong and i am out. Even if you are going with or against the trend you can apply risk management because technical analysis establishes an area where you want to either buy or sell.
Any reasonable approach you have should allow for asking the question “Where am i wrong?” and that allows for placing a risk management stop. Whereas in fundamentals the market going against you is not a sign that you are wrong but rather a sign that you should put on more.
So, that's the crux of why I completely transitioned away from fundamentals but again I've interviewed many people who think that technical analysis is a bunch of malarkey and have done tremendously well on fundamentals. So it’s really about what's right for you.
Nithin: From the people that you have come across and interviewed, have technical analysts in general made more money than fundamental analysts or have you seen any form of trend?
Jack Schwager: Firstly, I did not pick any biased sample sets while I interviewed people. What I saw was that the practice of trading or picking stocks depended on whom or which type of person I asked.
What I have also realised is that, the number of people who followed fundamental analysis or technical analysis and made money or not did not matter and does not prove anything in the long run. I did realize that the idea of either one of the beliefs being right or wrong did not exist and each approach worked differently for each different individual.
Some people may be fit for doing technical analysis while trading, while some may be fit for fundamental analysis. Some may even think that day trading is ridiculous, whereas some may gravitate to futures or stocks or systematic trading, or discretionary trading and it may be different for each specific trader or investor. There is and will not be any specific way of trading and there is only a right way for each person.
Nithin: Talking about systematic trading, retail traders don’t have access to as many tools as institutional traders and most retail traders do not know about usage of programming while trading. Zerodha are trying to build as many tools as possible for retail traders in India. Do you think back testing is necessary and should be done?
Jack Schwager: Yes, back testing is necessary if trading is based on a specific rule or a defined set of rules. For example, if I as a trader buy based on the rule where I take 10 days moving average of a stock is more than 40 days moving average, then yes, back testing should be done. If money has been made in the past using a specific set of rules, it does not guarantee that money will be made in the future using the same set of rules. What can be said though is that, if it did not work in the past, it is highly unlikely that it would work in the future. If a trading strategy can be defined by a set of rules, then it should be back tested.
Nithin: Talking about risk management, I have heard you say that you shouldn’t take more than one percent risk on a trade. I mean, if someone’s kind of working on a small-ish portfolio size, how does he ever get big by taking a 1% bet?
Jack Schwager: You know, the fact that the reality of limited resources doesn’t change the truth of the fact that bet size should be small. I mean, that’s a mathematical truism, and the mathematics and the markets don’t care about how much you could afford to...how much money you could afford to trade, or lose.
The reality is, if you want to be successful, your trade size should probably be 1% or infact less. As I’ve gotten older and I’ve read my original books, when I produced audios for them, and listened to the audio, I think it was New Markets Wizards, there was this chapter I was listening to, and I came across this line where somewhere I said in my conclusions in the summary of the book, that one of the things is you should limit your risks to very small levels to about, I think I might have used about 1 or 2 percent or less. And, what I thought was, after listening to the old book, in the book I would not have changed anything except 2 things. There were actually 2 things that struck me that I would have changed if I wrote the book now, which is more than 20 years later. In the whole book, there were like 2 things.
One was that line about 1 to 2 percent, now I would feel it should be one percent maximum and ideally half a percent or less.
And the other one was I think I had an analogy somewhere in there. I think it was mine or a trader’s, about using dieting as an analogy like how everyone knows it’s the right thing to do but it’s the matter of doing it. So, I think this was the trader’s analogy. He was using the analogy like you can exercise, everybody knows what you need to do. You exercise, you don’t eat fat, and I remember listening to that and tripping over it saying of course now, the science shows that it was wrong, and that you don’t eat sugars.
Nithin: So, all the traders you interviewed, do you think a lot of these guys actually followed this 1% or 2%?
Jack: No, no. Not all of them, but a lot of them. Well, they all, I wouldn’t even say they all had rigorous risk management because some of them didn’t use risk management in that sense. In some cases, their ability to identify value stocks and hold those positions and diversify among positions was good enough for them to realise extremely good gains with acceptable draw downs.
So, somebody like Martin Taylor, who at the time I interviewed, this was for the last full Market Wizards book, the hedge fund market wizards. I think I interviewed him in 2011. At the time, he was managing 7 billion dollars and he was in the process of closing up all his funds. He wasn’t closing up because he had a problem, he just had gotten tired of managing for investors, had enough money and was just going to have one fund with his own money and except a few friends and family and maybe a few investors he knew wouldn't bother him and that was that.
But he had achieved an extremely good track record over many years primarily initially in emerging markets but then he branched out also doing establish markets as well. And he specifically closed these funds because he didn't want to have to manage to certain maximum loss per month. Too many, like institutional investors, would have rules that they can't accept the manager would lose like let's say six or seven percent a month. Well he realized that there were going to be months that he was going to lose that much because he had a position that was seeing interim losses.
I interviewed him doing during one of his worst drawdowns he was down about 14-15 percent and is the biggest position by far and the one that was causing all the pain, I'm sorry, that's the wrong word, the one that was causing the losses at least at the moment was Apple. And he would never in a million years consider giving up on Apple.
I'd never seen anybody so wildly bullish or bearish on a position as he was on Apple. To put it in context, this was when Apple was $350 before the split and it was six months after that interview was 700 dollars. And the reason he was so sure was because he knew his numbers very well.
He saw what all the analysts were predicting. He saw that they were basically extrapolating previous earnings forward into the future and that's how they were getting their valuations. And he understood that what they were missing was the giant explosion in sales that was gonna occur overseas, particularly China. He was confident that that was gonna happen and so something like that would never have a risk, you know, money management risk, and if he did, this whole approach would kind of crumble.
So there are approaches, there are managers out there which are exceptions. But hey, that's somebody who's like truly an expert. So it's like you're going down an expert ski hill. You know, as an expert it can go down at and what may seem like an unsafe speed. That doesn't mean it's okay for somebody who's taking their first lesson to go up and try to do the same thing.
Nithin: Right, got it. So when you say what I like less than one percent, so this is a maximum loss on a trade or this is actually the money you put on the trade?
Jack: Oh, no no. None of the money that's margining the trade it's kind of irrelevant. All that counts are the money you would lose on the trade if you're on. So it doesn't make a difference how much money it is. It's just that your loss on each trade should be limited to about one percent per trade.
It could be more than that if, realistically, you know, you can say you have a hundred thousand dollars but you only have ten thousand in the account. You're really thinking in terms of your trading it like it's a hundred thousand. Because, you know, well, when you need more margin, you'll put it in. Okay, but if that's true, if you're not, if it's not a matter if you're kidding yourself. But if you truly think of your stake as $100,000, and you only have ten thousand dollars in the account, well, it's fine.
You find a thousand-dollar risk on the trade because you're really thinking of your stake as a hundred not as ten. Whatever your true stake is whatever you to account size is doesn't all have to be in because you may be adding margin as you need it that's what you're measuring against. And one percent is this type of thing. So you could be wrong a number of times and not do undue damage. Too many people think ‘Oh, I only got five percent on a trade it's not a big deal.’ Well, a few 5% losses and you're out of the game.
Nithin: Right, absolutely. So I've heard you say that Ed Thorpe is your favorite amongst everyone you interviewed and I think one of those things that he introduced to the world was the bet sizing thing, right? So do you think it's important I not to just evenly bet all trades? You know, kind of bet more on trades…
Jack: Umm..yeah..Thorpe was, yeah, it's hard..people ask..if it was my favourite and like, who was the most impressive person or achieved the most, I’d say maybe it was Thorpe but it's tough because there are so many other people, you know so many people who did phenomenal so it’s a tough question.
The one thing about Thorpe was, that almost nobody else can match except Jim Simmons of Renaissance is maybe even better, but Thorpe when he ran his hedge fund had such remarkable, in 19 years only 3 losing months and all under 1% and his gains were larger, and I did a simple binomial probability calculation with conservative assumptions, conservative because I consider wins and losses equal sizes when his were larger. I calculated that the probability of his results were equivalent to picking one atom from the mass of the earth, not the surface, but the entire global mass and then randomly picking the same atom. That probability is actually larger than Thorpe’s record, if the markets were that efficient and everything was random. So in that sense, there is nobody else I can say something like that about.
He was more efficient than anybody else that I interviewed. He’s just a brilliant guy and a PhD mathematician. He developed the Black Scholes model or the mathematical equivalent of that years before the paper was published and used it himself to make money, he invented a lot of strategies like statistical arbitrage, vertical arbitrage, the first to be doing it.
But he is famous to the world because he wrote a book “How to beat the Dealer” telling people how to win at casinos at Blackjack. His insight was that even though that the casinos have the edge even when you have the perfect cards, if you varied your bet size, this goes outside their risk management, you are betting more on higher probability hands, then you can take a game of a negative edge and turn it into a positive edge which is kind of a fascinating idea. However, you cannot do it now since they have changed the operations thanks to Ed Thorpe but back in those days, you could have done it.
And in trading, the edge is if you have multiple types of trades, you can analyse that you are good at a certain type of trade compared to others. You can take larger stakes on those which are more reliable. The bottom line is you want to bet bigger on the trades which you are good at.
Nithin: The other popular thing to trade in India is the derivative market (Futures and Options). The leverage is high, which is more like a weapon of mass destruction. How have all the traders who you have interviewed use leverage. Are they extremely leveraged or use no leverage?
Jack: For most parts, there isn’t much leverage. If you are using it, going back to the majority of traders, which is rigorous risk management like we talked about the example of some people who didn’t use it as it wasn’t consistent to their product but they had other things to compensate for it.
But for most people, risk management is important and if you have appropriate risk management then leverage is important because if you are leveraging, you are taking a much larger position and your exit point is much closer. If I’m going risk one percent on a trade and I’m going to trade 5 times as high as I would normally and I normally risk 1 percent for that size, my target for the stock is certain distance from the current price, since my position is 5 times as large, my target is 5 times as close, that sounds like the right thing to do.
But there might be trading setups where the market is extremely narrow range and volatility is going way down and you have reasons to believe that the market to explode on the upside. In a situation like that you might take a larger position, because you can define an exit point which is much closer because you are saying, the reason I’m doing this large trade because I think the market is going to be on the upside out of here and I have a very close stop point which I can identify as meaningful.
If it goes on the downside more than a specified amount, then I’m wrong and I’m out. So it’s a situation where you can define a reasonably close stop and with a high confidence on the trade, you can put on a much larger position but your exit points could be much closer than normal.
Nithin: Got it, makes sense. So for one successful trader you’ve interviewed, there could have a thousand traders who didn’t make and a lot of this you’ve interviewed have gone to zero and bounced back multiple times. So when do you think a retail trader should stop trading?
Jack: Yeah! There a number of traders who’ve completely wiped out before they were successful. I remember my interview with Michael Marcus which was the first chapter of the Market Wizards book and the tale of how many times he failed. I literally asked him ‘Why didn’t you think you should stop trading? What made you think you could trade?’ But he just felt he could do it and he just was not going to give up and that’s something that comes internally and nothing something that you find in people in general. What I’m saying is if you don’t allow yourself to lose too much each time as a trader, you won’t damage yourself as badly. So that’s about not risking too much when you enter the market and yeah, some people are not going to be cut out for trading, there’s no question of that. Not everybody is a born musician right?
Some people would have a natural talent or inclination and some people don’t. And the talent can be different, like Marcus, is an intuitive trader and somebody like Thorp is a pure quant guy, a mathematical genius, he would just figure out inefficiencies in the market that nobody else had realised and that is why he is such an incredibly lopsided win to loss ratio like 290 win and 3 losses (something like that).
Because he was able to use his mathematical skills and creative analytics to create strategies to have a very high probability of success. It’s not a trading talent the way we think it is as but it was a talent that could be exploited in the markets and the people who succeed had that kind of talent, whether it is intuitive or if it is quantitative with ways to translate it to the markets but it is a special talent and not everyone is going to be a great trader or even a moderately good trader.
People really do not educate themselves before they start trading, understand the right thing to do, have appropriate risk management, things I recommend in my books, they’ll have a reasonable amount of success. With experience and risk management, most people will end up being profitable, there still will be only a small percentage that will be really great but doing everything right will get you to profitability.
Nithin: Trading as a full-time profession, with the money in, basically to keep the family running puts an added pressure to perform which eventually will not be such a great thing for a trader, so what do you suggest someone should have a separate income before they begin full-time trading.
Jack: It’s very hard to earn a living trading but some people do it. I’ve seen a few traders who do it, a friend who lives in Colorado, Peter Brad, who has a blog and a recommendation site. He puts his own trades on and does it real time, was up around 35% last year, but he’s very big on chart analysis and risk management and is actually quite same in the way we think and look and the markets but he’s much more skilful and he has earned his living as a full time trader for 40+ years but I could never do that. I would be thinking what if I lose money this month, how am I going to pay the mortgage, it’s not for everybody.
I think for most people its financial pressure. I’ll give an example of a great trader of all time, Stanley Druckenmiller, a legend, he run George Soros’ Funds for quite a number of years, even the main fund, when George Soros was in eastern Europe, when the wall came down, when Germany converted into a democracy, spending lots of energy in those interests, the person running the shop was Druckenmiller. A lot of the quantum fund results in those years were primarily because of Druckenmiller.
But Druckenmiller ran his own hedge fund close to 40 years and compounded about 30 % a year, made an enormously great record and there was a point in his career where he didn’t have much money and his expenses were hung up and he was going month to month and the business wasn’t generating enough money to cover the expenses. He had the idea that interest rates are going to go down and he took a really large position.
This was in 1979-80 which was basically the peak of the giant bull market. He missed the top by about 10 days but he was stopped from the trade as he did not have money to hold the position and he had to win on the trade. He is one of the great traders of our time, one of the great trading calls of our time by picking nearly the exact top of one of the biggest bull market I’ve ever seen and despite that losing as he had to win on that particular trade. You have to win if you want to pay your mortgage on time, which itself is a recipe for disaster.
So you can’t ‘need’ the money, you need to go ahead and build a certain ‘financial cushion’ and then you if can afford to take a year or two to try and make it as a trader, you have something to fall back on, your life can go on as always before, you know there are circumstances where you can always try to do it.
But for most people trying to go just flat out, trying to earn a living as a trader, without having any substantial financial resource and needing to be profitable to support yourself, that is not a good recipe.
Nithin: Absolutely, now the first book 20 years old..
Jack: Its almost 30
Nithin: ohsorry..almost 30. Do you think the rules of the game have changed, I mean with AI, the HFTs, you know, if you were to write the market wizard today, do you think, the same thing you wrote 30 years back, would it still apply?
Jack: It wouldn’t have trading floors in it, which make some of the best stories, It wouldn’t have clicking quote boards, you know, which went away 20-30 years ago and certain more things, like all electronic trading didn’t exist, the markets have changed, oh computers! back when I wrote the market wizards, we had computers but it was still the early on, the first market wizards book, PCs were already there, but computing power was way lower, it was still the earlier days.
So a lot of things have changed, in the markets and related to the markets, but certain basic things don’t change and that’s the important stuff, so, all the risk management stuff..a lot of market observational stuff, bubbles and busts, a lot of elements of the markets really haven’t changed.
And so, the most recent market wizard book I wrote was ‘Hedge Fund Market Wizard’ and that was only 5 years ago and that was after all these changes and in fact that book has a long set of, like 50 rules/bits of Market wizarddom, you know, rules picked up from the market wizards, may come from that book, many come from all the market wizard books, and any of those rules could’ve been written 30 years ago, so for the important stuff, in that sense I don’t think that the markets have really changed.Nithin: Got it, and then what do you think is the most important psychological trait to be a successful trader, trading has got a lot do with psychology.
Jack: Right, there are a number of important psychological traits, you want to be unemotional about trading, right? If you’re trading for excitement, take up another sport another endeavour not a sport or don’t take up gambling as an endeavour because you think markets have a better shot.
Basically you have to be unemotional, trading if done right should be boring, I mean the actual act of trading, you know putting on and taking off positions, and holding positions. The closer to boring it is, the better you are as a trader. If there’s a lot of excitement, there’s a quote I used, not used actually was something I learnt when writing the little book of market wizards. The front quote I had there is from a free climber and I thought it was so pertinent to trading. Anyway, for those people who don’t know what free climbing is, it's basically people who climb sheer cliffs, I’m talking about 2000-3000 foot sheared cliffs, and there are not many people in the world who do this, if you don’t know what this is it’ll become clear in a second, these people don’t use any protection, no ropes, that’s why it’s called free climbing.
And I mean there are people who climb with ropes and protection and those who don’t use ropes for assistance and that’s ‘solo’, but free climbing is basically without any ropes and protection – no protection at all, so these people will be 2000 feet up on a 90 degree angle wall hanging on by their thumbs and going up and no protection at all.
The greatest and probably the world’s best free climber Alex Honnold and he was interview by this American TV show called 60 minutes which is kind of a magazine, news magazine type show and the reporter asks him “do you ever get an adrenaline rush?” and he says “Oh no, if ever a get an adrenaline rush something is drastically wrong! It should be calm and cold” and I actually was watching that on TV I grab my remote, I stopped, went and got a pad paper and wrote that down because I never heard truer words spoken about trading although it had nothing to do with it, you know, free climbing has nothing to do with trading in that sense but it was absolutely true because people have this image of trading like from Hollywood, there’s all this testosterone and shouting and excitement and you know, the whole image is like a crazy wild sport, but in reality if you go watch a good trader, you better bring along something to read, you know.
Nithin: Absolutely! So finally, you know, if was a retail trader, like a lot of us, starting off, what would you advice..like 2 or 3 things?
Jack: Okay, well basically, here’s my checklist, you’re a new trader – first of all educate yourself, you know, forget about trading right away, first read books. Which books depends, you’ll have to decide that for yourself, you’ll eventually finds what resonates with you, what feels right and whatever and then try taking that knowledge and watching the markets and develop a methodology.
Once you’ve got a methodology – paper trade that methodology, now if you’ve gotten past all those steps and it seems to be working, take an amount of money to trade and decide on a cut-off point where the amount you lose isn’t gonna change your life or make you miserable and then you can begin trading.
And if you hit your stop point liquidate everything, go back to the drawing board see what you did wrong, keep notes when you lose a trade and on why you lost and oh, actually some trades you may do everything right and still lose money, on trades where you’ve followed your rules and everything.When you deviate from what you should’ve done, make note of that and then if you get knocked out review that, do some more research come back and try again. And every time you lose that maximum loss point stop and at some point hopefully you'll get to the point where you get ahead of the game enough to get your exit point to break even and that point you are now getting a free education from the markets and then you can eventually raise above break even. That sort of protects you and then you just keep on going and if you’ve got it all right at some point, you’ll be making more than you lose.