Only the zeros are different:

How Great Traders Go Bad

By John A. Sarkett, Developer, Option Wizard

Like a pilot, a police officer or a trapeze artist, a professional trader knows he must follow the rules just to stay alive. Usually this bracing thought is enough to focus the mind. Usually, this awareness suffices.

But occasionally the realization is lost.

Mistakes follow.

Losses mount.

An otherwise great trader succumbs.

A great trader goes bad.

How to avoid that tragic circumstance was the subject of a Futures Industry Association presentation in Chicago by Ray Kelly, professional trader and trading coach.

"Large traders trade more zeros than small traders, but the process is the same," Kelly says. "Both on the upside and the downside."

The catalyst for destruction, Kelly says, is most often ego.

Ego is the Ebola virus to the active trader.

There is an antidote, however: balance, humility, ability to accept being wrong.

Can you or I become infected? Of course we can.

What can be done to protect against ego and its devastating effects?

Kelly says pay close, introspective attention to the following four areas: self-knowledge, market knowledge, trading strategy and risk management. Answer the hard questions for yourself, before the market does. Like meditation, or exercise, attention must be paid each day for maximal effectiveness.

Self-knowledge

First, when you come in the door to your trading room, leave your ego entirely outside. Kelly defines ego as the sense of who we believe we are: a trader, a religious person, a father, a spouse, etc.

When the over-inflated ego gains the throne, rules go out the door. Egotism consumes natural and healthy caution, replacing it with an illusion of invincibility. An overdeveloped ego fells even the most successful, sometimes especially the most successful trader.

Expecting occasional failure, the trapeze artist practices with a net. He knows that he is not more durable than the concrete below. He knows that he can only exist in the high-flying environment by following the rules.

Trouble is, ego is not software that can be easily re-installed in the trader psyche. It is hardware. You and I are hard-wired with ego. Ego is self-identity. Ego never wants to to be ignored, left out, left behind. But sometimes it gets out of control and becomes self-absorbed and unrealistic. Sometimes you have to decide not to run with the crowd. But to do so, you have to go against your wiring.

There is something in the human that wants to believe in the hero, the guru, the champion, and for many to become that person. If you can’t become the hero, it is almost as good to run with him or her -- a dream come true! Usually, you can’t. You may only watch the hero from the stands or the balcony. But in the financial markets, you have the opportunity to participate directly or partner with the prospective hero. His glory becomes your glory. This prospect is so appealing, so motivating it will cause some of us to leave sense, common or otherwise, far, far behind.

Watch out.

In the 1980s, your author participated in a risk arbitrage managed account program a major brokerage firm, supposedly run by supertraders. Ascending to the hero’s podium, my account executive disclosed returns were expected to be 60% to 100%, but if only mediocre returns were generated, the return might be as low as 30% or so. Hundreds of trades (and commissions) later, I went through the laborious task of reconstructing the trading history and actual return of my account. It was 12%, exactly the money market rate of the day.

Contrast the swashbuckling image of the wanne-be trading hero with the wry and self-deprecating words of $1.5 billion Chesapeake Capital CEO and former Turtle Trader Jerry Parker (another FIA speaker) who says: "We know we don’t know what we’re doing." Far from true, (the meaning was we can’t predict rate cuts, market movements, the future), but this kind of modesty contrasts starkly with those offering spectacular returns and is undoubtedly a better and safer way to sail the market oceans. His trading methodology is to take trend-following type positions across many markets, expecting a few large gains to outweigh numerous losses.

Defining success

While the psyche is often looking for others to admire and emulate, it is not taking the time and effort to define success for itself. This is usually too much hard work. Easier and more fun to soak up the vibes from the hero or try to be one yourself.

What is success? For speaker Ray Kelly, it has been earning 200K to 300K each year, 40% returns, no drawdowns, and spending time with his wife and children, he says.

To define your own success, you must answer the questions:

Sound too easy? Have you ever actually done it? Kelly says, "Great truths unfold at the level of the student. As a student learns more, these questions become deeper and more profound."

Ray Kelly’s own introspection included working through a family background of an alcoholic father, and a very religious Catholic background. The religious background instituted the idea that it was evil to be rich. The instability in his home made him feel that somehow all the tension and insecurity was because of him. Therefore, he was not worthy of success. These powerful subconscious beliefs limited his success, that is, until he worked through them. When he resolved his own conflicts, he was able to progress to a higher level of trading success.

Do these subconscious messages really sabotage your trading? Kelly relates the story of a trading associate. His son died in a tragic accident. Blaming himself, he started losing significant sums the very next week.

Kelly further cites a university study that indicates a high degree of unresolved guilt among prisoners. The study concludes that prisoners committed crimes so that external activity would match internal guilt, not the other way around.

Other enemies of trading success: divorce, employment change, trauma, illness, or anything that creates emotional distractions or pain.

"If you owned a Testarossa, you wouldn’t think anything of having it checked and tuned on a regular basis," Kelly says. "Many trader egos are too big for a regular tuneup, however."

What to do? Of ten you do not realize that you are laboring under the weight of conflict. It shows up as poor performance or an inability to follow your rules. Losses are the inevitable by-product. What to do? It depends on the person and the severity of the problem. The best course is to constantly do introspective exercises. Know the resources you need before you need them. If you are already in the fire? Walk away. Take time off. Get counseling. Don’t trade in the financial markets until your conflicts are resolved. Do not make the expensive mistake of thinking it will go away if you ignore it.

Other questions to ask yourself about your state of mind, Kelly cites:

"Society teaches us to places blame, to externalize our failures," Kelly says. "Bad system. Bad broker. Bad quotes. Introspection is just too painful for most."

But to be a successful trader, you must go against the grain, and do the heavy lifting of introspection.

Approach the markets with equanimity

Kelly says to incorporate a "bottlecap" mentality in your trading. "Like Laverne & Shirley on the TV sitcom at the Schott’s Brewery, you put one bottlecap on after another, and then you go home and plan your excitement after work," he says. "Don’t seek excitement from the markets, or unhappily, you may find it."

Similarly, R. Jerry Parker says trading is a brick upon brick enterprise, but that Commodity Trading Advisor (CTA) clients prefer a "rock star" approach. "They want magic," he says.

Trading in some 70 of the most liquid 150 futures markets, patiently seeking break-outs, the Chesapeake system is a technical, trend-following system. The system will generate 200 trades per year, of which some six will pay for losses and generate returns, he says. Obviously, if you invest too much negative emotion in the 194 losers, you likely won’t be around for the six big winners.

Market knowledge

Market knowledge is the second major pillar you must depend on to avoid a market catastrophe. You must ask yourself, continuously:

Kelly cites as a successful example trader David Druz, who runs the successful Tactical Asset Management Fund.

Druz defines exactly what his system does: "My trading system captures the capital that hedgers use to defend positions." He has backtested and quantified it, and so he knows and expects that his system will generate 30% drawdowns. But over time, he has achieved excellent results because he is focused, he understands his markets, he has good money management rules, and a realistic time horizon within which he plans his trading.

Part of market knowledge is defining how much you expect to make in the markets. If you’re a typical newcomer, you may be looking to double your money. There is, for example, a popular phrase in options trading: "percent to double", i.e. the percent your underlying must move to generate a doubling of your options price. For a pro like Jerry Parker, CEO Chesapeake Capital, the answer is much more modest. His goal: 2% per month.

Your trading system

Third, develop your trading system. For Chesapeake Capital, the system is rule-based, trend-following, diversified, no bias short or long.

"This flies in the face of what clients want: graduates of fancy schools, huge research, an intuitive approach that knows what’s going to happen before it happens, e.g. be overweight in the stock market before an interest rate cut," Parker says. "But obviously you can’t know what’s going to happen before it happens, and maybe the rate cut is the start of a major trend, and maybe it’s o.k. to get in after. That’s our approach."

Kelly also advises traders to develop a trading system that the trader can follow. Asystem that is geared to their own personality and financial means. Kelly says, "If you have abstract ideas of what you want and how you are going to accomplish it, that is what you will get, an abstract result."

Test your system, he says.

Then attend to business: Do your homework every night. Your competitors do. Determine your answers the night before the market.

Manage risk

Fourth, and most importantly, you must manage risk. No matter how great your knowledge of yourself is, your knowledge of the markets, and how sound your system is, if you don’t manage risk, you won’t last.

Kelly says the successful, long-term trader must answer:

Losses are expected. You are not a bad trader if you have them.

Options broker Jerry Kopf, Benjamin & Jerold, Chicago, puts it this way: "It’s o.k. to be wrong. It’s not o.k. to stay wrong."

Kelly makes a distinction between what some people call "drawdowns" and what he calls "losses". "A "drawdown" is a loss taken within a defined strategy. It is part of the strategy. If you do not have a strategy it a loss. People misname the loss in hopes to avoid the pain and to deceive themselves." A drawdown is not a personal statement about you, it is an expected part of the business plan.

Unwilling to take a small loss? For those involved in the spectacular blow-ups of recent days, small losses no longer were acceptable, so they were forced to accept disastrous losses. Keep losses predetermined and small. At best, professional traders are right 50% of the time or less, so they must take only small losses. A few large losses would put them out of business, and the goal is to stay in business. "Money management is crucial," Kelly says. "This is why the exchanges have revolving doors -- for those who don’t master this critical skill."

Kelly notes that when losing, amateurs increase bet size, but professionals decrease size. Don’t try to catch up on one trade. If your system is sound, it will make money over time. You will recapture losses over time. And that’s o.k. Because you are looking for 2% a month, correct?, not a fast double play.

Two last questions. The bottom line.

Am I profitable and am I as profitable as I could be at my full potential?

If not, the reason why must be answered, changes must be made.

Ray Kelly repeated one messages over and over: "If you want to keep getting what you are getting, keep doing what you are doing."

Like the pilot, policeman or trapeze artist, you respect the rules of the game, you respect the boundaries, you respect how hard the concrete is, and how soft you are, and so you survive. The alternative is too costly in every way.

Sidebar: "Not picking up the phone"

A bespeckled, thoughtful speaker, and former accountant, R. Jerry Parker, CEO, Chesapeake Capital, spoke to the FIA gathering on industry considerations as befits his position with the $1.5 billion trading company. His address covered topics such as CTA vs. hedge funds, client relations, and the rise of electronic exchanges. He left half his alloted time for Q and A, however, and this is where attendees were able to gain some insight into his firm’s trading techniques. He paused thoughtfully after each question, but his answers were short, simple, direct:

On markets: "There to fool people."

On neural nets: "Learning from the last trades? Not effective for us. Markets are always changing."

On trading systems: "Methodologies have degraded over time. It is getting tougher and tougher to develop a successful system."

On counter-trend trading: "The reason for it is a lot of traders as well as clients don’t like trend following. It’s not intuitive, not natural, too long term, not exciting enough."

On gamesmanship: "I must protect myself from those looking for my stops . . . I have to be a better gamesman than that. Go ahead and look for my stops, you won’t find them."

On victims of recent market disasters: "They said ‘the market’s wrong, it’ll come back’. The market is never wrong."

On day to day trading: "Probably my best technique is not picking up the phone to close out a winning trade."

On his background as a Turtle Trader: "Having a mentor is important. It’s important to live with someone who says ‘it’s o.k. to lose money.‘"

On advice to young traders: "Get a mentor. You’re in it for the long haul."

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John A. Sarkett writes on and trades in the financial markets. Developer of Option Wizard software, http://option-wizard.com, he can be reached at jas@option-wizard.com.

Ray Kelly is a veteran trader, financial consultant, and seminar speaker. He recently passed away.

R. Jerry Parker is CEO of Chesapeake Capital, Richmond, Virginia.

David Druz is CEO of Tactical Investment Management Fund. He can be reached via http://www.tacticalnet.com.

Jerry Kopf is a partner in Benjamin & Jerold Discount Stock and Options Brokers. You may reach him via http://www.stockoptions.com.