Excerpts from an interview:

Omega Research: Jack, in your own words, how do you define system trading?

Jack Schwager: Well, the essence of system trading is that it applies a set of specific rules for getting into positions, whether it’s on the buy or sell side, and every bit as important for getting out of those same positions. And there is no ambiguity. When certain conditions in the market arise that fulfill those rules, you enter the trade and when certain conditions exist that signal the exit of the trade, you liquidate it. And that unambiguous approach is what I would call systematic trading.

Omega Research: So do you believe that the systematic approach to trading is one of the best ways to trade successfully in today’s markets?

Jack Schwager: Well, I think it’s a very good approach for many people and it’s a matter of personality. For someone like myself, who does not like or do well under the emotional pressure, I think it’s a very good way of trading markets and it’s one which I think many people would find works well for them.

Omega Research: Did you find in your interviews with the Market Wizards that any of that group of elite traders used the systematic approach to trading?

Jack Schwager: Some of them did. A couple that come to mind are Ed Seykota, who managed only a handful of accounts and kind of while ago, but he, over the course of about 20 years, transformed accounts from $15,000 to $15 million using purely systematic approaches. There was another trader by the name of Larry Hite who had a company, Mint Investment, who at the time I interviewed them, were managing close to a billion dollars. So a couple of the traders who did have particularly impressive results did use purely systematic approaches. To be honest, though, the majority did not and that is because a lot of the market wizards had very kind of almost intuitive types of approaches which don’t translate into specific rules. And that is also a skill element which for most people wouldn’t make any difference anyway because they don’t have that natural instinct or talent to trade the way that these people do. So it still would mean, for most people, that a systematic approach might be the best avenue to start out with.

Charlie Wright of Fall River Capital offers some pearls of wisdom about trading as a business:

“Thinking of trading as a business has helped me enormously as a trader. It puts everything into perspective and helps me deal with my own psychological difficulties with trading execution. Once I stopped viewing trading as speculation, my trading improved. Once I realized that I was not going to get rich quick, that trading was not easy money, my trading improved. Once I realized that almost no businesses are successful overnight, my trading improved. Once I realized that I had to make an investment in the business, both in terms of my own education and in equipment and working capital, my trading improved. One concept that is commonly taught in business schools is that of ‘barriers to entry.’ This is a very simple concept that has important ramifications as you consider trading as a business. The basic principle is that the higher the barriers to entry in a business, the higher the investment to establish market share but ultimately the higher the margins and profits. A good example is the beer business. Controlled by several large breweries, it would be financially very difficult to start up a new brewery and acquire significant market share. When Phillip Morris bought Miller, they spent over a billion dollars to acquire the business and do the advertising and promotion necessary to obtain market share. But Miller was successful, and when they achieved the share of market they wanted, the profits were outstanding. The reverse is also true. If an industry has low barriers to entry, and there is a relatively small up front investment, there is much competition for profits and lower margins. This is the case for many service businesses, real estate brokers, securities brokers, cleaning services, etc. Restaurants are also a relatively low investment business. All you need is some decent space for tables and some cooking equipment and you are in business. However, the competition for customers is intense and thus the margins are low. There is no good or bad when analyzing barriers to entry for a particular industry. If the investment is low, the stress comes from being smarter and superior than everyone else at making money. If the barriers are high, the stress comes from taking the large financial risk and the uncertainty of obtaining the target market share. Either way, the business is always difficult. Trading is a low barrier business. You basically need a computer, a broker, and a modest amount of capital and you are in business. But because of the low barriers to entry, the competition for profits is very high. There is no such thing as gaining market share. Many people wrongly conclude that low barrier businesses are easy to start and trading is no exception. Many new traders think that trading will be easy and they will get rich quick. Experienced traders know that this will not happen. Trading is as difficult as any business I have ever been involved in. The main point to remember is that trading is a business with low barriers to entry. This means that the competition for profits is very high and you will have to be smarter, more disciplined or more creative than the majority to make money.”

Why Capitalism is Inevitable

Michael Mauboussin produced some great writing while at CSFB. Here is a complete list of all white papers from the Consilient Observer.

“I define fundamentals as being whatever market participants are thinking about the market. These ever-changing fundamental stories may be better described as being transient investment themes. The history of markets demonstrates that the extreme of every economic era is defined by a compelling concept that becomes so simple and so popular that it effectively becomes a slogan. Memetics, which is the study of the propagation of information, provides some insight into this phenomenon. A meme, similar to a gene, is an information code that is transmitted from person to person. The semiotics memetics model suggests that when these transient investment themes enter the propaganda realm, they finally lose their power to attract new investors into their paradigm. This understanding has identified extremes such as the “Fantasia” deflationary climax in the fall of 1998, the E*Greed extreme of 2000…”
Woody Dorsey

Over the course of researching and writing the book, Trend Following, I met with a wide range of traders, investors and market experts. Most of the players I met with were straight shooters who were open, direct and honest. I found it refreshing considering that for the past two years we have been bombarded with constant bad news about corruption, greed and dishonesty in practically every industry from natural gas (Enron) to finance, accounting, telecom and so on. So it is nice to know that there are entrepreneurs with great vision playing the trading game to win, but also playing with a sense of integrity. However, that does not negate the presence of those who play the game by their own less forthright rules.

For example, as has I have noted in my book and online, there is a huge disparity in the success of Richard Dennis’ students. Some were big winners, but, some were big losers such as one former “industry player” (a student of Dennis) who turned out to be an extreme disappointment.

During my first meeting with this person, he told me that he was launching a new airline. At the time I had no idea whether or not he had the ability to do this, but my limited knowledge of his background at that point made me take him at his word. So I suspended my judgment. Unfortunately my “wait and see” attitude disappeared rather quickly for in the next few hours it became painfully obvious that this individual did not have the resources to start an airline. In fact he was most likely finding it difficult to pay rent each month. Wow I said to myself — what a contrast to other students of Richard Dennis. Here was a student who had had some success, but now was in debt with serious delusions of grandeur.

The moral of the story can be found in human behavior. You can have all the training in the world from the world’s best teachers, but if your motivation and ability to follow through and stick to it are not there and if you have lost your moral compass, assuming you had one to begin with, you will probably end up like this former student of Dennis down and out.

You should work to have an understanding of the whole of Trend Following trading:

Listen to MP3 audio.

One source of trends comes from so-called “Shock-Free Monetary Policy”.

So you sat down at your PC and came up with a super-complex new trading strategy that mints money in everyone of your hypothetical back tests?

Watch out as Andrew Lo warns:

“..the first [rule of thumb] being that no matter how complex and subtle a strategy is and no matter how sophisticated it might be, it has to be possible to describe that strategy in relatively simple and intuitive terms to a sophisticated investor. In other words, regardless of how subtle and impressive and sophisticated the strategy is, I’ve never come across anything that couldn’t be described in relatively straightforward terms as to what the value added of that strategy was, whether it was risk transfer, superior information, better executions, mean reversion, and so on. So, I think that’s the first principle that I think is obvious to many investors; but to some who are not as familiar with quantitative methods, they may feel that they’re just not really smart enough to understand. But, I think that’s just not the case. The second rule of thumb is that you’ll never see a bad back test. Now, again, this may be obvious to the experienced investor, but there’s a very specific set of quantitative models that you can use to be able to gauge the bias that comes about from selection. The fact is that when I’ve talked with investors about doing due diligence, I’ve often said that, you know, whatever back test you’d like to see, I can certainly produce it for you. If you torture the data long enough, it will basically tell you anything you want…”
Andrew Lo

View Flash.

Video from PBS well worth watching.

“I asked him, what is it you guys are doing at LTCM (Long-Term Capital Management), and Myron (Scholes) characterized it in that way of his. He said, well you know, one way is to think of us as a gigantic vacuum cleaner sucking up nickels from all over the world.”
Merton Miller
Trillion Dollar Bet
NOVA, PBS, February 8, 2000