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Mr. Schwager has written extensively on the futures industry and great traders in all financial markets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund managers of the last three decades: Market Wizards (1989, 2012), The New Market Wizards (1992), Stock Market Wizards (2001), Hedge Fund Market Wizards (2012), and The Little Book of Market Wizards (2014). His other books include Market Sense and Nonsense (2012), a compendium of investment misconceptions, and the three-volume series, Schwager on Futures, consisting of Fundamental Analysis (1995), Technical Analysis (1996), and Managed Trading (1996). He is also the author of Getting Started in Technical Analysis (1999), part of John Wiley’s popular Getting Started series.

E Tavares: Jack it is a pleasure and an honor to be speaking with you today. You are a reference, even sort of like a guru for us in the futures / commodities industry. Throughout your work – and we read much of it – you seem to have a slight preference for trading futures over stocks and bonds. Is that right, and if so why?

J Schwager: That’s absolutely true. First of all, I got into the industry as a commodities analyst. There were no financial futures, which now dominate the markets, in those days. Two years as an analyst then 22 years as director of futures research for several firms, with several years designing trading systems along the way. Much of that continues in different shapes and forms, so the bulk of my professional career has been in futures. That’s the primary reason for me.

The stock trading that I do has been sporadic. It’s very different from my futures trading, which basically consists of trades with stops to control risk. In stocks I will be much more contrarian, looking to buy things when they have been out of favor, at low or pummeled prices. Not because I know much about the underlying fundamentals, just that it’s a type of business where I believe the long-term downside is very limited irrespective of the technical/price chart patterns, and there is much more upside than downside.

For example, in late 2008 I had no idea when the whole collapse in the equity markets would end but it seemed to be the classic panic. So I looked to buy very long-term out of the money LEAPS (call options) in things that were totally crushed, like FXI (China ETF) or XME (Metals & Mining ETF). They were trading so low that it was unlikely they would lose much more value from there. I did not have any stops even if the whole thing went to zero so it is quite a different way of trading from futures.

In fact it’s a complete 180 degrees different. For me futures is more like trading and stocks is more contrarian, long-term investing…

ET: … like value investing?

JS: Sort of, although I don’t do all the related fundamental work. That’s not my forte. But I look at things like prices hitting fifteen, twenty years lows, it’s a pure panic, commodities will not go out of favor, China and India will continue to grow, and so forth. So it makes sense to buy now and put it away for a few years. And if it goes to zero it goes to zero.

If XME goes from 50 to 12, it can go anywhere but I figure that at 12 it probably will not go much lower, but not because I have done any fundamental work.

ET: You just published a new edition of A Complete Guide to the Futures Market, which we can’t recommend enough. The first edition came out in 1984 and was already considered to be a seminal book on the subject. What prompted you to write a second edition more than thirty years later? Is it because the markets have fundamentally changed and as such the materials needed an update?

JS: No, the catalyst was the publisher! They bugged me throughout the 1990s to do an update and I finally balked once they threatened to get somebody else to do it. Once I got started I ended up turning it into three volumes and 1800 pages.

Then they wanted another update but just in a single volume. I finally agreed but at that point started working with a co-author that I respect a great deal, and just went over his revisions. The original 1984 book was still relevant; in fact without wanting to sound immodest it was very good. I thought I did a good job the first time around. However, today nobody is going to read a book that is over 30 years old. I thought it was a shame to let it go by the wayside when ninety percent of it was still pertinent and the rest could be easily updated.

There were no real meaningful changes to the first edition other than market updates, expansions in some topics and contractions in others. There were no analytical approaches that I thought were wrong now. Actually, hardly anything of substance needed to change.

So the book was still pertinent, it just needed to be revised and updated and a new edition was necessary to bring it to the attention of a new readership.

ET: Picking up on the analytics point, markets do evolve over time right? As such systems need to adapt. Perhaps a good example might be the famed Turtles system, which supposedly produced many millionaires almost a generation ago, but seems to be much less applicable today. Do these market changes prompt you to revise your techniques from time to time?

JS: That’s absolutely true but in the original book, while I did not cover the Turtle system per se, I did talk about broader trend following systems which are still applicable today. Back in the 1970s and 1980s these systems used to work extremely well but as more and more people started to use them they lost their efficacy, like anything else.

However, my approach in the whole book was not to say “this works absolutely”. Instead, I explained why a system worked. If you are going to do systems development you need to strictly avoid hindsight otherwise the results will be meaningless. All of that is still pertinent today. The systems I presented then worked, but I chose them primarily for illustration purposes.

When you get down to the particulars, like the exact signals, you are quite right – these tend to change over time. You have to be willing to adapt as a result. What doesn’t change is the appropriate methodology for developing, testing and implementing systems. What also remains true is the types of inputs that you might use. Yes, markets change but the broad principles and methodologies to me did not seem like they needed a lot of change.

That’s on the technical side. It’s really the fundamental approaches that changed the most because markets tend to go through these structural changes and such fundamental models can quickly lose their efficacy.

ET: Related to that, perhaps as an effort to keep traders aligned with the evolution of the market one of the sections of your book covers the development of systems for futures trading, an area that attracts a lot of interest these days, since most people now have access to enough computing power and market data to do all sorts of analyses.

However, when retail traders go into the market they are up against hyper sophisticated funds which most likely have examined all profitable combinations ahead of everyone else. Some can even execute trades much faster. So how can those retail traders have any chance of competing successfully in the market, meaning being consistently profitable over time? Are there areas like picking longer timeframes, higher risk tolerance and so forth that can give them an edge over the big players?

JS: You are probably talking about a sophisticated retail trader, someone who has experience and know what they are doing, meaning having an edge and a methodology with good risk management. In other words, someone who has a reason to be trading which in my opinion excludes the majority of people, who don’t have any of that. They are better off not trading at all.

In that sense, how does such a trader compete against the super firms with not only tremendous computing power but also teams of PhDs? You can’t beat the likes of Renaissance and DE Shaw at their own game. They are using super sophisticated and effective quant strategies. You can’t do it that way.

But the retail trader may have an approach that works. There are so many different possibilities and combinations that people can still come up with something that works. This is very possible although much more difficult compared to the 1980s for instance, let alone the 1970s.

The other distinction I would make is between systematic and discretionary trading. It is probably more difficult for a retail trader to excel using a systematic approach but I think a large percentage of them would fall under the category of discretionary. That’s where I think there still is quite a bit of room to be profitable with reasonable risk control.

Let’s say that a trader is making discretionary decisions based on charts. You can program some patterns, like a breakout or even a more complicated head & shoulders formation, test a mechanical approach based on that and you will probably come up with something that is not that great. However, the human mind is actually extremely good at finding patterns, to the point where certain people who have a particular skill in noticing them – especially at the subconscious level through intuition – are able to use them as a signal that would otherwise be missed in a pure mechanical system.

In that sense, as an example, it’s not that the market is forming a flag pattern, but rather that it is forming that pattern in a broader context with some other chart features that improves your edge. Then you go in with a stop to control your risk, and you can very much compete against the big funds with that approach.

Also, the retail trader has one big advantage over the big funds and that is size. It is a lot easier to trade and put in stops when you are trading small size as opposed to when you are trading billions or even hundreds of millions of dollars.

ET: What about timeframes? It seems longer is better for the smaller investor.

JS: Not necessarily. That depends on the individual methodology of each trader. However, if you are thinking in terms of conventional things like trend following, then you are correct.

I think I had in the original edition of the book, but is certainly there in the current edition, the concept that longer trends are more reliable. In other words, longer term crossovers perform better than shorter term ones. And there’s a very good reason for that: they are very difficult to trade. Markets tend to punish traders who employ easier approaches and reward those willing to suffer some pain.

The idea is that yes, when you use a long term approach it is true that you are getting in much later on a trend and you also surrender a much larger portion of open profits when you are right – and not many people are willing to go there since both are painful things. However, it is also true that shorter term systems give you so many back and forth whipsaws – and you can test this empirically over time like I did – that on balance you are worse off. Those whipsaws more than offset the larger gains from getting in earlier and the smaller surrender of profits from getting out earlier.

In that sense trading over a longer horizon has more efficacy, but emotionally it is a very difficult thing to do.

ET: In the book you describe in detail various trading approaches, including technical and fundamental. And while expressing some preference for the former you suggest that it is up to traders to find what works for them. This is a crucial point that is often forgotten.

JS: When I give talks about trading and lessons from Market Wizards one of the foremost points I make, maybe the first point about what you should do, is the need to find an approach that works for you. That’s going to be different for everybody. So many people don’t realize that. They try to chase the best methodology or learn from somebody else.

It’s like you can have the most expensive suit but if it’s from someone who is not your size you will not look good in it. It’s much better to have a cheaper suit that fits you. It’s the same thing with trading. You can’t make someone else’s trading methodology work for you. Everybody has their own skills, preferences, biases, emotional strengths and weaknesses and all those traits suggest having a different approach for each person.

This is matter of trial and error and being conscious of what seems to work, what you are comfortable with, what you believe and so forth. Some people should use just technical, other just fundamentals and others a combination of the two. I can’t really tell anybody what would work for them – that’s a question only they can answer.

ET: What really moves the markets in your opinion? Some people say it’s just a random walk, a coin flip, and so impossible to make money since it is very hard to figure out if the next flip will be heads or tails. Others say there is a hidden structure, at least during certain time periods, and with enough education and determination you might be able to figure it out. Who is right?

JS: If the random walkers are correct, all market participants are wasting their time because you can only make money if you are lucky. It also means that I wrote four Market Wizard books about a bunch of very lucky people. There are many reasons as to why there is something else at play. In fact, I wrote a whole chapter on this in another book, Market Sense and Nonsense, debunking the random walk theory.

Now, the markets behave like they are random or have a lot of randomness to them. That part is true. But what is generally wrong about the random walk theory is that, first of all, the idea that everything is discounted and fully reflected in the price at all times, and therefore nobody can make money, is demonstrably false.

I’ll give you a recent example, in addition to the many I outlined in that chapter. It’s one of my favorites and it’s from a recent talk by Richard Thaler, the renowned behavioral economist. There is a closed end fund with the ticker CUBA (like the Caribbean island), which like most closed end funds usually trades at a 15-20% discount to the value of the basket of securities that compose it. And then in one day all of the sudden it skyrocketed up to a 70% PREMIUM. What could have happened?

Well, President Obama had just given a speech that he would normalize relations with Cuba. Now, CUBA did not hold any Cuban securities for two reasons: 1) there were no Cuban companies to invest in; and 2) even if there were it would have been illegal to do so. It did hold some South American companies, but nothing directly in Cuba!

So you had this huge change in one day in the price of the fund when none of its securities were directly affected by the catalyst causing the price surge. And of course a couple of days later the price went back to the prior levels.

There are so many other examples. Take the internet bubble. You have this sixfold share price rise in one and a half years then back to the original prices in one and half years. But there were no major news developments that satisfactorily explained the moves in either direction. During the advance, there was a market euphoria and a buying-at-any-price mentality because people were afraid of missing the bull market. Then the music stopped and everybody is looking for a chair and there are no more chairs around. Once the buying fever broke, prices collapsed because the gains were never justified in the first place.

And the random walk theory is wrong because it misses a tremendously essential component of the markets and that is human emotion. It does not play a major role all the time, but when it does it can cause massive dislocations.

However, it doesn’t mean it’s simple. The irony is that while I believe the efficient market hypothesis is wrong, it is still very difficult to beat the markets. In early 1999 you could have said that the market was experiencing a bubble and that one should go short, and you would have been absolutely right. But when the market finally topped out in March 2000, you could have gone bust by then. So you can have markets be non-random and yet be very difficult to beat. And that is what fools many people into believing that they are random.

It’s also a fault in logic. The converse of a true statement is not necessarily true. You can say that because markets are random they are difficult to beat. However, the converse – markets are difficult to beat and therefore the markets are random – is a flaw in logic. It is true that all polar bears are white mammals, but not all white mammals are polar bears.

ET: Over the years you have interviewed the best in the business, the Market Wizards. These guys are truly amazing but there is one question that has always intrigued us, appreciating how hard it is to make it in the markets, as you just described. How can you truly distinguish luck from excellence, since both play such a significant role in speculation?

For example, statistically speaking it is very unlikely to have twenty flips that all come out heads, but with enough people flipping coins there will be a very small group who will do it. Without this perspective you could get the erroneous idea that they really know how to produce heads. How can you distinguish those lucky flippers from investors who happened to be profitable over, say, twenty years? In other words, couldn’t the Market Wizards be more a product of chance than a particular trading approach, especially as markets continuously change?

JS: Yes, in most cases it is very difficult to figure that out. Just because someone has done well for ten years or even twenty years doesn’t guarantee that they weren’t just lucky over that period.

If you have 1024 people flipping 10 coins, on average, you can expect one of them to toss 10 heads. However, even if you had every person on earth flip 200 coins instead of ten, what are the odds that one of them will get 195 heads? That’s going to be infinitesimal small. 

I’ll give you an example. The first fund of Edward Thorp ran for 19 years, with only three losing months during all that time, and all of them less than a 1% loss. The gains were much larger than the few losses that occurred. Using a binomial loss-win distribution to gauge the probability of his performance is actually very conservative because his wins were much larger. But even with that conservative approach, the probability of achieving Thorp’s record is actually significantly less than the probability of randomly picking the same atom twice out of the mass of the Earth.

So there are people out there who have records that are so lopsided, so preposterously skewed towards winning, that evidence of skill is very strong. DNA evidence probabilities are in the order of a few billion to one, but here we are talking about extraordinarily greater odds. So track records such as Thorp’s would be impossible if there were not non-randomness in the markets. 

ET: That is very interesting. And actually very relevant for your FundSeeder venture, since we believe the goal is to find the best trading talent out there that would have otherwise remained hidden, correct?

JS: Yes, although you need a long track record to demonstrate that irrefutable evidence of skill. However, while finding people who can deliver superior return-to-risk – our key measure of performance, as opposed to just returns – based on a daily basis (which is statistically far more significant than the conventional use of monthly data) may not guarantee that they are skilled you will have some assurances that this is a person who more likely than not has skill. It doesn’t prove it though. For that you need a very long track record.

ET: Yes, but at the same time we are reminded of how past results don’t guarantee future results. This means that if you pick a trader based on a great performance over the last, say, 5 years, even if you use the most refined risk-adjusted returns measurements all that can easily change on a dime going forward.

So how can you navigate through all this and reach a solid, informed decision on trading performance? Or, rather than results, are traits like consistency, a good trading plan, risk management and so forth the key differentiator for you?

JS: That cliché remains absolutely true. But there are a couple of elements to it.

If you are talking about strategies that correlate to sectors, indexes or hedge fund style, a good past performance in the past can actually be an indication of potential poor performance in the future. In my book Market Sense and Nonsense, I empirically showed that for these strategies investing in the worst performers over the past 1, 3, and 5 years actually does better than investing in the best.

So not only do I agree with the contention that past superior performance does not necessarily imply superior future performance, the relationship is often inverse. My qualification here is that it depends on the strategy. Those strategies that correlate significantly with sectors, indexes, or specific hedge fund styles can become overbought and oversold as we talked about earlier, hence the tendency for a reversal in performance.

However, I want to separate this situation from a trader who is uncorrelated to any index, sector or hedge fund style. For that type of trader superior return/risk performance could indicate trading skill as opposed to reflecting a portfolio in a sector of strategy style that has become overbought. While even then you can’t say that past performance is predictive, if you are going to look for good traders, it certainly makes more sense to focus on those who have been successful. There is no rationale for assuming a trader who has not done well in the past will suddenly start doing well. 

So you might as well focus your research on those who have demonstrated that ability. Then, as you suggest, you have to evaluate other things more carefully, like why they have done well, what their edge is. For example, someone with a great risk-adjusted return might have employed a strategy of selling way out-of-the money puts on equities since late 2008. That strategy would have produced great return/risk performance, almost like a money machine, but the trouble is that type of strategy also embeds a large tail risk. So even though the track record of this strategy would show low volatility, there would be the risk of catastrophic losses if there were another abrupt market selloff as in 2008 or 2000.

So you have to take into account exposure to event risk. Ironically, many strategies with low volatility are the most susceptible to event risk. For these strategies you can have low volatility, low volatility, low volatility… and then all of the sudden extraordinarily high volatility.

If there was no adverse event in the track record, you can end up with very misleading conclusions if you don’t account for this. I only look at risk-adjusted returns to select from a larger universe and then I take a deeper look into the associated strategies. 

ET: Finally, there’s this somewhat inspirational belief that if you do well in the industry at some point you can trade for a living – from your mansion at the beach sipping daiquiris. You have met so many people over the years. Do you know any smaller investors that live exclusively from market speculation, or is this just a mirage used to suck people into the markets?

JS: Sure. I’ll just provide one example because he is a friend. Peter Brandt started trading some forty years ago, starting at Commodities Corp, a firm that hired proprietary traders back then. He then left after some years and ended up trading his own account for the rest of his career. Not managing other people’s money but living off his trading income, making money consistently over the years.

That’s the trader you just described. He doesn’t use any powerful computers. He’s just an experienced chart analyst with good risk management discipline. He hasn’t won every single year although he has been profitable most of the years. He has lived his entire life like that.

ET: One major drawback regarding that lifestyle is that not having a steady income stream on the side could really affect your psychology because your heightened emotions might get in the way. The pressure to make money can really throw you off track.

JS: That’s a great point. I have never put myself in a situation where my livelihood depends exclusively on trading. I trade sporadically. Sometimes I trade, sometimes I don’t. I have never entertained any thought of trading for a living. It is more of a hobby than anything else. But I believe that if I tried doing it for a living I would fail because I couldn’t handle the emotion of your living expenses coming out of trading. So it does require a special kind of person to be able to do that and only a small percentage of people can do that.

If I had enough money to live comfortably for the rest of my life then I might be able to do it. But if I had a cushion that would only last two or three years, I’m pretty sure my emotions would eventually sabotage me. So that would not be a good idea. This is actually a very important point.

ET: Thank you very much for sharing your insights. It sure has helped us and we’re sure many, many other people over the years. All the best to you

JS: Thank you.

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