Maverick Trading: Proven Strategies For Generating Greater Profits From The Award-Winning Team At Maverick Trading

ISBN-13: 9780071784313

Media Type: Hardcover

Publisher: McGraw Hill LLC

Publication Date: 11-22-2011

Pages: 304

Product Dimensions: 6.34(w) x 9.22(h) x 1.06(d)

Darren Fischer has evaluated and consulted more than 200 funds spanning asset classes such as hedge funds, private equity, venture capital, and real estate. He is a trader at Maverick Trading. Jon Frohlich joined Maverick Trading in 2002. He travels across North America introducing nascent traders to the powerful tools he has learned. Robb Reinhold has decades of experience as a trader. A passionate educator, he travels the world teaching and recruiting new traders for Maverick Trading when he’s not trading in the currencies market.

Read an Excerpt

MAVERICK TRADING

PROFESSIONAL TECHNIQUES TO CREATE GENERATIONAL WEALTH

The McGraw-Hill Companies, Inc.

Excerpt

CHAPTER 1

Don't Put It All on Black: Risk Management

We don't care if you ignore every other chapter in this book and get your trading ideas by sacrificing a goat under the light of a full moon. If you don't make a commitment, right here and right now, to developing and following a comprehensive and methodical risk management strategy, please put this book down, walk over a few aisles, pick up Roulette for Idiots, and plan your next trip to Las Vegas. There are a multitude of casinos that would like to develop a lifelong relationship with you.

Trading without a risk management system is gambling. Gambling relies on hope. When you gamble, in the long run, the house always wins. The balance of this book will lay out in minute detail a proven system for making money in the markets, but if you don't master risk management from the beginning, we guarantee that you will lose money, regardless of the trading or investing system you decide on in the end.

INEFFECTIVE RISK CONTROL

Ineffective risk control is, if anything, more dangerous than a lack of risk controls. At least with a lack of risk controls, your emotions will let you know when the pain becomes too great, and you will liquidate your position. Adherents of ineffective risk controls spout watchwords like an oracle and will often follow their creed straight to a 55-gallon drum of Kool-Aid and an imploded portfolio.

This book is not a rehash of Warren Buffett's investment philosophy. Buffett's strategy, while successful, does not fit with our investment style. Additionally, a multitude of authors have covered and tried to emulate Buffett.

However, Buffett does have two rules that we follow:

Rule 1: Don't lose money.

Rule 2: Never forget rule 1.

Keeping this bit of wisdom in mind, we've found that we need to convince people who are new to Maverick's system to break some bad (money-losing) habits.

Dollar Cost Averaging

This is also known as DCA. Should someone suggest with a straight face that this concept is either an investment strategy or a method of risk control, run, do not walk, out of his office. Such people should not be entrusted with a piggy bank, much less with substantial amounts of capital.

In this misguided concept, you establish a position and then continue to add to that position if it begins to decline in value, thereby lowering the average unit cost of the position. The basic tenet of DCA is that you get to buy more of something with less money. We would rather buy more of something with more money.

DCA makes a very large and dangerous assumption: what goes down, must come up. Wrong, no, nyet, nein, non. Just take a look at Lehman Brothers (bankrupt), old General Motors (bankrupt), Citibank (down 90 percent from its all-time high), and any of a myriad of stocks that either have gone the way of the dodo bird or have failed to exceed their previous highs of several years ago.

From an objective viewpoint, every dollar that your portfolio declines in value today is one less dollar that you can use to trade tomorrow. Most amateur traders don't understand the mathematics of dollar cost averaging on losing positions. Imagine a trader who sells his winning trades after a $500 profit but lets a losing trade go against him, doubling and tripling down as the stock moves lower. When he finally has to sell the position, he will take a loss of several thousand dollars, erasing 5 to 10 of his positive trades. The negative mathematics of doubling down on losing positions ensures that the trader will have an abysmal reward/risk ratio in the end. At Maverick, we teach pyramiding in winning trades to get the mathematics working in our favor, adding to a trader's reward/risk ratio.

The arguments made by financial advisors who advocate DCA as a method of risk control have several implications that we disagree with philosophically. (1) These advisors tell you that you can't time the market, so don't worry about short-term swings. (2) These same advisors illustrate the supposed benefits of this strategy by showing examples where the stock or mutual fund is higher than your entry price when you exit the position, with the implication that you can time the market when you get out. If this isn't an example of talking out of both sides of your mouth, we don't know what is.

Darren: In a previous firm, I consulted with alternative asset funds seeking to raise capital from institutional investors. In 2008, I was speaking with a long-only fund manager to determine if it would be worthwhile for his firm and mine to enter into a relationship. As any fund manager would be, he was extremely excited at the prospect of gaining access to institutional capital. He gave an elaborate presentation focusing on the fact that he was a stock picker par excellence and went over his entire methodology regarding how his bottom-up approach was certain to pick winners "over the long run." For his cornerstone example, he highlighted an office supply company that was already in an established downtrend.

After listening to his presentation, I said, "Well, this looks interesting, but what do you do if you're wrong?"

His reply: "What do you mean?" A little red LED in my brain started blinking at the rapid rate.

"When would you exit the position? What would you do if this stock dropped 50 percent?"

"I'd buy more." Not with my money, I thought. I ended the call shortly afterward and politely declined interest in working with his fund in the future. That stock did, in fact, go on to fall 50 percent from where it was when the manager recommended it and has yet to recover.

Even professional managers who control millions and even billions in pension funds, endowments, and trusts can fall victim to the dangers of dollar cost averaging.

Efficient Market Theory

Proponents of the efficient market theory (EMT) hold that you can't time the market, that the price action reflects all that is known about the stock at the time, and that trying to time the market is ultimately detrimental to a portfolio. These people believe that the best investment philosophy is to systematically invest in a broad-market index fund.

Ah, the world of academia. Viewed strictly at a single point in time, from a strictly economic point of view, this idea has a certain appeal, especially immediately after significant events (such as earnings surprises, natural disasters, or management changes).

However, viewed over time and with some simple psychology, we have found that you can time the market, with remarkable accuracy. EMT fails to adequately take into account fear and greed among the market drivers (institutional investors).

Systematic Investing

Whoever first came up with the term systematic investing should be applauded for her marketing genius (notice that we don't say her investing acumen). This concept conditions people to think that it's acceptable to lose money. The implication is that the money manager to whom you are writing the check every month is smarter than you are. What crap.

This doesn't mean that you shouldn't put aside some income every month to increase your trading capital. It just means that we don't feel it is prudent to blindly send a check to a mutual fund every month, regardless of its performance.

Systematic investing is an offshoot of dollar cost averaging. Think of it as DCA on a much broader scale with a marketing spin. In plain language, the mutual fund people are saying, "Send us a portion of your money on a regular basis, regardless of our performance, because we know better. Investing is dangerous for you, but easy for us, and you'll just screw it up if you try to go it alone. Don't pay any attention to the man behind the curtain. Short-term losses are to be expected; don't ask about underperformance, outright losses, window dressing, our modest management fee, the marketing fees we charge to let you and others know how great we are, or any of the other fees we use to bleed you dry and then tell you that losses aren't our fault."

The cold reality is that 75 to 80 percent (depending on the year) of so-called professional mutual fund managers underperform their benchmark indices. To add insult to injury, the fund managers get to pick which index they benchmark to.

"But what about peer rankings?" you say. That's like putting a bunch of underperformers in the room and ranking them by how little they underperformed.

Mutual fund charters often stipulate that the fund will be fully invested (less than 5 percent in cash) at all times. That's like saying, "You will stay on that ship at all times, even if it is sinking."

Blind Diversification

This theory holds that if you pick individual stocks, you should have some exposure to a variety of sectors (for example, having five technology companies in your portfolio is not diversification, but having one company each from the technology, consumer staples, financial, energy, and industrial sectors is diversification) because various sectors come into and out of favor in the market, and as a few stocks lose value, the others will gain value. This practice offers some protection in a bull market, but what happens in a massive bear market where everything loses value?

You will see shortly that we trade our portfolio using a basket of positions. That is not the same as diversification. We are actively picking strong sectors and weak sectors and taking positions accordingly.

Hope

Hope is the first form of risk control for many new retail investors. The hope method involves blindly buying a stock, often taking too large a position, and then hoping the value increases. The hope method usually results in a new investor watching a position decline in value day after day. Occasional up days are met with maniacal glee; the down days are met with increasing gloom and stress.

When the position moves substantially against them, such as a 10 percent correction or, even worse, a significant gap down, adherents of the hope method say, "OK, I can weather this. I'll just wait until it gets back to the price I bought it at and then get out with a breakeven. I can live with that."

Unfortunately, these investors have just become part of the herd. All the other investors, including institutions, who bought at an unsustainable high are thinking the same thing and acting the same way.

Often a stock will approach its previous high, probably where the investors bought it, and then fail to break through to a new high. Then the mantra among the hope investors becomes, "Just one more day."

"Just one more day" turns into a week with further losses. The week becomes a month. The trade becomes an "investment for the long term." Dollar cost averaging starts to look like a good option. The losing position becomes a substantial portion of the portfolio. The pain mounts, and these investors are checking the position every 30 minutes. Finally, the pain becomes unbearable, and they capitulate and wind up selling at the bottom.

All of these are ineffective risk controls. They do nothing to actually control risk and actually contribute to and reinforce losses.

WHAT CAN YOU CONTROL?

To clarify a few things:

1. You are a retail investor/trader. Your purchase or sale of a few hundred or a few thousand shares of a stock will not appreciably move the market, either igniting a bull run or precipitating a catastrophic sell-off.

2. Institutional investors (pension funds, market makers, endowments, long-only funds, mutual funds, and hedge funds) are not actively out to make you lose money. Their primary concern is making money for their funds and their clients. Quite simply, they don't care if you come along for the ride or get run over by the bus.

3. You cannot anticipate every piece of information that will affect the markets, so don't try. You don't control what goes on in another country, what a company's earnings announcement will be, what an analyst will say about said earnings, or how the institutional investors will react to any piece of news.

4. The only things that you can control are which positions you take and how much capital you are willing to risk on each position. That's it.

Of the two things that you can control, position selection and the amount of capital you are willing to risk, the amount of capital you are willing to risk is more important. You will never be correct in 100 percent of your trades or investments. When you are starting out, you will be doing well if 50 percent of your trades are profitable. As you gain more experience, a good year will be 60 percent correct trades. Any year you bat over .700 will be a year to remember. The sooner you accept these statistics and move on, the sooner you will be profitable.

To make trading a long-term, profitable career, you need to adopt the mantra, "I would rather be profitable than right."

NOT ALL LOSSES ARE CREATED EQUAL

A loss is a loss is a loss, isn't it? No. There are many factors that can cause a loss. Price, timing, direction, momentum, volatility, and external factors can all cause losses. In the following chapters, we will be discussing strategies primarily involving options. You will find situations where you may ultimately be correct on direction, but you are off on timing, and the decay in time value makes the position lose value. Likewise, volatility in a position may make certain strategies and tactics prohibitively expensive, so that the reward/risk ratio doesn't make sense. In other instances, you may find an outperforming stock with an excellent setup, but a broad-market move may move the position against you.

As mentioned previously, an experienced trader, using established guidelines and entry points, should expect 60 percent correct trades. Put another way, even when you do everything correctly, four out of every ten trades will lose money. The losing percentage is even higher for a trader who trades by the seat of his pants and bases his decisions on emotion rather than rules.

A trade that moves against you and is exited at a predetermined loss after being properly selected with a high-probability setup and with the appropriate strategy is an acceptable loss. Letting a trade move against you when you have no predefined loss limit is not an acceptable loss.

TRADING AS A BASKET

No trader enters a trade expecting to lose money. Ask a trader right before or right after she enters a trade what she expects to happen, and you will universally hear that the trade will be spectacularly profitable. Unfortunately, for a significant percentage of trades, this is not the case.

Trading as a long-term career is a game of statistics. Some trades will be profitable, and some trades will generate losses. The common cliché is to let your winners run and to limit your losses. This is easier said than done, especially for traders who have never been taught risk control.

A common and career-shortening practice of new and/or undisciplined traders is to devote all their available capital to a single trade at a time. Additionally, maintenance margin requirements typically allow traders to increase their position after an overnight holding period.

Increasing a position in this manner can produce spectacular gains, but more often it produces spectacular losses, unnecessary stress, and interference with a trader's objectivity.

For example, using some system (which one is immaterial at this point), a trader identifies what looks like a good trade in XYZ Corporation. Let's say he has $10,000 in a margin account, the overnight margin requirement is 50 percent, and the maintenance margin requirement is 25 percent.

Absolutely convinced that this trade will produce a profit, the trader buys $20,000 of XYZ (half of which is his $10,000 and half is the broker's money). The next day, the stock hasn't moved appreciably. As he looks at his trading power, the brokerage says he has another $10,000 in buying power at his disposal [his $10,000 account less $5,000 (25 percent maintenance margin on $20,000 in XYZ stock) divided by 50 percent (the overnight margin requirement)]. He buys another $10,000 of XYZ.

On Day 3, he finds that he has another $5,000 in buying power, so he adds to his position again, ending up with $35,000 in XYZ.

After the bell on Day 3, an event occurs—let's say an earnings announcement—and XYZ gaps down 5 percent. The value of his XYZ position is now $33,250, a loss of $1,750. A 5 percent drop in XYZ decimated his account by 17.5 percent. Additionally, because of the volatility, the brokerage may increase the maintenance margin requirements on XYZ, and the trader may face a margin call or forced liquidation. This series of actions is summarized in Table 1-1.

Additionally, the trader now needs to make trades equal to a 21 percent gain just to get back to his starting position.

Typically, one of three things will happen: the trader will make more all-or-nothing bets (often incurring even greater losses), he will throw in the towel and not trade anymore, or he will learn risk controls and methodically work his way back to profitability.

It can't be stressed enough that at least 40 percent of your trades will generate losses. It may be the first 40 percent, the last 40 percent, or interspersed throughout the trading activity of a year. Despite all the preparation that you will do prior to a trade, you never know whether the trade will be a winner or a loser until it is done.

The key is to not incur a loss in any single trade that is so catastrophic that it knocks you out of your trading career.

Rather than devoting all your preparation and effort to finding a single trade at a time and then committing all your capital to that trade, the better, safer, and less stressful method is to find and make multiple trades at the same time, ending up with a basket of positions.

At Maverick Trading, we will typically look at three to six setups per week, of which one to four will trigger (we will discuss trade triggers at a later time), and we will commonly have between four and ten open positions at any one time. Over the course of a year, we will make between 150 and 200 trades.

This practice forces traders to continually refresh their portfolios, eliminating languishing and unprofitable positions to free up capital for new, potentially profitable setups.

Figure 1-1 is a fairly common statistical distribution of trades for a trader who does everything correctly.

(Continues...)

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Excerpted from MAVERICK TRADING by DARREN FISCHER. Copyright © 2012 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents

Introduction vii

Chapter 1 Don't Put It All on Black: Risk Management 1

Chapter 2 Playground Economics: Determining Market Direction 17

Chapter 3 Reading the Tea Leaves: An Introduction to Chart Reading 39

Chapter 4 Options and Trading Techniques: The Secret Sauce 109

Chapter 5 What Are These Things in My Toolbox? 147

Chapter 6 Getting into the Game: Technology and Broker Selection 199

Chapter 7 Batting Practice: Paper Trading 211

Chapter 8 The Big Time: Live Trading 221

Chapter 9 You Versus You 229

Chapter 10 You Versus the World 249

Chapter 11 The End of the Beginning 269

Index 277