WAY OF THE TURTLE
By CURTIS M. FAITHThe McGraw-Hill Companies, Inc.
Copyright ©2007 Curtis M. Faith
All rights reserved.
ISBN: 978-0-07-148664-4
Contents
AcknowledgmentsForewordPrefaceIntroductionone Risk Junkiestwo Taming the Turtle Mindthree The First $2 Million is the Toughestfour Think Like a Turtlefive Trading with an Edgesix Falling Off the Edgeseven By What Measure?eight Risk and Money Managementnine Turtle-Style Building Blocksten Turtle-Style Trading: Step by Stepeleven Lies, Damn Lies, and Backteststwelve On Solid Groundthirteen Bulletproof Systemsfourteen Mastering Your DemonsEpiloguebonus chapter Original Turtle Trading RulesBibliographyIndex
Excerpt
CHAPTER 1
RISK JUNKIES
High risk, high reward: It takes balls of steel to play this game.—Told to a friend before starting the Turtle program
People often wonder what it is that makes someone a trader rather than aninvestor. The distinction is often unclear because the actions of many peoplewho call themselves investors are actually those of traders.
Investors are people who buy things for the long haul with the idea that over aconsiderable period—many years—their investments will appreciate invalue. They buy things: actual stuff. Warren Buffett is an investor. He buyscompanies. He doesn't buy stock. He buys what the stock represents: the companyitself, with its management team, products, and market presence. He doesn't carethat the stock market may not reflect the "correct" price for his companies. Infact, he relies on that to make his money. He buys companies when they are worthmuch more to him than the price at which the stock market values them and sellscompanies when they are worth much less to him than the price at which the stockmarket values them. He makes a lot of money doing this because he's very good atit.
Traders do not buy physical things such as companies; they do not buy grains,gold, or silver. They buy stocks, futures contracts, and options. They do notcare much about the quality of the management team, the outlook for oilconsumption in the frigid Northeast, or global coffee production. Traders careabout price; essentially they buy and sell risk.
In his informative and engaging book Against the Gods: The Remarkable Storyof Risk, Peter Bernstein discusses how markets developed to allow thetransfer of risk from one party to another. This is indeed the reason financialmarkets were created and a function they continue to serve.
In today's modern markets, companies can buy forward or futures contracts forcurrencies that will insulate their business from the effects of fluctuations incurrency prices on their foreign suppliers. Companies also can buy contracts toprotect themselves from future increases in the price of raw materials such asoil, copper, and aluminum.
The act of buying or selling futures contracts to offset business risks causedby price changes in raw materials or fluctuations in foreign currency exchangerates is known as hedging. Proper hedging can make an enormousdifference for companies that are sensitive to the costs of raw goods such asoil. The airline industry, for example, is very sensitive to the cost ofaviation fuel, which is tied to the price of oil. When the price of oil rises,profits drop unless ticket prices are raised. Raising ticket prices may lowersales of tickets and thus profits. Keeping ticket prices the same will lowerprofits as costs rise because of oil price increases.
The solution is to hedge in the oil markets. Southwest Airlines had been doingthat for years, and when oil prices rose from $25 per barrel to more than $60,its costs did not increase substantially. In fact, it was so well hedged thateven years after prices started to go up, it was getting 85 percent of its oilat $26 per barrel.
It is no coincidence that Southwest Airlines has been one of the most profitableairlines over the last several years. Southwest's executives realized that theirbusiness was to fly people from place to place, not to worry about the price ofoil. They used the financial markets to insulate their bottom line from theeffects of oil price fluctuations. They were smart.
Who sells futures contracts to companies like Southwest that want to hedge theirbusiness risk? Traders do.
Traders Trade Risk
Traders deal in risk. There are many types of risk, and for each type of riskthere is a corresponding type of trader. For the purposes of this book, wedivide all those smaller risk categories into two major groups: liquidity riskand price risk.
Many traders—perhaps most of them—are very short-term operators whotrade in what is known as liquidity risk. This refers to the risk that atrader will not be able to buy or sell: There is no buyer when you want to sellan asset or no seller when you want to buy an asset. Most people are familiarwith the term liquidity as it applies to finance in the context of theterm liquid assets. Liquid assets are assets that can be turned intocash readily and quickly. Cash in the bank is extremely liquid, stock in awidely traded company is relatively liquid, and a piece of land is illiquid.
Suppose that you want to buy stock XYZ and that XYZ last traded at $28.50. Ifyou look for a price quote for XYZ, you will see two prices: the bid and theask. For this example, let's say you get a quote on XYZ as $28.50 bid and $28.55ask. This quote indicates that if you wanted to buy, you would have to pay$28.55, but if you wanted to sell, you would get only $28.50 for your XYZ stock.The difference between these two prices is known as the spread. Traderswho trade liquidity risk often are referred to as scalpers or marketmakers. They make their money off the spread.
A variant of this kind of trading is called arbitrage. This entailstrading the liquidity of one market for the liquidity of another. Arbitragetraders may buy crude oil in London and sell crude oil in New York, or they maybuy a basket of stocks and sell index futures that represent a similar basket ofstocks.
Price risk refers to the possibility that prices will move significantlyup or down. A farmer would be concerned about rising oil prices because the costof fertilizer and fuel for tractors would increase. Farmers also worry thatprices for their produce (wheat, corn, soybeans, etc.) may drop so low that theywill not make a profit when they sell their crops. Airline management isconcerned that the cost of oil may rise and interest rates may go up, raisingairplane financing costs.
Hedgers focus on getting rid of price risk by transferring the risk to traderswho deal in price risk. Traders who jump on price risk are known asspeculators or position traders. Speculators make money bybuying and then selling later if the price goes up or by selling first and thenbuying back later when the price goes down—what is known as goingshort.
Traders, Speculators, and Scalpers—Oh, My
Markets are groups of traders that interact to buy and sell. Some of the tradersare short-term scalpers who are only trying to make the tiny spread between bidand ask over and over again; others are speculators who are trying to profitfrom changes in prices; yet others are companies trying to hedge their risks.Each category is rife with experienced traders who know their jobs well, alongwith novices. Let's examine a set of trades to illustrate how different tradersoperate.
ACME Corporation is trying to hedge the risk of rising costs at its Britishresearch laboratory by buying 10 contracts of British pounds on the ChicagoMercantile Exchange (CME). ACME is at risk because the British pound has beenrising and costs at the research laboratory are paid in British pounds. A risein the exchange rate between the British pound and the dollar will increase thecosts for its research facility. Hedging that risk by purchasing 10 Britishpound contracts will protect it from a rise in the exchange rate because theprofits on the futures contracts will offset the increased costs that resultfrom the change in the exchange rate that occurs when the British pound risesagainst the dollar. ACME buys the contracts for $1.8452 from a Chicago floortrader, Sam, who trades as a scalper.
The actual transaction is executed by ACME's broker, MAN Financial, which hasemployees on the floor. Some of those employees are phone clerks at a bank ofdesks that surround the trading floor, and others are traders in the Britishpound trading pits who execute trades for MAN. Runners take the orders from thephone desk to the trader in the pits, where that trader executes the trade withSam. For large orders or during fast markets, the trader representing MAN on thefloor may use hand signals to receive buy and sell orders from MAN's phoneclerks.
Futures contracts are defined by the exchange on which they are traded in adocument known as a contract specification. These documents define thequantity, the type of goods, and in some cases the quality of a particularcommodity. In the past, the size of a contract was based on the quantity thatwould fit into a single railroad car: 5,000 bushels for grains, 112,000 poundsfor sugar, 1,000 barrels for oil, and so on. For this reason, contractssometimes are referred to as cars.
Trading takes place in units of a single contract: You cannot buy or sell lessthan one contract. The exchange's contract specification also defines theminimum price fluctuation. This is referred to in the industry as a tickor minimum tick.
A contract for British pounds is defined by the CME to be 62,500 British pounds,and the minimum tick is a hundredth of a cent, or $0.0001. Thus, each tick ofprice movement is worth $6.25. This means that Sam stands to make $62.50 forevery tick in the spread because he sold 10 contracts. Since the spread at thetime he sold the contracts to ACME was two ticks wide at $1.8450 bid and $1.8452ask, Sam will try to buy 10 contracts at the other side of the spread at $1.8450immediately. If he buys successfully at $1.8450, this will represent a profit oftwo ticks, or just over $100. Sam buys his 10 contracts from a large speculator,Mr. Ice, who is trying to accumulate a position betting on the price going down;this is known as a short position. Mr. Ice may hold those contracts for10 days or 10 months, depending on how the market moves after this purchase.
So, there are three types of traders involved in this transaction:
• The hedger: ACME Corporation's trader in the hedging department, whowants to eliminate the price risk of currency fluctuation and hedges byoffsetting that risk in the market
• The scalper: Sam, the floor trader, who trades liquidity risk andquickly trades with the hedger, hoping to earn the spread
• The speculator: Mr. Ice, who ultimately assumes the original "pricerisk" that ACME is trying to eliminate and is betting that the price will godown over the next few days or weeks
Panic in the Pits
Let's change the scenario slightly to illustrate the mechanisms behind pricemovement. Imagine that before Sam is able to unload his 10 contract shortposition by purchasing them back, a broker who works for Calyon Financial startsbuying up contracts at the $1.8452 ask price. That broker purchases so manycontracts that all the floor traders start to get nervous.
Although some of the floor traders may have long positions, many of them alreadymay be short 10, 20, or even 100 contracts; this means that they will lose moneyif the price goes up. Since Calyon represents many large speculators and hedgefunds, its buying activity is particularly worrisome. "How many more contractsis Calyon trying to buy?" the floor scalpers ask. "Who is behind the order?" "Isthis just a small part of a much larger order?"
If you were a floor trader who already had sold 20 contracts short, you might begetting nervous. Suppose Calyon was trying to buy 500 or 1,000 contracts. Thatmight bring the price up as high as $1.8460 or $1.8470. You definitely would notwant to sell any more contracts at $1.8452. You might be willing to sell some at$1.8453 or $1.8455, but maybe you would be looking to get out of your contractsby buying them back at $1.8452 or perhaps even at a small loss at $1.8453 or$1.8454 instead of the $1.8450 you originally were looking for.
In a case like this, the bid-ask spread might widen to $1.8450 bid and $1.8455ask. Or the bid and the ask might both move up, reaching $1.8452 bid and $1.8455ask, as the scalpers who had been selling short at $1.8452 started trying to getrid of their position at the same price.
What changed? Why did the price move up? Price movement is a function of thecollective perception of buyers and sellers in a market: those who are scalpingto make a few ticks many times each day, those who are speculating for smallmoves during the day, those who are speculating for large moves over the courseof weeks or months, and those who are hedging their business risks.
When the collective perception changes, the price moves. If, for whateverreason, sellers no longer are willing to sell at the current price but demand ahigher price and buyers are willing to pay that higher price, the price movesup. If, for whatever reason, buyers no longer are willing to pay the currentprice but only a lower price and there are sellers who are willing to sell atthat lower price, the price goes down.
The collective perception can take on a life of its own. If enough floor tradersare caught with short positions when a large buy order comes in, panic canensue. A large buyer might drive the price up sufficiently to trigger other buyorders that have been placed in the markets, causing even more price movement.For this reason, experienced scalpers will get out of their short positionsquickly and scalp only on the buying side when prices start moving up.
Using the example described above, a floor trader who is not quick enough mightrapidly find himself with a 10-, 20-, or even 50-tick loss per contract. If heholds 50 contracts with a 50-tick loss, this represents a loss of $15,625 (50 ×50 × $6.25), more money than he may have made that entire week or month. At somepoint the psychological pain of watching so much money disappear may be so greatthat the floor scalper panics and buys at whatever price the market offers. In afast market this may take only 1 or 2 minutes; in a slower market it may take 10or 15.
One can see that the experienced trader not only buys out of her short positionearly, she buys a few more contracts to profit further as the price moves up.When a less experienced trader panics and starts buying, an opportunity ispresented to an experienced trader to again sell and exit his recently acquiredlong position to make another profit.
The next chapter delves into the psychological biases that create differences inoutlook and behavior between an inexperienced and probably losing trader and hismore successful and experienced counterpart. It also discusses the differenttypes of trading styles and market states that favor each of those styles. Laterchapters show how Rich's training turned very inexperienced traders intoprofitable ones in only a few weeks time.
CHAPTER 2
TAMING THE TURTLE MIND
Human emotion is both the source of opportunity in tradingand the greatest challenge. Master it and you will succeed.Ignore it at your peril.
To trade well you need to understand the human mind. Markets are comprised ofindividuals, all with hopes, fears and foibles. As a trader you are seeking outopportunities that arise from these human emotions. Fortunately, some very smartpeople—behavioral finance pioneers—have identified the ways thathuman emotion affects one's decision-making process. The field of behavioralfinance—brought to popular attention in Robert Shiller's fascinating book,now in its Second Edition, titled Irrational Exuberance and greaterdetails of which were published by Hersh Shefrin in his classic Beyond Greedand Fear—helps traders and investors understand the reasons whymarkets operate the way they do.
Just what does make prices go up and down? (Price movements can turn anotherwise stoic individual into a blubbering pile of misery.) Behavioral financeis able to explain market phenomena and price action by focusing on thecognitive and psychological factors that affect buying and selling decisions.The approach has shown that people are prone to making systematic errors incircumstances of uncertainty. Under duress, people make poor assessments of riskand event probabilities. What could be more stressful than winning or losingmoney? Behavioral finance has proved that when it comes to such scenarios,people rarely make completely rational decisions. Successful traders understandthis tendency and benefit from it. They know that someone else's errors injudgment are opportunities, and good traders understand how those errorsmanifest themselves in market price action: The Turtles knew this.
Emotional Rescue
For many years economic and financial theory was based on the rationalactor theory, which stated that individuals act rationally and consider allavailable information in the decision-making process. Traders have always knownthat this notion is pure bunk. Winning traders make money by exploiting theconsistently irrational behavior patterns of other traders. Academic researchershave uncovered a surprisingly large amount of evidence demonstrating that mostindividuals do not act rationally. Dozens of categories of irrational behaviorand repeated errors in judgment have been documented in academic studies.Traders find it very puzzling that anyone ever thought otherwise.
The Turtle Way works and continues to work because it is based on the marketmovements that result from the systematic and repeated irrationality that isembedded in every person.
How many times have you felt these emotions while trading?
• Hope: I sure hope this goes up right after I buy it.
• Fear: I can't take another loss; I'll sit this one out.
• Greed: I'm making so much money, I'm going to double my position.
• Despair: This trading system doesn't work; I keep losing money.
With the Turtle Way, market actions are identified that indicate opportunitiesarising from these consistent human traits. This chapter examines specificexamples of how human emotion and irrational thinking create repetitive marketpatterns that signal moneymaking opportunities.
(Continues...)Excerpted from WAY OF THE TURTLE by CURTIS M. FAITH. Copyright © 2007 by Curtis M. Faith. Excerpted by permission of The McGraw-Hill Companies, Inc..
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