What makes a great trader? For years, financial industry expert Jack Schwager has picked the brains of remarkable individuals who have consistently beaten the markets to find out the answer. Now, in Hedge Fund Market Wizards: How Winning Traders Win, he talks with some of the world's greatest hedge fund experts, highlighting the lessons to be learned from each so that you can apply their wisdom to your own trading.

Over the past few decades, hedge funds have become an increasingly popular investment vehicle, but their explosive growth has made trading more competitive than ever. In Hedge Fund Market Wizards, Schwager shares with readers the invaluable lessons he learned from the fifteen traders profiled, which include some of the industry's legendary figures, each of whom has compiled an exemplary return-to-risk record.

From the founder of the world's largest hedge fund to a manager going it alone, the traders interviewed in this book approach their field in radically different ways. But each of them has brought new and unique insights and developed distinct strategies that have allowed them to outperform the markets again and again.

Just as he did in his previous bestsellers, Market Wizards and The New Market Wizards, Schwager asks the questions that get to the core of what makes a successful trader tick. Distilling forty essential lessons to be learned from the market luminaries it profiles, Hedge Fund Market Wizards offers valuable guidance and timeless insights for both investment professionals and market enthusiasts looking to improve their trading abilities by learning from the best.

Praise for HEDGE FUND MARKET WIZARDS

"Traders regularly use passages and chapters from Schwager's books as a reference for their own methods and to guide their own trading. His work is an inseparable part of the consciousness and language of trading itself. Schwager's books are essential reading for anyone who trades, wants to trade, or wants to pick a trader."―From the Foreword by Ed Seykota

"Jack Schwager is the era's premier chronicler of financial talent. When historians look back at this mad time and wonder who the key players were, they will turn to Schwager's books."
―Robert R. Prechter, Jr., Editor, The Elliott Wave Theorist

"Hedge funds have evolved into a market force, and the timing of Hedge Fund Market Wizards is as valuable as the lessons it contains. Jack's book excels in knowledge and insight, rather than specific rules that are short-lived. Among the gems are mistakes are the catalyst for improvement, stable returns are suspicious, and you can't succeed without embracing the risk inherent to your trading style. As you would expect, the book is masterful."
―Perry J. Kaufman, Managing Director, Kaufman Analytics, Ltd., and author of New Trading Systems and Methods

"Great traders are almost always fascinating human beings. Jack Schwager is the perfect interviewer, equally adept at eliciting life stories and professional secrets. A must-read."
―William Poundstone, author of Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

JACK D. SCHWAGER is a recognized industry expert on futures and hedge funds, and the author of a number of widely acclaimed financial books. He is currently the co–portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. He is also an advisor to MarkeTopper Securities, an India-based quantitative trading firm. Previously, Mr. Schwager was a partner in the Fortune Group, a London-based hedge fund advisory firm that specialized in creating customized hedge fund portfolios for institutional clients. His prior experience also includes over twenty years as a director of futures research for some of Wall Street's leading firms.

Hedge Fund Market Wizards

How Winning Traders Win

By Jack D. Schwager, Ed Seykota

John Wiley & Sons

Copyright © 2012 John Wiley & Sons, Ltd
All rights reserved.
ISBN: 978-1-118-27304-3

Excerpt

CHAPTER 1

Colm O'Shea

Knowing When It's Raining

When I asked Colm O'Shea to recall mistakes that werelearning experiences, he struggled to come up with anexample. At last, the best he was able to do was describe atrade that was a missed profit opportunity. It is not that O'Shea doesn'tmake mistakes. He makes lots of them. As he freely acknowledges, he iswrong on at least 50 percent of his trades. However, he never lets amistake get remotely close to the point where it would provide a goodstory. Large trading losses are simply incompatible with his methodology.

O'Shea is a global macro trader—a strategy style that seeks to profitfrom correctly anticipating directional trends in global currency, interestrate, equity and commodity markets. At surface consideration, a strategythat requires participating in directional moves in major global marketsmay not sound like it would be well suited to maintaining tightlyconstrained losses, but the way O'Shea trades, it is. O'Shea views histrading ideas as hypotheses. A market move counter to the expecteddirection is proof that his hypothesis for that trade is wrong, and O'Sheathen has no reluctance in liquidating the position. O'Shea defines theprice point that would invalidate his hypothesis before he places a trade.He sizes his position so that the loss from a move to that price level islimited to a small percentage of assets. Hence, the lack of any good warstories of trades gone awry.

O'Shea's interest in politics came first, economics second, andmarkets third. His early teen years coincided with the advent ofThatcherism and the national debate over reducing the government'srole in the economy—a conflict that sparked O'Shea's interest in politicsand soon after economics. O'Shea educated himself so well in economicsthat he was able to land a job as an economist for a consultingfirm before he began university. The firm had an abrupt opening foran economist position because of the unexpected departure of anemployee. At one point in his interview for the position, he was askedto explain the seeming paradox of the Keynesian multiplier. Theinterviewer asked, "How does taking money from people by sellingbonds and giving that same amount of money back to people throughfiscal spending create stimulus?" O'Shea replied, "That is a really goodquestion. I never thought about it." Apparently, the firm liked that hewas willing to admit what he did not know rather than trying to bluffhis way through, and he was hired.

O'Shea had picked up a good working knowledge of econometricsthrough independent reading, so the firm made him the economist forthe Belgian economy. He was sufficiently well prepared to be able touse the firm's econometric models to derive forecasts. O'Shea, however,was kept behind closed doors. He was not allowed to speak to anyclients. The firm couldn't exactly acknowledge that a 19-year-old wasgenerating the forecasts and writing the reports. But they were happy tolet O'Shea do the whole task with just enough supervision to make surehe didn't mess up.

At the time, the general consensus among economists was that theoutlook for Belgium was negative. But after he had gone throughthe data and done his own modeling, O'Shea came to the conclusionthat the growth outlook for Belgium was actually pretty good. Hewanted to come up with a forecast that was at least 2 percent higherthan the forecast of any other economist. "You can't do that," he wastold. "This is not how things work. We will allow you to have one ofthe highest forecasts, and if growth is really strong as you expect, we willstill be right by having a forecast near the high end of the range. There isnothing to be gained by having a forecast outside the range, in whichcase if you are wrong, we would look ridiculous." As it turned out,O'Shea's forecast turned out to be right, but no one cared.

His one-year stint as an economist before he attended universitytaught O'Shea one important lesson: He did not want to be an economicconsultant. "As an economic consultant," he says, "how youpackage your work is more important than what you have actually done.There is massive herding in economic forecasting. By staying near thebenchmark or the prevailing range, you get all the upside of being rightwithout the downside. Once I understood the rules of the game, I becamequite cynical about it."

After graduating from Cambridge in 1992, O'Shea landed a job as atrader for Citigroup. He was profitable every year, and his trading lineand responsibilities steadily increased. By the time O'Shea left Citigroupin 2003 to become a portfolio manager for Soros's Quantum Fund, hewas trading an exposure level equivalent to a multibillion-dollar hedgefund. After two successful years at Soros, O'Shea left to become a globalmacro strategy manager for the multimanager fund at Balyasny, aportfolio that was to be the precursor for his own hedge fund,COMAC, formed two years later.

O'Shea has never had a losing year. The majority of his trackrecord, spanning his years at Citigroup and Soros, is not available forpublic disclosure, so no precise statements about performance can bemade. The only portion of this track record that is available is for theperiod at Balyasny, which began in December 2004, and his currenthedge fund portfolio, which launched in June 2006. For the combinedperiod, as of end of 2011, the average annual compounded net returnwas 11.3 percent with an annualized volatility of 8.1 percent and aworst monthly loss of 3.7 percent. If your first thought as you read thisis "only 11.3 percent," a digression into performance evaluation isnecessary.

Return is a function of both skill (in selecting, implementing, andliquidating trades) and the degree of risk taken. Doubling the risk willdouble the return. In this light, the true measure of performanceis return/risk, not return. This performance evaluation perspective isespecially true for global macro, a strategy in which only a fraction ofassets under management are typically required to establish and maintainportfolio positions. Thus, if desired, a global macro manager couldincrease exposure by many multiples with existing assets under management(i.e., without any borrowing). The choice of exposure willdrive the level of both returns and risk. O'Shea has chosen to run hisfund at a relatively low risk level. Whether measured by volatility(8.2 percent), worst monthly loss (3.7 percent), or maximum drawdown(10.2 percent), his risk metrics are about half that of the average forglobal macro managers. If run at an exposure level more in line with themajority of global macro managers, or equivalently, at a volatility levelequal to the S&P 500, the average annual compounded net returnon O'Shea's fund would have been about 23 percent. Alternatively, ifO'Shea had still been managing the portfolio as a proprietary account,an account type in which exposure is run at a much higher levelrelative to assets, the returns would have been many times higher forthe exact same trading results. These discrepancies disappear if performanceis measured in return/risk terms, which is invariant to theexposure level. O'Shea's Gain to Pain ratio (a return/risk measuredetailed in Appendix A) is a strong 1.76.

I interviewed O'Shea in London on the day of the royal wedding.Because of related street closures, we met at a club at which O'Shea wasa member, instead of at his office. O'Shea explained that he had chosento join this particular club because they had an informal dress code. Weconducted the interview in the club's drawing room, a pleasant space,which fortunately was sparsely populated, presumably because mostpeople were watching the wedding. O'Shea spoke enthusiastically as heexpressed his views on economics, markets, and trading. At one pointin our conversation, a man came over and asked O'Shea if he couldspeak more quietly as his voice was disrupting the tranquility of theroom. O'Shea apologized and subsequently dropped his voice level tolibrary standards. Since I was recording the conversation, as I do for allinterviews—I am such a poor note taker that I don't even make theattempt—I became paranoid that the recorder might not clearly pick upthe now softly speaking O'Shea. My concerns were heightenedanytime there was an increase in background noise, which includedother conversations, piped-in music, and the occasional disruptivebarking of some dogs one of the members had brought with him.I finally asked O'Shea to raise his voice to some compromise levelbetween his natural speech and the subdued tone he had assumed. Themember with the barking dogs finally left, and as he passed us, I wassurprised to see—although I really shouldn't have been—that it was thesame man who had complained to O'Shea that he was speaking tooloudly.

* * *

When did you first become interested in markets?

It was one of those incredible chance occurrences. When I was 17, I wasbackpacking across Europe. I was in Rome and had run out of books toread. I went to a local open market where there was a book vendor, and,literally, the only book they had in English was Reminiscences of a StockOperator. It was an old, tattered copy. I still have it. It's the only possessionin the world that I care about. The book was amazing. It broughteverything in my life together.

What hooked you?

What hooked me early about macro was ...

No, I meant what hooked you about the book? The book hasnothing to do with macro.

I disagree. It's all there. It starts off with the protagonist just reading thetape, but that isn't what he developed into. Everyone gives him tips, butthe character Mr. Partridge tells him all that matters, "It's a bullmarket."

That's a fundamental macro person. Partridge teaches him that thereis a much bigger picture. It's not just random noise making the numbersgo up and down. There is something else going on that makes it a bullor bear market. As the book's narrator goes through his career, hebecomes increasingly fundamental. He starts talking about demand andsupply, which is what global macro is all about.

People get all excited about the price movements, but theycompletely misunderstand that there is a bigger picture in which thoseprice movements happen. Price movements only have meaning in thecontext of the fundamental landscape. To use a sailing analogy, the windmatters, but the tide matters, too. If you don't know what the tide is,and you plan everything just based on the wind, you are going to end upcrashing into the rocks. That is how I see fundamentals and technicals.You need to pay attention to both to make sense of the picture.

Reminiscences is a brilliant book about the journey. The narrator startsout with an interest in watching numbers go up and down. I started outwith an interest in politics and economics. But we both end up in a placethat is not that far apart. You need to develop your own marketexperience. You are only going to fully understand what the traders inyour books were saying after you have done it yourself. Then yourealize, "Oh, that's what they meant." It seems really obvious. Butbefore you experience it and learn it, it's hard to understand.

What was the next step in your journey to becoming a traderafter reading Reminiscences?

I went to Cambridge to study economics. I knew I wanted to studyeconomics from the age of 12, well before my interest in markets. I wantedto do it because I loved economics, not because I thought that was apathway to the markets. Too many people do things for other reasons.

What did you learn in college about economics that wasimportant?

I was very lucky that I went to college when I did. If I went now, Ithink I would be really disappointed because the way economics iscurrently taught is terrible.

Tell me what you mean by that.

When I went to university, economics was taught more like philosophythan engineering. Since then, economics has become all about mathematicalrigor and modeling. The thing about mathematical modeling isthat in order to make problems tractable, you need to make assumptions.Assumptions then become axiomatic for the entire subject—not becausethey are true, but because they are necessary to get a solution. So, it iseasier to assume efficient markets because without that assumption, youcan't do the math. The problem is that markets aren't efficient, but thatfact is just conveniently ignored.

And the mathematical models can't include the unpredictableimpact of speculators, either.

That's right. Because once you introduce them, you have a mathematicalmodel that can't be solved. In the current world of economics, mathematicalrigor is valued above all else. It's the only way you will get yourPhD; it's the only way you will get a career in academia; it's the only wayyou will get tenure. As a consequence, anyone I would call an economisthas been moved out of the economics department and into history,political science, or sociology. The mathematization of economics hasbeen a disaster because it has greatly narrowed the scope of the field.

Do you have a favorite economist?

Keynes. It's a shame that Keynesianism in the United States has becomethis weird word whose meaning is barely recognizable.

That's because in the United States, people apply the wordKeynesianism to refer to deficit spending, regardless of whetherit occurs in an economic expansion or contraction.

That's not what he said.

I know that. Although he certainly would have favored deficitspending in 2008 and 2009, he would have had a very differentperspective about deficit spending in the expanding economythat prevailed in previous years.

Yes, Keynes was a fiscal conservative.

I'm curious as to your views regarding the critical dilemma thatcurrently faces the United States. On one hand, if deficits areallowed to go on, it could well lead to a catastrophic outcome.On the other hand, if you begin substantially cutting spendingwith current unemployment still very high, it could trigger asevere economic contraction, leading to lower revenues andupward pressure on the deficit.

The argument for fiscal stimulus is a perfectly coherent, logical case. Thecounterargument that we should cut spending now is also a perfectlyrational case. But both sides are often expressed in totally irrational ways.I think the biggest mistake people make is to assume there is an answerwhen, in fact, there may not be a good answer.

I actually had the same perception after the 2008 presidentialelection. I thought the economy had been so mismanagedbetween the combination of exploding debt and a postbubblecollapse in economic activity that there might not be anysolution. The American humor newspaper, the Onion, capturedthe situation perfectly. Their headline after Obama was electedwas, "Black Man Given Nation's Worst Job."

All solutions that will work in the real world have to embrace the factthat the U.S. is not as rich as Americans think it is. Most politicalsolutions will be in denial of that fact. The relevant question is: Whichdifficult choice do you want to make?

Did you know what you wanted to do when you were inuniversity?

Yes, become a trader. Although looking back at it, at the time, I didn'tquite know what that meant.

What was your first job after graduating?

I got a job as a junior trader at Citigroup in the foreign exchangedepartment. My first week at work was the week when the pound waskicked out of the ERM.

The Exchange Rate Mechanism (ERM), which was operative in the decadesprior to the implementation of the euro, linked the exchange rates of Europeancurrencies within defined price bands. The U.K. was forced to withdraw from theERM in 1992 when the pound declined below the low end of its band.

The week when George Soros in the popular vernacular "brokethe Bank of England"?

Yes. As you may know, I worked for George Soros before starting my ownfund. My favorite George Soros story concerns an interview with ChancellorNorman Lamont, who stated that the Bank of England had £10billion in reserve to defend the pound against speculators. George apparentlywas reading an account of this interview in the next morning's paperand thought to himself, "d10 billion. What a remarkable coincidence!—that'sexactly the size of the position I was thinking of taking."

 

At the time, I remember explaining to the head of the trading floorwhy the pound would not leave the ERM. I argued that it would bepolitical suicide for the conservative government to drop out of theERM; hence they would make sure it didn't happen.
(Continues...)Excerpted from Hedge Fund Market Wizards by Jack D. Schwager. Copyright © 2012 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons.
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