Killer Instinct and the Home Run Mentality

Venture capital is financial capital provided to early stage companies, which have a high potential for rapid growth and scalability. These companies usually are high tech companies that possess a disruptive technology, or a novel business model. Typically, VC investments occur after the company has obtained it’s seed funding, and this subsequent capital raise, is recognized as the first in a series of growth funding rounds. It is the intention of the VC firm to successfully exit this investment, by means of a a liquidity event( sale or IPO) within the required time-frame ( 3-7 years). Hopefully, they will have generated a large enough return on their investment to justify the extremely high risk of funding a start-up.

Investing in start-ups is so risky that VC’s typically only invest in about 2% of the companies they look at. Nevertheless, in an effort to increase their probability of success, VCs will build a portfolio of companies, knowing that approximately 60% will break even, 20% will go bankrupt, and 20% will hit a home run. It is the concept of the home run that is fundamental to understanding the venture capital model. In VC parlance a home run is any investment which can return the whole capital of the portfolio at least once, and a 25X multiple is usually accepted as a proxy for that level of performance.

Consider that of the nearly 2,000 technology initial public offerings since 1980, only 5% account for over 100% of the $2-trillion-plus in wealth creation. And even within this small wealth generating group, only a handful delivered the bulk of the huge payoffs. Therefore we can draw the conclusion that it is in the tails where venture returns are generated.The home run’s impact on venture returns is critical to it’s success, and every successful venture fund in history has included at least one home run. Most VC firms are often referenced by the particular home run company they invested in, as with Kleiner- Perkins and Google, or Accel Partners and Facebook.

The home run theme in venture capital parallels the "killer mentality" found in all successful traders. It is a concept that is universally shared by all the great traders - Paul Tudor Jones, Louis Bacon, George Soros, and John Paulson. This mentality is a recurring theme with traders like Bill Eckhardt, Tom Baldwin, Bruce Kovner, and almost all the “Wizard” traders. Just like the VC firms that were recognized by the extemely successful companies they invested in, these traders are remembered for the career changing trades they made, i.e., Soros shorting the British Pound, and Paulson shorting CMOs.

Successful trading is not so much about finding a better indicator or trading system. Trading boils down to mathematics and patience. It is about the ability to identify and wait for extremely profitable opportunities, and then take maximum advantage of them. Just like venture capital, the trades that can make a difference, are found in the tails.

This is one reason why trading is so difficult. There is the eternal dichotomy, where one must be conservative with risk, getting out of losing trades quickly, while at the same time pressing and adding when the moment is right. We often find traders that are so risk averse and gun shy that they can never get past trading their 1s, 2s, and 3 lots, and at the same time we see traders that revenge trade out of frustration. However, it is rare to find the trader that realizes that 80% of the time, he is going to make or lose a small amount of money or scratch. But, realizes that the corollary to that statistic are the frequent times when opportunity and probability calls for the trader to step beyond their own comfort levels and risk thresholds, and lever up.

Successful traders tend to increase their size in direct proportion to their confidence in a trade. And, what is true for size is also true for time. The less-successful trader is apt to become risk-averse in the face of a profitable position and exit early. Overzealously attempting to avoid the turning of profitable trades into losing ones can have a detrimental effect also, because it makes the strategy of pressing your winners, unable to reach it's true potential because profits are cut short.

I have had the privilege of trading beside Tom Baldwin and Charlie Di Francesca in the Bond pit, and Dimitri Balyasny, while we were both prop traders with Schonfeld Group , and before I bought my CBOT membership, I leased my first seat from Bill Eckhardt. All these traders had the uncanny ability to know when to press a trade, and I am sure that each one of these traders would admit that this ability was paramount in their success. Bill Eckhardt is quoted as saying, ““One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.”

Avoiding losses by taking small winners will make the trader “feel” successful, as their P&L will be more profitable in the short term, but it will directly affect their long term performance. It will also become progressively more difficult to overcome slippage and commissions when scalping for small profits as your size increases. Therefore, traders must practice what is best for them, and not what makes them feel better. It is only then that their P& L will progress to the next level.

THE SWEET SCIENCE

It has always been my contention that trading is not rocket science, but more like the sweet science. Just like a boxer steps into the ring to fight a larger, stronger opponent, a traders sits down in front of his screen(s), and faces what is arguably a much tougher and more formidable opponent. At times the trader’s opponent is very predictable and easy to hit, but the majority of the time, his opponent is extremely unpredictable and elusive.

A good fighter will recognize the type of opponent he is facing that night by gradually sizing up his opponent's strengths and weaknesses, and then “take what’s given him”, and a good trader will analyze the market’s price action, and do the same. Just like the fighter, the trader will know his opponent’s tendencies and have a plan, and just like the fighter,the trader will ultimately rely on his instincts and his ability to analyze the type of market that is confronting him currently, and adjust accordingly.

The boxing analogy to trading was never more apparent to me than last night, as I watched Manny Pacuiao pick apart the much larger and stronger Tony Margarito. It was all there on display:; skill, technique, pacing, discipline, and patience. Manny took advantage of what was given to him, and exploited Margarito’s weaknesses, while staying away from his opponent’s strengths. He took the fight to Tony and pressed at the right times, and when the openings weren't there, he pulled back and rested.

Good traders share the same attributes as good fighters. They know and understand their opponent, and don’t take anything for granted. They don’t underestimate their opponent, leaving themselves vulnerable to a “knockout”, and they don’t overestimate their adversary, rendering themselves intimidated and tentative.

There are times when the market is only giving you scalps, and there are trend days or event driven moves, where there might be +20 points in a trade. A good trader will recognize the difference and know when to go for the knockout. Successful traders control their risk, but when the opportunity presents itself, they will hold, press, and add to their winners.

You can scalp and make money, but it’s a lot of work. It may also appear to be less risky, because you are taking smaller losses, but you are also going to be taking many more losses.  And there is too much emphasis on “tools” for trading, and not enough emphasis on developing an intuitive feel for the market. Do traders really need an indicator, to tell them when the market is choppy? Quite simply, if you can accurately interpret price action and you have a good money management methodology, you are going to make a lot of money.

I find there is a very strong positive correlation between my P&L and the amount of time I am in a trade. I am not concerned with my percentage of winners, but more concerned with the size of my winners relative to my losers and my hold time. I’ll risk 5 or 6 ticks on 50 bonds, and sit with the trade for 4 hours or more, if there is a high probability I can take a point out of the trade. Just like a boxer must learn not to be afraid to get hit, a trader must learn not to be afraid to lose money. In fact, I much rather risk 3-4 points in the ES, to make 10-12 points, then to risk 1 point to make 3 points. I am going to get stopped out much less, and I am going to make much more money. Of course, you need markets that are moving, and that have much larger ranges than we are currently experiencing to execute this strategy.

As Bill Eckhardt remarked, you can go broke taking profits, if those profits are too small. IMO, the only way to make a lot of money trading electronically, is to hold your winning trades for a longer period of time. This will allow you to to trade with wider stops, which will result in getting stopped out less. It’s O.K. to pick your opponent apart and win the contest by outscoring him, but if you want to take it to the next level, you have to know when to go for the knockout and the big win.

TURTLE SOUP

William Eckhardt is one of the most consistently successful CTAs in futures trading, and along with Richard Dennis, is the founder of the Turtles. It was Eckhardt that bet Dennis that successful trading could not be taught, and it was this bet that gave birth to the Turtle Trading Program. Although he lost the wager with Dennis, Eckhardt went on to be an immensely successful CTA, and is regarded by many as one of the best futures traders.

“If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and inevitably lose.” – William Eckhardt

“It’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies.” – William Eckhardt

“One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.” – William Eckhardt

“The people who survive avoid snowball scenarios in which bad trades cause them to become emotionally destabilized and make more bad trades. They are also able to feel the pain of losing. If you don’t feel the pain of a loss, then you’re in the same position as those unfortunate people who have no pain sensors. If they leave their hand on a hot stove, it will burn off. There is no way to survive in the world without pain. Similarly, in the markets, if the losses don’t hurt, your financial survival is tenuous.” – William Eckhardt

“I know of a few multimillionaires who started trading with inherited wealth. In each case, they lost it all because they didn’t feel the pain when they were losing. In those formative first few years of trading, they felt they could afford to lose. You’re much better off going into the market on a shoestring, feeling that you can’t afford to lose. I’d rather bet on somebody starting out with a few thousand dollars than on somebody who came in with millions.” – William Eckhardt

“In many ways, large profits are even more insidious than large losses in terms of emotional destabilization. I think it’s important not to be emotionally attached to large profits. I’ve certainly made some of my worst trades after long periods of winning. When you’re on a big winning streak, there’s a temptation to think that you’re doing something special, which will allow you to continue to propel yourself upward. You start to think that you can afford to make shoddy decisions. You can imagine what happens next. As a general rule, losses make you strong and profits make you weak.” – William Eckhardt

“If you’re playing for emotional satisfaction, you’re bound to lose, because what feels good is often the wrong thing to do. Richard Dennis used to say, somewhat facetiously, “If it feels good, don’t do it.” In fact, one rule we taught the Turtles was: When all the criteria are in balance, do the thing you least want to do. You have to decide early on whether you’re playing for the fun or for the success. Whether you measure it in money or in some other way, to win at trading you have to be playing for the success.” – William Eckhardt

“Trading is also highly addictive. When behavioral psychologists have compared the relative addictiveness of various reinforcement schedules, they found that intermittent reinforcement – positive and negative dispensed randomly (for example, the rat doesn’t know whether it will get pleasure or pain when it hits the bar) – is the most addictive alternative of all, more addictive than positive reinforcement only. Intermittent reinforcement describes the experience of the compulsive gambler as well as the future trader. The difference is that, just perhaps, the trader can make money.” However, as with most affective aspects of trading, its addictiveness constantly threatens ruin. Addictiveness is the reason why so many players who make fortunes leave the game broke.” – William Eckhardt

“Don’t think about what the market’s going to do; you have absolutely no control over that. Think about what you’re going to do if it gets there. In particular, you should spend no time at all thinking about those rosy scenarios in which the market goes your way, since in those situations, there’s nothing more for you to do. Focus instead on those things you want least to happen and on what your response will be.” – William Eckhardt

MARKET DELTA , MARKET PROFILE, & DEMARK STUDIES