Reblog: Lessons From a Trading Great: Paul Tudor Jones

From Jack Schwager’s Market Wizards:

October 1987 was a devastating month for most investors as the world stock markets witnessed a collapse that rivaled 1929. That same month, the Tudor Futures Fund, managed by Paul Tudor Jones, registered an incredible 62 percent return. Jones has always been a maverick trader. His trading style is unique and his performance is uncorrelated with other money managers. Perhaps most important, he has done what many thought impossible: combine five consecutive, triple-digit return years with very low equity retracements. (I am fudging slightly; in 1986, Paul’s fund realized only a 99.2 percent gain!)

Jones has succeeded in every major venture he has tried. He started out in the business as a broker and in his second year grossed over $1 million in commissions. In fall 1980, Jones went to the New York Cotton Exchange as an independent floor trader. Again he was spectacularly successful, making millions during the next few years. His really impressive achievement though was not the magnitude of his winnings, but the consistency of his performance: During his three and a half years as a floor trader, he witnessed only one losing month.

It’s been 25 years since Paul Tudor Jones (PTJ) was featured in the original Market Wizards. He has since maintained his all-star track record. According to the New York Times, as of mid-2014, PTJ’s flagship fund averaged long-term annual returns of around 19.5%. And what’s even more impressive is that he didn’t have a single losing year over those 25 consecutive years — a feat unheard of in the hedge fund industry.

To follow is an examination of this legendary fund manager, whose trading style resembles that of a street fighter and whose gut-instinct for market turns are unparalleled.

PTJ on the most important thing… “Don’t lose money”

“…at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”

PTJ has an aggressive, cut-throat trading style, which is necessary if you want to string together multiple 100%+ years like he did. But what’s extraordinary about this record is the lack of drawdowns. It’s something only a handful of traders have ever accomplished (ie, Druckenmiller, Soros, Brandt).

He achieved this by mastering risk-management and consistently chopping off that left tail. This is a key trait of ALL top traders and investors… and PTJ stands out as one of the best. He learned the critical importance of managing risk through the painful and indelible experience of trading and making mistakes.

• Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great money management tools.
• That was when I first decided I had to learn discipline and money management. It was a cathartic experience for me, in the sense that I went to the edge, questioned my very ability as a trader, and decided that I was not going to quit. I was determined to come back and fight. I decided that I was going to become very disciplined and businesslike about my trading.

Author Brian McGill writes, “We are never taught more deeply and more truthfully than by pain.” True words…

PTJ has mentioned that when hiring traders he prefers those who have blown up accounts and suffered the pain of large losses. These traders have had risk management seared into their very being. This is a trait that almost has to belearned through experience and can’t be taught.

Side note: I remember reading the original Market Wizards book over a decade ago when I was as a green-behind-the-ears market punter. It seemed that every interview included a “Market Wizard” recounting their blown account from the early days and physical and emotional anguish that came with it. I thought to myself “wow, that sounds shitty. I’ll just never do that so I don’t have to experience something similar. Luckily, I’m an extremely levelheaded guy who doesn’t get emotional over trading. I’ll just stick to my risk management protocols and be fine.”

Fast forward a couple of years, two blown out accounts and a lot of money up in flames later, and yours truly finally realized how naive (stupid, ignorant, arrogant etc) he’d been. One of the Market Wizards (don’t remember the name) said something along the lines of “experiencing the pain of blowing up an account is a necessary stepping stone to learning how vital risk management is.” I couldn’t agree more. I emerged from the visceral and painful experiences of those big losses humbled and equipped with a maniacal focus on not losing money. Those early losses were important money spent on my trading tuition.  

Like Seykota said, “The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.” For some reason this is a platitude repeated by many, but understood by very few.

• I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money.
• There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum drawdown pain and maximum upside opportunities.
• Don’t ever let them get into your pocket — that means there’s no reason to leverage substantially.
• When I am trading poorly, I keep reducing my position size. That way, I will be trading my smallest position size when my trading is worst.
• I have very strong views of the long-run direction of all markets. I also have a very short-term horizon for pain.
• Everything gets destroyed a hundred times faster than it is built up. It takes one day to tear down something that might have taken ten years to build.

On The Importance of Asymmetry And Macro

So much of successful trading consists of finding the right balance between risk management and betting big on the juiciest opportunities. This is one of the most difficult questions a trader is forced to constantly grapple with. There are no perfect answers.

Markets are fluid and dynamic. There will always be many unknowns. And because of this inherent complexity, a trader should always err on the side of capital preservation over profit maximization. It’s a lot easier to get steam rolled than it is to hit the cover off a fat pitch.

An important tool in rectifying the capital preservation/profit maximization dilemma is the understanding and implementation of asymmetry in trading.

Profitable trading is about finding and creating positive asymmetry. Positive asymmetry is when potential gains are multiples of potential losses. The greater the positive multiple, the greater the asymmetry. A trader should always be thinking in this fashion of potential risk weighted against potential reward (risk/reward).

A trader can find asymmetric opportunities through many approaches (ie, technical, fundamental, macro, sentiment etc) and then create more asymmetry through position sizing and risk/trade management. Finding and creating asymmetry is a central aspect of PTJ’s approach.

• [I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.
• I’d say that my investment philosophy is that I don’t take a lot of risk, I look for opportunities with tremendously skewed reward-risk opportunities.

PTJ is a macro trader. Trading macro means different things to different people. To PTJ, it means he doesn’t adhere to any single approach and is unconstrained in where he goes and what he trades. He also often takes a top-down approach when assessing markets. He simply uses whatever tool that works and makes him money.

• I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader.
• The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge. Because I think there are certain situations where you can absolutely understand what motivates every buyer and seller and have a pretty good picture of what’s going to happen. And it just requires an enormous amount of grunt work and dedication to finding all possible bits of information.

Market prices are the reflection of two forces: supply and demand. It’s the goal of the trader to use the tools at his disposal to better understand the supply and demand situation of the asset he’s trading. A mental model we use at Macro Ops is the Transaction Approach to determine buying and selling in markets.

• I know from studying history that credit eventually kills all great societies. We have essentially taken out our American Express card and said we are going to have a great time.
• Maybe there are macroeconomic forces at work that are part of a larger super cycle that we don’t have any control over. Perhaps we are simply responding to the same type of cycles that most advanced civilizations fell prey to, whether it was the Romans, sixteenth century Spain, eighteenth-century France, or nineteenth-century Britain.
• You look at every bear market and they’ve always basically occurred because of an uptick in inflation and an uptick in interest rates.

Markets move in cycles. There’s the short-term cycle (aka the business cycle) and the longer-term cycle. These cycles are predominantly driven by credit (debt) and its affects on demand and the balance sheets of countries, companies, and people. Understanding the interaction of these two debt cycles and how they drive bull and bear markets is at the foundation of how our team at Macro Ops approach markets.

And because credit is the largest factor in driving demand, Central Banks, who control the cost of money (credit), are the primary causes of bull and bear markets.

• When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500.
• When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form.
• Certain people have a greater proclivity for [macro trading] because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility, of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.
• These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation.

Many market participants — especially the “smart” ones — fail because they think they can understand every move. To them, it’s more important to sound intelligent than it is to make money over the long-term. Academic economists who have a history of sounding smart but being wrong are great examples of this.

As a trader you have to know what you know and know what you don’t know… and never get the two mixed up. Markets will never fail to surprise you. One of the most dangerous things in this game is uniformed conviction. Be humble, embrace your fallibility and know that it’s impossible to really know the why in this game with anything close to absolute certainty.

Why it pays to be a “Slave to the Tape”

PTJ has an uncanny knack for reading the tape (price action) and getting a feel for where markets are going. A product no doubt of the era in which he came up, where information was scarce and the tape was the primary signal and information source. Since the market always knows more than you do, a trader has to respect price above all else.

• The inability to read a tape and spot trends is also why so many in the relative value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced ‘100-year events’ every five years.
• While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.
• …at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s? If it’s going up you’re supposed to be long it. But there’s no question that it’s just easier for me to leverage with some degree of conviction the short side of some markets.
• I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart.
• …technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action.

Livermore would say, “Your business with the tape is now — not tomorrow. The reason can wait. Buy you must act instantly or be left.” PTJ understands that truth and pays ultimate respect to price action as a result.

• All the trades I have on are interrelated. I look at it in terms of what my equity is each morning. My goal is to finish each day with more than I started.
• Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle… I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops.
• It’s not that we had any unfair knowledge that other people didn’t have, it is just that we did our homework. People just don’t want to believe that anyone can break away from the crowd and rise above mediocrity.

Evolution, Staying Frightened, and Emotional Detachment

The evolution of a trader generally follows the progression of moving from simplicity —> complexity —> informed simplicity. The goal is to build up your knowledge base, find what works, and strip yourself of what doesn’t. Da Vinci was right when he said “simplicity is the ultimate sophistication”. Many traders hide their ignorance with complex models, indicators, and theories filled with big words but of little value.

• There’s a fundamental information set that you acquire with regard to each particular asset class and then you overlay a whole host of technical indicators and that’s how you make a decision.
• Tullis taught me about moving volume. When you are trading size, you have to get out when the market lets you out, not when you want to get out. He taught me that if you want to move a large position, you don’t wait until the market is in new high or low ground because very little volume may trade there if it is a turning point.
• I consider myself a premier market opportunist. That means I develop an idea on the market and pursue it from a very low-risk standpoint until I have repeatedly been proven wrong, or until I change my viewpoint.
• When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion.
• …because of the complexity of defining interacting and changing market patterns, a good trader will usually be able to outperform a good system.
• It doesn’t make any difference whether it’s pork bellies or Yahoo. At the end of the day, it’s all the same. You need to understand what factors you need to have at your disposal to develop a core competency to make a legitimate investment decision in that particular asset class.
• Now I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out; if they are going for me, I keep them.
• The idea that you can’t beat the markets is a frightening prospect. That is why my guiding trading philosophy is playing great defense. If you make a good trade, don’t think it is because you have some uncanny foresight. Always maintain your sense of confidence, but keep it in check.
• I think one of my strengths is that I view anything that has happened up to the present point in time as history. I really don’t care about the mistake I made three seconds ago in the market. What I care about is what I am going to do from the next moment on.
• I try to avoid any emotional attachment to a market. I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.
• [No loyalty to positions] is important because it gives you a wide open intellectual horizon to figure out what is really happening. It allows you to come in with a completely clean slate in choosing the correct forecast for that particular market.
• I know that to be successful, I have to be frightened. My biggest hits have always come after I have had a great period and I started to think that I knew something.
• When I think of long/short business, to me there’s 5 ways to make money: 2 of those are you either play mean reversion, which is what a lot of long/short strategies do, or you can play momentum/trend, and that’s typically what I do.  We’ve seen cheap companies get cheaper many, many times.  If something’s going down, I want to be short it, and if something’s going up, I want to be long it.  The sweet spot is when you find something with a compelling valuation that is also just beginning to move up.  That’s every investor’s dream.

PTJ is a legendary trader because he’s great at playing defense and neurotic about protecting his capital. He never pigeonholed himself into a single trading approach but instead uses a multitude of tools; adopting what works and tossing what doesn’t. Through years of studying the tape he developed an instinctual feel for price action which allows him to spot turning points in markets and be aggressive at inflection points.

And above all else, even after obviously becoming one of the greatest, he’s still maintained a deep sense of humility in approaching markets which has allowed him to remain mentally flexible and robust.

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”