|Interview with Jack Schwager
[notations by NQoos]
highlights by NQoos
I agree with much but not all below. NQoos 8-)
Jack Schwager, Co-Manager of Fortune Asset Management's Market Wizards Funds (a fund of hedge funds) and author of Market Wizards, The New Market Wizards, and Stock Market Wizards requires little introduction to the TradeStationWorld community. Based on his prior experience, which includes 22 years as the director of futures research for some of Wall Street's leading firms and ten years as the co-principal of a commodity trading advisory firm, and countless interviews with traders, we'd like to share with you some of his thoughts on the world of strategy trading.
Janette: Jack, have you always been a believer in strategy trading?
Jack: No, I certainly haven't always felt that way because when I first started out in my first five or six years in the business, I was purely a fundamental analyst and actually was very skeptical, if not cynical, about technical analysis. That attitude was based on biases rather than any actual evaluation. It wasn't that I tried technical analysis and found it didn't work; it just seemed to me intuitively that it wasn't scientific.
Janette: How did your opinion change?
Jack: My perceptions about technical analysis changed through someone who worked for me by the name of Steve Chronowitz. At the time, I was a Research Director for a futures firm and Steve was my technical analyst. I noticed that Steve did pretty well with his calls, and I knew he was purely a technical analyst. So I asked him to show me what he was doing, and I showed him what I was doing fundamentally. We basically educated each other on our respective methodologies. Once I became exposed to technical analysis, I saw that maybe it might work because the market is just reflecting the input of all the participants. It's not a matter of magic-it's just basically a reflection of market psychology, which is human nature, and one could argue that human nature really doesn't change, so there might very well be repeatable patterns.
Janette: Did you start using technical analysis in your own trading?
Jack: The transformation began when I started experimenting using technical analysis. I found it very appealing because I was also trading my own account and one problem I always had with fundamental analysis was that it never gave you entries or exits.
Janette: Can you give us an example?
Jack: Certainly. Fundamental analysis tells you if the market is over-priced or under-priced, given the known information, but you don't always have all the inputs. For example, if your analysis tells you the wheat market is
underpriced at $3.50, and it goes down to $3.00, it would be more underpriced as long as the fundamentals didn't change. There is nothing that will get you out of the position, and there are a number of weaknesses in that. To begin, you have to be drastically wrong only one time to wipe out your account. Beyond that, the price weakness could develop because of fundamental changes that are clearly not predictable such as a drought or a huge export order from an unexpected source. Alternatively, you could have structural changes in the market that might not become evident until after the fact. In other words, once all the smoke cleared a year later you could say,
"Ah, this is why prices went that way," but there's no way you could have seen it at that time. All of these problems relate to the fact that in fundamental analysis, the very approach is inherently in contradiction to money management control. I'm talking about fundamental analysis on futures or index markets here, not fundamental analysis on individual equities.
The nice thing about technical analysis is that by definition you're using an approach in which the money management is built-in. If a market is going down, you're not going to be buying more because it's at a better price. On the contrary, you're going to be getting out of the trade because you're long and you lost money. In other words, if you're losing money, the trends have changed and your stops are going to get activated. In short, I found it much easier to trade with technical analysis than with fundamental analysis.
Janette: Is there one specific trade you can point to?
Jack: Yes, one trade I will always remember as
one of the best trades I ever made, was ironically a losing trade. It was a trade that occurred the first year I started using technical analysis in trading. The D-Mark was in a narrow basing pattern for many months, and I thought it was bottoming out. So, I went long, but I put a stop in right below the base.
When the D-mark started to go down, I got stopped out and took a modest loss on the trade. The D-Mark then proceeded to go down and down, and I just knew that if I hadn't been using technical analysis that the small loss could have been a huge loss.
That's just one example of a trade that helped to solidify my biases in favor of using technical analysis. I still used fundamental analysis sometimes to define my direction in the market, but I strictly used technical analysis for timing. That was the transition I underwent. Thus my attitudes about technical analysis going in, with no knowledge of the markets, were radically different than they were six years later and thereafter.
Janette: That's really interesting that you're saying that
this was one of the best trades although it was a losing trade because of all the experienced you gained. Can you give us more background on how you started in the markets?
Jack: I got into the markets out of graduate school with an Economics degree. I expected to have jobs offered to me on a silver platter (coming out of an Ivy League School). After two weeks of going to employment agencies and not getting any calls back, I got pretty frustrated. So, I came up with the idea of putting an ad in the New York Times
"Position Wanted" section, saying nothing more than, "M.A., major in Economics, minor in Math, Brown University. Looking for an analytical job.
Janette: What was the outcome?
Jack: Well, I got fifteen calls back on that one small ad. Unfortunately, fourteen were bogus responses. I followed up on one and then learned the game, which spared me from the rest. All the responses except for one were really the type of thing where they lead you on to believe that there's a job, and when you show up, you're solicited for one of these chain marketing deals-really taking advantage of people who are looking for jobs. The one legitimate inquiry I had was from Reynolds Securities (which subsequently was merged into Dean Witter for a commodity analyst job that had opened up.
Now, I don't know if it's any different these days, but when I went through college and graduate school, in economics, they taught you nothing...zero...not anything...not one word about commodity markets. When I was asked if I knew anything about commodities, my
"insightful" response was -- and I still wince at the memory -- "something like gold?" That really was all I knew about it. The Research Director was writing a commodity column for Barron's and would have other people do the leg work and write a draft that he would then rewrite and use it for his column. When he was interviewing candidates for this position, he got it down to four people, and had each of us write an article on a commodity. I was assigned copper. Well, I knew nothing about it, so I went down to Grand Army Plaza, which is this huge library in Brooklyn, New York, and I literally spent the week there reading everything I could on copper. I got the American Metal Market Bulletins going back for as many years as they had and sat there going through them a day at a time, absorbing any information I could get. I also went through years of the McGraw Hill weekly letters on metals and other assorted articles on copper. I essentially educated myself as an
"expert" in copper. After about a week, I knew enough to write an article. I wrote the article and got the job. I was told later on by someone who worked in the same department and who became a good friend that they had passed around the articles of the various candidates and everybody said
"hire this guy!" I actually kept the article and ten years later, I came across it cleaning up my files and read it. At that point, I had lots of knowledge about commodities, especially fundamentals, and was actually surprised at how good it was-you wouldn't have known that the person writing it only had one week's worth of experience with the markets. So, I really wrote myself into the job.
Janette: And how did the Complete Guide to the Futures Markets come about then?
Jack: It's amazing that when I think about all these things how many of them are purely accidental... I mean, I fell into this business accidentally, I ended up writing books accidentally. What had happened was that after I was an analyst for nine months, a magazine started called
"Commodities," which is now called "Futures Magazine" I submitted some articles which were published and I eventually became a contributing editor for the magazine. Those articles gave me a little name recognition and also some experience writing for publications.
At the time, Perry Kaufman was the editor for this enormous compendium called
"The Handbook of Futures Markets." He was soliciting articles on all different subjects relating to commodities. Each contributor had a different subject, so he asked me to write about fundamental analysis. I started writing and after a month or so, I realized that I had seventy pages and was nowhere near done. It seemed crazy to submit such a block of writing as an article in someone else's book. I called Perry and told him that the subject was too broad and suggested that I give him an article that was more focused on another, narrower subject.
Having seventy pages already written, my thinking was that I probably had a third of a book. I sent what I had to John Wiley, along with a proposal and table of contents, and they came back and said they were interested. Well, as it turned out, I had grossly underestimated how much of the book I had done; I didn't have a third of the book done, it was more like a tenth. The book ended up being about 750 pages long and this was pre-computer-at least as far as I was concerned. There were lots of charts and tables... I dictated the entire book and then corrected the drafts. Moreover, all the tables and charts were not being done on Excel or any other software. If I had to do a regression analysis with two variables, I'd do it on an ordinary calculator (that is, one without regression functions). It was really labor intensive, and I ended up taking a 9-month sabbatical to finish the book. It was one of those things where I worked through many nights. When I look at the book now, I think it would take me a year to read it and am amazed that I wrote it in about the same time without a computer!
Janette: It is quite remarkable.
Jack: Anyway, I finished the book, put it in a box (because it was that heavy-a couple of thousand pages in typewritten text and accompanying charts and tables) and I took the train to New York. I remember dropping it on the editor's desk with a great sigh of relief to be done with it. I don't know if I even had a Xerox copy of it. The one conviction I had at the time was that I was done writing analytical books. I decided that if I ever wrote another book again, it would be for a more general audience. I had this fun idea to interview great traders and thought it would be a good subject for a book. The idea for the book and its eventual title
"Market Wizards" came to me years before I actually wrote it. Several years after the publication of
"The Complete Guide to the Futures Markets," another publisher approached me who wanted to do a series of books on fundamental analysis of different markets (e.g., gold analysis, bond analysis, currencies analysis, etc.) and to have one master editor oversee the project. Their idea was to keep the content very focused and to charge a very high price per book, printing just a thousand copies per volume. I said that the project was going in exactly the opposite direction of where I wanted to go. I told them that if I was going to do any other book, it would be along the lines of the
"Market Wizard" book concept. They liked the idea, and that's how I came to write the
"Market Wizard" series.
Janette: It's a great series. Jack, in your book you are quoted as saying that
"Trading without a strategy is like building a house without a blueprint". How do you define a trading strategy and do you feel that there are main categories, or subsets of strategies?
Jack: First I should say that particularly with all the experience I've had with meeting traders and interviewing traders both from writing the books and also as a fund of funds manager, one thing I've come to respect is that
you don't necessarily have to have a
precise cookbook, recipe type, strategy-but
you do need to have an approach and a methodology. I don't think
you could be a successful trader if you just sit in front of a screen and say
"Oh, I think I'll buy this and sell that," without having specific factors that you look at or a plan on how to get in and when to get out. If you're kind of winging it like that, I don't think that's going to work
- even for people who are discretionary. They still have more of a methodology than that.
Janette: Around here we always say,
"plan the trade, then trade the plan".
This is the principle concept your books try to get across. Now, as far as the developing a methodology, do you feel there is one approach that works best when you're looking for buy and sell rules?
there are lots of different approaches. When speaking of purely systematic traders, the group can be broken down as trend following and pattern recognition. Of course, trend following is also based on patterns, but I break it out separately because it accounts for the majority of technical systems and has specific behavioral characteristics. Pattern recognition is a
"catch all" for a lot of different things. It might mean mathematically defining certain patterns on the chart and acting when those patterns arise or it might mean looking at probabilities of certain price moves or neural nets, or a cyclical-based system, or a host of other mechanical, mathematical approaches. Once you get into mathematical approaches, there is also the whole area of statistical arbitrage, which has to do with trading one instrument against another and looking for deviations from normal relationships between different instruments and trying to arbitrage those distortions. That's an approach that is completely automated and systematic, yet has nothing in common with trend following.
Janette: Would you also lump counter-trend strategies into this category?
Jack: Yes. Counter-trend, if its purely mechanical, would also fall into what I would term the pattern recognition category. Although when you're dealing with futures markets, I have my doubts that a pure counter-trend methodology can work effectively on its own.
[ I have no doubts 8-) NQoos] I think counter-trend has its place as a way of combining it with trend systems.
[agree] I believe it's very difficult to design profitable counter-trend systems, which are not subject to large risk. However, counter-trend systems can be very useful even if they break even because they are completely inversely correlated to trend following strategies. A break-even counter-trend strategy will cut volatility tremendously when you combine it with a trend-following system. In other words, counter-trend systems are a useful tool for smoothing returns.
Counter-trend strategies could work great if you know if you're going to have a trading range market, but they could lose an unlimited amount of money if you have a trending market. I remember one time someone came to me with one of these systems that someone was trying to sell him them. It was a chart of the Eurodollar market, which showed all the buy signals lower than the sell signals. I took one quick glance at the chart and noticed one very obvious thing -- it was a broad trading range. I asked him to go back and have the vendor run the strategy on a market that had a strong trend. I never heard back from him again.
One major difficulty in trading counter-trend strategies by themselves is that there's an intrinsic contradiction between counter-trend systems and money management. Think about it... you're going to sell a market because it goes up too much or some indicator is oversold. So you go short. Then the market goes up more, the indicator becomes more oversold. What are you going to do? Go short more? However, you say to yourself,
"I'm smarter than that... I can't do that because if I do, that then I'll lose an unlimited amount of money and it violates all my money management rules...I'm going to put a stop in". Okay, fine. If you do that, when the market is oversold you go short and if it goes more oversold, you get out-that fights the strategy.
Janette: Now, focusing on the technical aspects, what benefits do you see in having a mechanical trading strategy?
Jack: Well, the tremendous advantage is a lot less wear and tear on your psyche. I've been in both places as a human trader and a strategy trader and I will tell you it's a lot more comfortable being a purely systematic trader. You don't have to worry about the market going violently against you. If you have a purely systematic approach, the strategy will get you out. But most importantly, you don't agonize over the decision-making. Do I get out now? Should I give it another day or two? Should I add? The system will take care of all the decisions. By definition, as a strategy trader, you shouldn't try to second guess or anticipate the system signals. So, there's a lot less emotional wear and tear with a systematic approach. I find it much more comfortable to trade that way.
This brings up another point-what's right for me is right for me and may be right for some other people, but it certainly is not right for everyone. Each person must find an approach that is personally comfortable.
You need to trade an approach that fits your personality. For example, I'm analytical and I don't enjoy making emotional decisions or being a gunslinger. For me, trading automated is far more comfortable than trying to trade while making decisions on when to pull the trigger. However, you can give a really good trading strategy to somebody whose personality is not in tune with it, and I guarantee you it will not work.
Janette: For those traders who are just starting out to develop a strategy, what essential factors do you think they should consider?
Jack: In one of my books, I use the line
"There are a million ways to make money in the markets. The irony is that they're all very difficult to find". The emphasis is that there are a million ways to do it. That means
everybody has got to find his or her own path. I think anybody who says,
"You really have to use daily and weekly charts and everything shorter term is just a waste of time," is just talking nonsense.[exactly] As is, the person who says,
"Daily and weekly charts are much too long. Markets act much too quickly. You really should use tick charts." They're both wrong.
There is no "have to". You can come up with perfectly good methodologies using any time frame or using no charts at all. It comes down to what you naturally gravitate toward.
I believe that the main value of most popular methodologies, such as Gann, Elliott Wave, Candlesticks, etc., is that for some people they are a really comfortable way to look at the markets. For some people, using Elliott Wave interpretation of market action fits the way they think-it works for them. But is it really Elliott Wave or is it because that person has some facility to interpret Elliott Wave and that's why he's successful? To me, these methodologies are just another way of looking at the markets and what's the best fit for that person. It's
like wearing glasses...
one person's prescription is not going to work for another person, but
that doesn't mean that one prescription is better than the other. It just means that one is right for one person, and
if each person gets the right prescription, they can see much better.
Janette: So, where would a person start?
Jack: First of all, you can't just sit down and say I'm going to be a great technical or systematic trader and start designing strategies.
You've got to watch markets in real-time and paper trade. You've got to get some real life experience to get some feel. From your experience, you draw ideas of what you think might work, and then take the ideas and systematize them in some way and test to see if that assumption bears out. It's not a matter of taking someone else's system and trading it. If you do that, you won't have any confidence or feel for it. Every strategy is going to go bad at certain points, and when that happens you'll end up bailing because you don't have any reason to have confidence in it; its not yours, you haven't done the analysis, and it doesn't reflect anything that you've done. So I think it's important for each person to develop his own methodology.
Janette: In your video series, Jack Schwager's Complete Guide to Designing and Testing Trading Systems", you talk about some of the pitfalls, specifically the
"Super Razzle Dazzle". What are you trying to get across?
Jack: What I was trying to say was, whether in articles about systems, ads for systems, or people giving presentations about systems, you'll invariably find these examples of the strategy with phenomenal trading signals. It looks just great.
The reason it looks great is because the example was chosen with the benefit of hindsight.
[...I do this on this website to convey the concepts.
There are other factors, some that I am unaware of when I trade that make the
trade work.. call it intuition or experience.]
Every conceivable strategy can be made to look great if you choose the right example.
[you must prove to your that a strategy works]
Janette: Then what should a trader be looking for?
Jack: Well, it's not the performance measures. It's testing the system correctly-no matter what performance measures you're using. Testing a strategy correctly means you're not using hindsight-plain and simple. If you're using hindsight, you're doing it wrong. The question then becomes,
"How do you do test a system it without hindsight?" There are two ways to do it. First, you can take a small amount of data, say one or two markets out of 30, or short segments of time for all markets and you use that data to develop the rules of your system.
Then use those rules and test them on the unseen data.
The other way is a walk-forward simulation. You place yourself back in time. Say it's 1985. You use data prior to 1985 to develop the system rules, and then test the system for 1985. You then repeat the process with data prior to 1986 and test 1986, and so on. The point is you use data up to a certain point of time and test on a point of time forward from that point and walk forward through time. Both of the approaches I've described are valid because they don't use hindsight. The single most important thing about testing trading strategies is to
[solely]-if you don't, then whatever you get is totally meaningless.
Janette: Okay, so once you've done the
'walk-forward simulation' or 'small data sampling' and you've got all this data back, how do you evaluate it?
Jack: You want to
look at return to risk. This is particularly true of the futures markets. Return by itself is totally meaningless. Here's an example: Let's take a strategy that returns 20% a year and has periodic drawdowns of 40%, and another strategy that only makes 10% a year but its worst drawdowns were 5%. Well, you might look at the system with the 20% return and think, "well, it's twice as good." But, what you could do is take the 10% system and leverage it 4:1 and end up with a 40% return with a 20% worst drawdown. Thus the system wiht a 10% return (but only a 5% drawdown) is actually a tremendously superior strategy. Return by itself has no meaning because you can take any strategy and just by leverage, change its return. So the only thing that's valid is return to risk.
Janette: That makes a lot of sense.
Jack: And the reason I said it was
particularly true of futures is because there's always excess capital (no reasonable person trades at full margin)
and there's no cost to borrow, so to become totally transformable and interchangeable. In that case it becomes an exact ratio- if the return to risk of Strategy A is 2:1, then it's superior to Strategy B if Strategy B's return to risk is anything less than 2:1, no matter what it's return is, because you can transform the lower return system to a higher return through leverage.
Janette: If we want to oversimplify the steps of constructing a trading strategy, how would you define the steps?
1. Come up with the ideas through market observation and research.
2. Develop a systematic set of rules based on these ideas.
3. Test the system without hindsight.
4. Implement the system. This is the simplest part. You just follow the signals.
Implementation is nothing--it's an afterthought. You just have to be consistent with what you develop. If you believe in it, then you will trade it exactly as it is.
Sometimes people will say "Yes, but...I know my strategy says I should be long, but you have to understand that this is a particular case, which is an exception for this and this reason and it's not in my system." Well, if it's not in your system, make it part of the system. Then go back and without hindsight test to see whether it indeed helps the system. If it does, then incorporate the exception as part of your system. Then you have no reason to intervene and change what the strategy is telling you until the next time you think you have a reason, and when that happens, repeat the process. So, the simple answer is if anyone ever comes up with a reason for why they shouldn't follow their strategy, then they should incorporate that exception as part of the strategy. If you find yourself second-guessing the system, it means you don't truly have confidence in it, and you shouldn't be trading in it.
Janette: Jack, what are your thoughts on optimization?
Jack: Optimization can have some uses, but I think it often causes more harm than good because it's so misused. That doesn't mean that optimization doesn't have any value. However, if you're going to evaluate the merits of a strategy based on optimization, then it's worse that useless because it's going to totally distort the true efficacy of the system. You can test a million parameters set for a system and some of those will be enormously good. If you're going to judge how the system performs based on that, you're going to have a tremendously distorted picture. Optimized results are always going to overstate what a strategy can do. Do not use optimized results in any form for evaluating a system.
The key question, however, is--will optimized parameter values perform better than randomly selected values in the future? The assumption is that they will is by no means a foregone conclusion. There are certain approaches optimization may help tune the strategy to the changing markets, but you can only determine that by testing. You have to be a scientist about it and actually test including optimization and see if it adds anything. Don't just assume that the optimization on past data tell you anything about the future. That is something that you have to evaluate on a case-by-case basis.
Janette: Thanks, Jack, your insights always seem focused on what is really important.
Jack D. Schwager is currently the Managing Member of Market Wizard Funds, L.L.C., in Vineyard Haven, MA. His prior experience includes 22 years as the director of futures research for some of Wall Street's leading firms. Schwager is a frequent seminar speaker and has lectured on a range of analytical topics with particular focus on the characteristics of great traders, technical analysis, and trading system evaluation. He holds a B.A. in Economics from Brooklyn College and an M.A. in Economics from Brown University.