The crowd, the world, and sometimes even the grave step aside for the man who knows where he’s going, but pushes the aimless drifter aside.
Ancient Roman saying
Now you understand that the search for the Holy Grail is an internal search. In addition, you should have some idea of what might be holding you back. Now it’s time to decide what you want. Sam requested a 10-minute consultation with me because he just couldn’t seem to get results he was happy with. I said yes, so e met at O’Hare Airport in Chicago at the end of one of my business trips. The conversation went something like this:
What can I help you with, Sam?
Well, I just don’t think my trading results are on track.
What does “on track” mean?
I am not happy with my results.
What are your goals for trading in the market this year?
Well, I really don’t have any goals.
What would you like to accomplish in the market this year?
(After a long pause) I’d like to buy my wife a car out of my trading profits.
Okay. What kind of car are we talking about? A Rolls-Royce? A Mercedes? A Lexus? A pickup truck? What do you want to buy her?
Oh, an American Car – one that sells for about $15,000.
Great. When would you like to buy this car?
September. In about three months!
Fine. How much money do you have in your trading account?
About $10,000.
So you want to make 150 percent in your account in about three months?
Yes, I guess that’s right.
Do you realize that 150 percent return in three months is equivalent to an annual rate of return of almost 1,000 percent?
No, I didn’t.
How much are you willing to lose in your account in order to make that much?
I don’t know. I really haven’t thought about it.
Are you wiling to lose $5,000?
No, I couldn’t do anything like that. That’s way too much.
Are you willing to lose $2,500? That’s 25 percent.
No, that’s still too much. Maybe 10 percent.
So, you want to make 150 percent in the market in three months, and you’re only willing to take a 10 percent risk in the process?
Yes.
Do you know of any trading method that will consistently give you a reward-to-risk ratio of 15 to 1?
No.
I don’t know of any either. Three-to-one is usually a very good reward-to-risk ratio.
Although there are many trading and investing methods that make good money, I don’t know of any that meet those requirements. However, most beginning traders and investors with small amounts of money are constantly giving themselves similar expectations – expectations that they are unlikely to meet.
Designing Objectives : A Major Part of Your System Work
I once worked with a man whose job was to give money to budding commodity trading advisors (CTAs). Part of his job was to assess the various systems that these CTAs had developed, and many people considered him to be one of the world’s experts in system development.
One day I said to him, “If you could give any particular suggestion to traders who are trying to come up with a new system, what would it be?” His response was, “To spend at least 50 percent of the system development time working out objectives.” He said that objectives were a critical part of any system, and yet few people bother to spend time working on them. If you’re going to develop a system for trading or investing in the market, then decide exactly what it is you want to accomplish before you begin.
Your objectives are a critical part of your system. How can you develop a trading system if you have no idea what it’s supposed to do? Similarly, how can you go somewhere when you have no idea where you are going? You just can’t do it. So you need to decide what you want to accomplish first. Once you’ve done that, you can decide if your goals are realistic. If they are, then you can develop a trading system to accomplish those goals.
I took my friend’s advice to heart when we did our first workshop, “How to Develop a Winning Trading System to Fit You.” A major portion of that workshop was devoted to objectives. However, so many people grumbled over including objectives as part of the workshop that we now require workshop participants to complete the objectives section prior to the workshop.
Typical comments included “What does this have to do with trading in the markets?” “This is private material; I don’t want to spend class time talking about my equity or anything like that.” None of them seemed to realize that if they didn’t spend time on their objectives, they wouldn’t really be able to develop a system that “fit” them. They needed to assess themselves for strengths and weaknesses; for time; resources, capital, and skills; and for what it was they were trying to accomplish. What kind of results did they want to make? What kind of drawdowns were they wiling to tolerate in order to make those returns? This is one of the real keys in our search for the Holy Grail.
Tom Basso On Objectives
Tom Basso was a guest speaker at the first three system development workshops that we did. During those workshops, I frequently interviewed him on his objectives in order to demonstrate how one should approach this portion of the task. Tom was kind enough to volunteer to do another of those interviews for this book.
Tom Basso was the president of the Trendstat, Inc., located in Scottsdale, Arizona. He was a professional money manager who qualified both as a CTA and a registered investment advisor (RIA). He was also a private investor in that he invested his own money in his funds.
Tom was interviewed by Jack Schwager in his book The New Market Wizards at my suggestion. Schwager then named him “Mr. Serenity,” and he considers him his best personal role model out of all the market wizards he interviewed. Basso is also one of the most logical, organized people I have ever met. As a result, I thought you might like to learn how Tom thinks about trading system development.
The first part of the objectives exercise involves taking a self-inventory of your time, money, skills, and other resources. Tom’s answers are in italics:
Tom, how much capital do you have?
We currently have about $95 million under management.
How much money do you need to live on each year?
About $80,000.
How much of that must come out of your trading profits?
None of it. I get a salary through Trendstat.
I ask that question in order to determine what percentage of one’s trading capital the person needs to make in order to just survive. This is important just to determine if it’s reasonable. For example, those who need to make 30 percent or more just to survive are putting themselves in a rather untenable position, plus giving little opportunity for the trading capital to grow.
I frequently get people who have about $100,000 of trading or investment capital, but they need about $50,000 to live on each year. In my opinion, they are putting themselves in a very difficult position. They might believe they can make 100 percent every year, and perhaps they can. But if they start out with a 30 percent drawdown – which is quite possible – their situation becomes very tenuous at best. That’s why it’s best to think about these situations before you get into them. Obviously, none of these things is a problem for Tom Basso.
Part 1. Self-Assessment
Tom, how much time during the day do you have to devote to trading? [This is important because the amount of time you have available almost dictates the kind of trading system you must develop. Those who have a full-time job and just look at the markets in the evening must, quite obviously, find a fairly long-term system to use.]
I’ve got about six hours each day, but that time is mostly involved in managing our trading business.
When you are trading, how many distractions can you expect to have?
Many.
So obviously, you need a trading methodology that allows you to deal with those directions.
Yes.
How much time do you expect to devote to developing your trading system, to doing your personal psychological work, and to working on your business plan for trading?
In my case, I’ve already put in a lot of time over the last 20 years. However, we’re always planning and doing research. I put in however much time it takes.
What are your computer skills? What skills do you need before you begin this trading venture?
I’m very good with computers. I custom programmed all of Trendstat’s early models myself. However, at this time I have a fully automated office and a staff of full-time programmers. My job is simply to look for inefficiencies and see to it that the staff takes care of them.
What do you know about statistics?
I understand and can use simple statistics. In addition, I’m familiar with some multivariate statistics.
How do you rate your market knowledge? [Here you should include knowledge of trading mechanics, what moves the markets, how to execute orders effectively at low cost, which trading indicators you might need, and so on.]
I have extensive experience in options, futures, stocks, bonds, mutual funds, cash currencies. I am very familiar with trade mechanics and low-cost execution. I also have my own perception of how the markets work.
What are your psychological strengths and weaknesses, especially in terms of trading system development?
I am very strategic and patient, and I believe those qualities are useful in developing long-term strategies for trading. I’m self-confident, which gives me a lot of psychological strength in trusting the systems we develop. In terms of weaknesses, I guess I’m always trying to get a lot done – perhaps too much. Sometimes that can distract me from my primary mission as a trader.
How about your strength and weaknesses in terms of personal discipline?
I am fairly good at discipline. I have no problems following a system.
Do you tend to get compulsive (that is, do you get caught up in the excitement of trading), do you have personal conflicts (that is, do you have a history of conflicts in your family life, at your job, or during past trading experience), or do you have any emotional issues that constantly crop up, such as fear or anger?
I certainly don’t think of myself as compulsive. I don’t find trading exciting at all. It’s just a business to me. I look at trading as an interesting brain tease.
I don’t think I have any conflicts. My family life is reasonably stable. In addition, I rarely get angry or frustrated. I used to get tense from time to time. But I learned something in one of your workshops about what happens first when I get tense. In my case, my fingers got tense first. As soon as I became consciously aware of it, I automatically went into relaxation state. And now it’s so automatic for me that I don’t even notice it.
Based on your personal inventory, what do you need to learn, accomplish, or solve prior to beginning trading? How will you do that?
I think my personal inventory was and is quite strong. I’m able to trade well.
I hope, for those of you who have a lot of things to overcome, this inventory will be an eye-opener. You really need to think about all of these things before you start developing a trading system. Why? Because the essence of a good trading system is to find one that best fits you!
Part 2. Defining Your Objectives
This section is probably the most important part of developing a trading system. Until you know where you want to go, you can never get there. As a result, a major portion of the time you spend in developing a trading system should be directed to developing objectives.
Objectives probably should be treated differently for individual traders and investors than for those who are managing money. Since Tom fills both roles, I asked him both sets of questions. First, here are the questions for individual traders and investors.
A. Objectives for Individual Investors and Traders
What is your advantage or edge in trading? What is the particular concept that you are trading that gives you an advantage? [If you don’t know, various concepts are discussed in detail in Chapter 5.]
Strategic thinking is our edge because so many people don’t do that. We also have an edge in terms of patience and detachment. Most people are neither patient nor detached. Computer programming is also an edge. Most people don’t take it to the level that we do. Long-term automated trend following is the outflow of the edge.
How much money do you have personally? How much of that money could you afford to lose? For example, most funds stop trading at 50 percent. How about you? How much risk can you afford to take on a given trade?
I have several million dollars, and I could afford to lose 25 percent of that comfortably. All of my money is in our trading program, and we’re only risking between 0.8 to 1.0 percent per trade. However, if I were trading on my own, I’d go to 1 percent to 1.5 percent. I think 2 to 3 percent risk would push the envelope on me, partially because I could be in up to 20 markets at a time.
How much money do you need to make each year? Do you need to live off that money? What if you don’t make enough to live off it? Can you make more than you need to live off so that your trading capital can grow? Can you sand regular withdrawals from your trading capital to pay your monthly bills?
My income comes from my salary at Trendstat, so I don’t need anything from my trading income. Trading income is simply a second income for me.
I know this doesn’t pertain to you, but I’ll ask anyway because it’s one of the standard questions under objectives. Are you being realistic, or are you expecting to trade like the best trader in the world? For example, suppose you have a very good system that is right half the time and gives you profits that are twice as large as your losses. In that system, just by chance, you could still easily have 10 losses in a row. You system is still working as expected, but you could easily have 10 losses in a row. Could you tolerate that?
I think I’m quite realistic about the returns and the risk. I also know that about 10 losses in a row. I’ve gone through that in the past, so I know that it is to be expected.
Do you have the time to trade short term?
I have about six hours each day to devote to trading. The rest of my time is devoted to specific business or personal commitments. I don’t plan to trade short term so that is not a problem.
How much social contact do you need?
I don’t need much, but I enjoy it.
Can you work by yourself day after day? Do you need one or two other people around, or do you need a lot of people around? How much do those other people influence you?
I have a full staff of people at Trendstat, but I don’t need that. I can easily work by myself. Those people don’t influence me at all in terms of the early development of our trading models.
In summary, what do you expect to make each year as a percentage of your trading capital?
About 20 to 40 percent.
What risk level are you willing to tolerate in order to achieve that?
About half the potential gain, so the maximum loss would be 20 percent in a year.
What is the largest peak-to-trough drawdown you are willing to tolerate?
About 25 percent.
How will you know your plan is working, and how will you know when it’s not working? What do you expect from your system in various kinds of markets? Trending? Consolidating? Highly volatile?
I plan everything. I set up worst-case scenarios, and we run thorough them just as an exercise. I have specifications on the best case and the worst case for each scenario. Thus, when something comes along, I’ve usually planned for it and have a range of expectancy. If the results fall within that range, then I know everything is as planned. If the results fall outside of that range, then I know that something needs to be fixed. We’ll then step in and study what went wrong.
Generally, I expect a 40 percent return at the best and a 10 percent return at the worst, with average returns of 15 to 25 percent. We also expect worst-case drawdowns of 25 percent.
I remember one year I had a return greater than 40 percent. I’m glad that happened because it was outside the extremes of our parameters. What it told me is that our risk was too great and that we could also be outside the range on the downside. As a result, we went in and cut down our risk so that the worst case on the downside couldn’t happen.
B. Objectives of Trading Advisors
Now let’s do the objectives for you as a trading manager. What kind of clients do you want? Retail clients? A few good friends? Several pool operators placing money with you? Very sophisticated traders?
We want balanced clients that have reasonable objectives. My objective here is to remain one of the top 100 firms by size, so we’ll take the kinds of clients who’ll get us there. We have both retail and institutional clients. In some ways they are different and in other ways they are the same, but both types are fine with us.
What are your clients like? What are their goals? What kind of service do you provide for them? For example, by putting their money with you, are they attempting a special type of diversification?
Our clients are definitely looking for diversification. We provide that with four different programs that strive for returns in the 10 to 20 percent range with lower drawdowns. We’re looking for returns of 20 percent with 10 percent drawdowns. Our clients know that so that’s what they’re getting in terms of their goals.
Since you are trading client’s money, how much risk can they tolerate? When would they be likely to withdraw their money?
They expect risk in the 5 to 10 percent range. Any drawdown that is over 15 percent or that lasts over a year is deadly – lots of clients would fire us.
For that matter, how much gain can they tolerate before they get too excited?
Gains over 25 percent definitely get noticed. We don’t want to be too high, or clients tend to draw a straight line to the moon and then expect that kind of performance to continue.
What kind of fees do you charge? In other words, what is the total amount extracted from the client’s account each quarter or month? What kinds of returns will you have to make in order to able to satisfy a client who is subject to those fees?
We charge a management fee of 2 percent and an incentive fee of 20 percent. Our clients are happy with those fees as long as hey can make their 15 to 20 percent returns after fees and hey are not too uncomfortable with the drawdowns.
What is your trading capacity? How do you expect to achieve it? What do you expect to do when you achieve it? How will that change your trading?
Our capacity is about $1 to $2 billion. We expect to achieve it by our current policy of marketing to banks, large-pool operators, and high-net-worth individuals. When we reach it, we’ll simply turn away new money. As we grow, our trading needs to be continually consolidated at fewer trading desks.
What’s the worst thing that can happen in terms of your client relationships? How can you prepare for that so that it will not occur?
The worst thing that can happen to a client is a surprise. We make sure that doesn’t happen by educating our clients. I even wrote a book to prepare them, Panic Proof Investing.
How will you handle a large infusion of new capital or a large withdrawal?
A large infusion of new capital is planned in our programs. Large withdrawals are easily handled by the software we’ve developed.
As you can tell, Tom Basso has carefully planned every little detail of his trading program. That’s why an exercise like this one is so important. It gets you thinking about issues you probably would not have thought about had you not done the exercise.
Part 3 . Trading Ideas
The last section gets specifically into how you want to trade. It has to do with ideas about markets, entry, exit, and money management – the specifics of your trading plan.
Tom, what kind of markets do you want to trade? Is it appropriate to specialize? Do you want to trade only liquid markets, or are there some illiquid markets you’d like to trade?
I’m a generalist, not a specialist. There are 20 futures markets that I trade, 15 cash currency markets, and 30 mutual funds. All of them are very liquid because I concentrate on only liquid markets. If I didn’t concentrate on these liquid markets, then we’d have a very small capacity – not the several billion we’re shooting toward.
What beliefs do you have about entering the markets? How important do you believe entry to be ?
Entry is probably the least important component of my trading. I want to enter the market when there is a change of trend. At that very instant – when the trend changes – the reward-to-risk ratio is the best it will be for the rest of the trade.
Given your goals in terms of returns and drawdowns, what kind of initial risk stop do you want? If it’s close, will you be able to get right back into the market so that you will not miss a move?
Stops, in my opinion, should be a violation of the reason why I wanted to get into the trade in the first place. And, yes, I always have a way to get back into the trade.
My stop is a function of the market and what it’s doing. It’s only indirectly related to risk – unless the risk is too big for me to even take a position. I control risk as part of my position sizing, which I suspect you’ll ask about later on in this interview.
How do you plan to take profits? Reversal stops? Trailing stops? Technical stops? Price objectives? Contrary to popular opinion, much of your emphasis should be in the area of stops and exits.
I don’t limit the amount I can make in a trade. My philosophy is to let my profits run. If I ever find a trade that keeps going in my direction, so that I never have to get out, great!
I use trailing or technical stops. Once those are hit, I’m out of the position.
What do you do in terms of position sizing?
I set up a portfolio of instruments to be traded at set risk and volatility limits as a percent of equity. I monitor the amount of initial risk and volatility and keep them at set limits. In addition, I keep the ongoing risk and volatility at fixed percentages of my equity. As a result, I always know how much fluctuation can occur in my portfolio overnight and it’s well within my sleeping limits.
Perhaps now you can understand why planning your objectives is so important to developing a trading system. If you do, then I’ve done my job in this chapter. The rest of this chapter gives you the opportunity to answer the same questions for yourself.
It’s easy to take a few minutes to answer the questions (and some of you won’t even do that). However, what is critical is to really take the time to think about the issues raised by these questions. That’s why this section should be 50 percent of the task of preparing to trade.
Setting Your Own Objectives
Part 1 : Self-Assessment
How much time during the day do you have to devote to trading? [This is important because the amount of time you have available almost dictates the kind of trading system you must develop. Those who have a full-time job a and just look at the markets in the evening must, quite obviously, find a fairly long-term system to use.]
When you are trading, how many distractions can you expect to have?
How much time do you expect to devote to developing your trading system, to doing your personal psychological work, and to working on your business plan for trading?
What are your computer skills? What skills do you need before you begin this trading venture?
What do you know about statistics?
How would you rate your market knowledge?
[Here you should include knowledge of trading mechanics, what moves the markets, how to execute orders effectively at low cost, any trading indicators you might need, and so on.]
What are your psychological strengths and weaknesses, especially in terms of trading system development?
How about your strengths and weaknesses in terms of personal discipline?
Do you tend to get compulsive (that is, do you get caught up in the excitement of trading), do you have personal conflicts (that is, do you have a history of conflicts in your family life, at your job, or during past trading experience), or do you have any emotional issues that constantly crop up, such as fear or anger?
Based on your personal inventory, what do you need to learn, accomplish, or solve prior to beginning trading? How will you do that?
You really need to think about all of these things before you start developing a trading system. Remember, the essence of a good trading system is to find one that best fits you!
Part 2. Defining Your Objectives
This section is probably the most important part of developing a trading system. Until you know where you want to go, you can never get there. As a result, a major portion of the time you spend in developing a trading system should be in terms of developing objectives.
Objectives for Individuals
What is your advantage or edge in trading? What is the particular concept that you are trading that gives you an advantage? [If you don’t know, various concepts are discusses in detail in Chapter 5. Think about the issues and then answer the question.]
How much money do you have personally? How much of that money could you afford to lose? For example, most funds stop trading at 50 percent. How about you? How much risk can you afford to take on a given trade?
How much money do you need to make each year? Do you need to live off that money?
What if you don’t make enough to live off it? Can you make more than you need to live off of so that your trading capital can grow? Can you stand regular withdrawals from your trading capital to pay your monthly bills?
Are you being realistic, or are you expecting to trade like the best trader in the world? For example, suppose you have a very good system that is right half the times and gives you profits that are twice as large as your losses In that system, just by chance, you could till easily have 10 losses in a row. Your system is still working as expected, but you could easily have 10 losses in a row. Could you tolerate that?
Do you have the time to trade short term?
How much social contact do you need?
Can you work by yourself day after day? Do you need one or two other people around, or do you need a lot of other people around? How much do these other people influence you?
In summary, what do you expect to make each year as a percentage of your trading capital?
What risk level are you willing to tolerate in order to achieve that?
What is the largest peak-to-trough drawdown you are willing to tolerate?
How will you know you plan is working, and how will you know when it’s not working? What do you expect from your system in various kinds of markets? Trending? Consolidating? Highly volatile?
Objectives for Trading Managers
Now, let’s do the objectives for those of you who want to be a trading manager.
What kind of clients do you want? Retail clients? A few good friends? Several pool operators placing money with you? Very sophisticated traders? Institutional clients?
What are your clients like? What are their goals? What kind of service do you provide for them? For example, by putting their money with you, are they attempting a special type of diversification?
Since you are trading clients’ money, how much risk can they tolerate? When would they be likely to withdraw their money?
For that matter, how much gain can they tolerate before they get too excited?
What kind of fees do you charge? In other words, what is the total amount extracted from the client’s account each quarter or month? What kinds of returns will you have to make in order to be able to satisfy a client who is subject to those fees?
What is your trading capacity? How do you expect to achieve it? What do you expect to do when you achieve it? How will that change your trading?
What’s the worst thing that can happen in terms of your client relationship? How can you prepare for that so that it will not occur? How will you deal with client problems or problem clients?
How will you handle a large infusion of new capital or a large withdrawal?
Part 3 . Trading Ideas
The last section gets specifically into how you want to trade. It has to do with ideas about markets, entry, exit, and money management – the specific of your trading plan.
What kind of markets do you want to trade? Is it appropriate to specialize? Do you want to trade only liquid markets, or are there some illiquid markets you’d like to trade?
Do you want any conditions to set up before you enter the market? If so, what are those conditions? [Tom did not answer this question, but you might fid it useful to answer it.]
What beliefs do you have about entering the markets? How important do you believe entry to be?
Given your goals in terms of returns and drawdowns, what kind of initial risk sop do you want? If it’s close, will you be able to get right back into the market so that you will not miss a move? [In other words, discuss what kind of stop loss you plan to have.]
How do you plan to take profits? Reversal stops? Trailing stops? Technical stops? Price objectives? Contrary to popular opinion, much of your emphasis should be in the area of stops and exits.
What do you do in terms of position sizing?
[Write down any specific ideas you may have here.]
These are about the most important topics you need to think about.