BRUCE KOVNER ON RISK MANAGEMENT
The Market Wizards series is a collection of books written by Jack Schwager that captures the philosophies, traits, experiences, and advice of great traders, seeking to draw out lessons that could help all traders from novices to professionals. The following is an excerpt from Jack about Bruce Kovner. A new never before seen video recalling this interview will be hosted to FundSeeder later this week.
In Market Wizards, the first book of the series, Schwager interviewed Bruce Kovner, a Harvard political science professor turned trader who founded the extremely successful global macro hedge fund firm, Caxton Associates. When Schwager interviewed Kovner for Market Wizards, he had been trading for ten years and had achieved an astounding 87% average annualized compounded return during that period. Although this type of return is impossible to maintain, Kovner continued to do very well in the ensuing decades until he retired in 2011. The following excerpts from Market Wizards focus on Kovner’s third trade, which instilled a lifelong respect for the importance of risk management, and Kovner’s advice on risk control.
INSTRUCTION: The paragraph below begins the excerpt section. It begins with interview subject speaking rather than a bold typeface question, as is the case in all other articles of this type.
My third trade is what really put me in the business. In early 1977, an apparent shortage was developing in the soybean market. It was a demand driven market. Every week the crush was higher than expected and nobody believed the figures. [The crush is the amount of soybeans processed for use as soybean meal and soybean oil.] I was watching the July/November spread [the price difference between the old crop July contract and the new crop November contract]. Since it looked like we were going to run out of soybeans, I thought that the old crop July con tract would expand its premium to the new crop November contract. This spread had been trading in a narrow consolidation near 60-cents premium July. I figured I could easily stop myself out just below the consolidation at around a 45-cents premium. At the time, I didn’t realize how volatile the spread could be. I put on one spread [that is, bought July soybeans and simultaneously sold November soybeans] near 60 cents and it widened to 70 cents. Then I put on another spread. I kept on pyramiding.
How big of a position did you build up?
I eventually built up to a position of about fifteen contracts, but not before I had to switch brokerage firms. When I started out, I was trading at a small brokerage house. The head of the company, who was an old floor trader, went over the trades every day and spotted what I was doing. By that time, I had built my position up to about ten or fifteen contracts. The margin on a single outright contract was $2,000, while the spread margin was only $400.
He told me, “The spread position you have on trades like an outright long position. I am going to raise your margins from $400 to $2,000 per contract.” [Spread margins are lower than outright margins, reflecting the assumption that a net long or short position will be considerably more volatile than a spread position. Reason: In a spread, the long contract portion of the position is likely to at least partially offset price movement in the short contract position. In a shortage situation, however, an intercrop spread, such as long July soybeans/short November soybeans can prove to be nearly as volatile as a net long or short position.]
He was obviously quite concerned with the risk in your position.
Yes. He was concerned that I had only put up $400 margin per spread, on a spread that behaved like a net long position.
Actually, he wasn’t that far off.
He was right, but I was furious. So I moved my account to another brokerage firm, which shall remain nameless, for reasons that will soon become clear.
You were furious because you felt he was being unfair, or—
Well, I am not sure I thought he was being unfair, but I certainly knew he was an obstacle to my objective. I moved my account to a major brokerage house, and got a broker who was not very competent. The market kept moving up and I kept adding to my position. I had put on my first spread on February 25; by April 12, my account was up to $35,000.
Were you just adding to your position as the market went up, or did you have some plan?
I had a plan. I would wait until the market moved up to a certain level and then retraced by a specified amount before adding another unit. My pyramiding did not turn out to be the problem.
The market had entered a string of limit-up moves. On April 13, the market hit a new record high. The commotion was tremendous. My broker called me at home and said, “Soybeans are going to the moon. It looks like July is going limit-up, and November is sure to follow. You are a fool to stay short the November contracts. Let me lift your November shorts for you, and when the market goes limit-up for the next few days, you will make more money.” I agreed, and we covered my November short position.
All of it?!
All of it [he laughs loudly].
Was this a spur of the moment decision?
It was a moment of insanity. Fifteen minutes later, my broker calls me back, and he sounds frantic. “I don’t know how to tell you this, but the market is limit-down! I don’t know if I can get you out.” I went into shock. I yelled at him to get me out. The market moved off of limit-down by a little bit and I got out.
Did you end up getting out at limit-down?
I got out between limit-down and slightly above limit-down. I can tell you the dimensions of the loss. At the moment I covered my short November position leaving myself net long July, I was up about $45,000. By the end of the day, I had $22,000 in my account. I went into emotional shock. I could not believe how stupid I had been— how badly I had failed to understand the market, in spite of having studied the markets for years. I was sick to my stomach, and I didn’t eat for days. I thought that I had blown my career as a trader.
But you still had $22,000 compared to your original stake of only $3,000. Keeping things in perspective, you were still in pretty good shape.
Absolutely. I was in good shape, but—
Was it the stupidity of the mistake or was it the money that you had given back that caused such emotional pain?
No, it wasn’t the money at all. I think it was the realization that there really was “fire” there. Until then, I had ridden $3,000 to $45,000 without a moment of pain.
On the way up, did you think, “This is easy”?
It was easy.
Did you give any thought to the possibility that the market streak could eventually go the other way?
No, but clearly, my decision to lift the short side of my spread position in the middle of a panic showed a complete disregard for risk. I think what bothered me so much was the realization that I had lost a process of rationality that I thought I had. At that moment, I realized that the markets were truly capable of taking money away every bit as fast as they gave it to you. That made a very strong impression on me. Actually, I was very lucky to get out with $22,000.
I assume that your quick action that day probably averted a complete disaster.
Absolutely. After that day, the market went straight down as fast as it had gone up. Perhaps, if I hadn’t made my stupid mistake, I might have made the mistake of riding the market down.
What eventually happened to the spread?
The spread collapsed. Eventually, it went below the level that I had first begun buying it at.
Since you liquidated your position on the day the market and the spread topped, you would have given back a portion of the profits even if it wasn’t for the disastrous decision that forced you out of the market.
That may be true, but for me, that was my “going bust” trade. It was the closest I ever came to going bust and, psychologically, it felt as if I had.
Was that your most painful trade?
Yes. Far and away.
Even though you actually ended up making a substantial amount of money on the trade?
I multiplied my money by nearly sixfold on that trade. I was, of course, insanely leveraged, and I didn’t understand how risky my position was.
Was getting out of your entire position immediately after your broker called to tell you the market was limit-down a matter of panic, or do you think you had some instinctive common sense about controlling risk?
I’m not sure. At that moment, I was confronted with the realization that I had blown a great deal of what I thought I knew about discipline. To this day, when something happens to disturb my emotional equilibrium and my sense of what the world is like, I close out all positions related to that event.
Do you have a recent example?
October 19, 1987—the week of the stock market crash. I closed out all my positions on October 19 and 20 because I felt there was something happening in the world that I didn’t understand. The first rule of trading—there are probably many first rules—is don’t get caught in a situation in which you can lose a great deal of money for reasons you don’t understand.
Let’s get back to the period after your soybean trade. When did you start trading again?
About a month later. After a few months I had my account back to about $40,000. Around that time, I answered an ad for a trading assistant position at Commodities Corporation. I was interviewed by Michael Marcus in his usual idiosyncratic manner. He had me return to Commodities Corporation several weeks later. “Well,” he said, “I have some good news and some bad news. The bad news is that we are not hiring you as a trading assistant; the good news is that we are hiring you as a trader.”
How much money did Commodities Corporation give you to trade?
Thirty-five thousand dollars.
Were you trading your own money, as well, at the same time?
Yes, and that is something I am very glad about. Commodities Corporation had a policy that allowed you to trade your personal account, as well as the company account, and Michael and I were very aggressive traders.
Were you influenced by Michael?
Oh, yes, very much. Michael taught me one thing that was incredibly important [pause].
That is a great lead-in. What is the punch line?
He taught me that you could make a million dollars. He showed me that if you applied yourself, great things could happen. It is very easy to miss the point that you really can do it. He showed me that if you take a position and use discipline, you can actually make it.
It sounds like he gave you confidence.
Right. He also taught me one other thing that is absolutely critical: You have to be willing to make mistakes regularly; there is nothing wrong with it. Michael taught me about making your best judgment, being wrong, making your next best judgment, being wrong, making your third best judgment, and then doubling your money.
You are one of the most successful traders in the world. There are only a small number of traders of your caliber. What makes you different from the average guy?
I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. Second, I stay rational and disciplined under pressure.
Can trading skills be taught?
Only to a limited extent. Over the years, I have tried to train perhaps thirty people, and only four or five of those have turned out to be good traders.
What happened to the other twenty-five?
They are out of the business—and it had nothing to do with intelligence.
When you compare the trainees that made it to the majority that did not, do you find any distinguishing traits?
They are strong, independent, and contrary in the extreme. They are able to take positions others are unwilling to take. They are disciplined enough to take the right size positions. A greedy trader always blows out. I know some really inspired traders who never managed to keep the money they made. One trader at Commodities Corporation—I don’t want to mention his name—always struck me as a brilliant trader. The ideas he came up with were wonderful; the markets he picked were often the right markets. Intellectually, he knew markets much better than I did, yet I was keeping money, and he was not.
So where was he going wrong?
Position size. He traded much too big. For every one contract I traded, he traded ten. He would double his money on two different occasions each year, but still end up flat.
“Let’s say you do buy a market on an upside breakout from a consolidation phase, and the price starts to move against you—that is, back into the range. How do you know when to get out? How do you tell the difference between a small pullback and a bad trade?
Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I’m getting out before I get in. The position size on a trade is determined by the stop, and the stop is determined on a technical basis. For example, if the market is in the midst of a trading range, it makes no sense to put your stop within that range, since you are likely to be taken out. I always place my stop beyond some technical barrier.
Don’t you run into the problem that a lot of other people may be using the same stop point, and the market may be drawn to that stop level?
I never think about that, because the point about a technical barrier—and I’ve studied the technical aspects of the market for a long time—is that the market shouldn’t go there if you are right. I try to avoid a point that floor traders can get at easily. Sometimes I may place my stop at an obvious point, if I believe that it is too far away or too difficult to reach easily.
To take an actual example, on a recent Friday afternoon, the bonds witnessed a high-velocity breakdown out of an extended trading range. As far as I could tell, this price move came as a complete surprise. I felt very comfortable selling the bonds on the premise that if I was right about the trade, the market should not make it back through a certain amount of a previous overhead consolidation. That was my stop. I slept easily in that position, because I knew that I would be out of the trade if that happened.
What eventually tells you that you are wrong on a major position trade? Your stop point will limit your initial loss, but if you still believe in the fundamental analysis underlying the trade, I assume that you will try it again. If you are wrong about the general direction of the market, won’t you take a series of losses? At what point do you throw in the towel on the trade idea?
First of all, a loss of money itself slows me down, so I reduce my positions. Secondly, in the situation you described, the change in the technical picture will give me second thoughts. For example, if I am bearish on the dollar and a major intermediate high has been penetrated, I would have to reevaluate my view.
Do the losses bother you at all anymore?
The only thing that disturbs me is poor money management. Every so often, I take a loss that is significantly too large. But I never had a lot of difficulty with the process of losing money, as long as losses were the outcome of sound trading techniques. Lifting the short side of the July/November soybean spread was an example that scared me. I learned a lot about risk control from that experience. But as a day-in, day-out process, taking losses does not bother me.
Did you have any losing years?
Yes, in 1981 I lost about 16 percent.
Was that due to errors you made, or the nature of the markets?
It was a combination of the two. My main problem was that it was the first major bear market in commodities I had experienced, and bear markets have different characteristics than bull markets.
Was it a matter of becoming complacent about markets always being in an uptrend?
No, the problem was that the principal characteristic of a bear market is very sharp down movements followed by quick retracements. I would always sell too late and then get stopped out in what subsequently proved to be part of a wide-swinging congestion pattern. In a bear market, you have to use sharp countertrend rallies to enter positions.
What other mistakes did you make that year?
My money management was poor. I had too many correlated trades.
Was your confidence shaken at all that year? Did you go back to the drawing board?
I went back and designed a lot of risk management systems. I paid strict attention to the correlations of all my positions. From that point on, I measured my total risk in the market every day.
You talk about both the importance of risk control and the necessity of having the conviction to hold a position. How much risk do you typically take on a trade?
First of all, I try very hard not to risk more than 1 percent of my portfolio on any single trade. Second, I study the correlation of my trades to reduce my exposure. We do a daily computer analysis to see how correlated our positions are. Through bitter experience, I have learned that a mistake in position correlation is the root of some of the most serious problems in trading. If you have eight highly correlated positions, then you are really trading one position that is eight times as large.
What advice would you give the novice trader?
First, I would say that risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice. Whatever you think your position ought to be, cut it at least in half. My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 percent risks.
Besides overtrading, what other mistakes do novice traders typically make?
They personalize the market. A common mistake is to think of the market as a personal nemesis. The market, of course, is totally impersonal; it doesn’t care whether you make money or not. Whenever a trader says, “I wish,” or “I hope,” he is engaging in a destructive way of thinking because it takes attention away from the diagnostic process. “
The Undiscovered Market Wizards Search
Jack Schwager is one of the cofounders of FundSeeder (fundseeder.com) a new online technology company that provides traders with a free graphic and analytics platform, as well as offering traders worldwide the opportunity to get discovered. FundSeeder’s technology allows traders to verify their track records, benefit from performance analytics and risk management tools, access an emerging manager support structure, find potential trader employment opportunities and, if regulated, connect with investors.
As the Chief Research officer of FundSeeder, Schwager plans to select traders discovered via FundSeeder as interview subjects for his next Market Wizards book, tentatively titled Undiscovered Market Wizards. If you would like an opportunity to be featured in this book or to be selected to manage investor capital, or if would just like to enjoy a great trading analytics platform free of charge, click on the link below to sign up for FundSeeder today.
