Hedge funds haven't been spared by the crisis. The New York Times reported on October 23 that,
"The funds, pools of fast money that defined the era of Wall Street hyper-wealth, are in the throes of an unprecedented shakeout. This unregulated, at times volatile corner of finance — which is supposed to make money in bull and bear markets — lost $180 billion during the last three months. Investors, particularly wealthy individuals, are heading for the exits."
"Supposed to make money in bull and bear market" – that's a very important point. Many funds have NOT been acting as hedge funds. Instead, just like "day-traders" in the late 1990s, they've not been trading, they've just been buying. Here's how Bob Prechter, EWI's founder and CEO, put it in his May 2008 Elliott Wave Theorist (excerpt):
"One thing that bothered me from the start about the whole hedge-fund mania was the media’s cultivation of another misnomer. Hedge funds hedge; but these funds are entirely on the opposite end of the spectrum: as leveraged and vulnerable as you can get. … today’s so-called hedge funds should be called spec funds.
"Investors in spec funds also seemed to believe that their managers would buy and sell as necessary in anticipating market conditions, as if they are smart traders. But they are not traders. They are buyers on leverage. There is hardly a trader among them. Traders go long and short and sometimes they go to cash, depending on their analytical outlook. Buyers just buy.
"Does this sound familiar? It should, because the spec-fund phenomenon since 2003 has been nothing but a beefed-up, more-leveraged version of the equally erroneously named 'day-trader' phenomenon of 1999-2000."
Which brings to mind another memory. Two summers ago, I got to attend a 4-day intensive trading course by a friend of EWI and a legendary trader, Dick Diamond. He started trading for his personal account in 1965. In the 1960s, he said, market conditions were similar to the 1990s mania: everything was going up. He used it to his advantage and “rode the wave,” as he puts it, between 1965 and 1968.
In 1968, he made $900,000. The next year, the bull market ended and Dick lost 70% of his capital. That’s when he realized that for a trader, knowing how to short the market was just important as knowing how to be long.
Choppy or bearish markets are not “bad”; it's a part of the markets' natural cycle. The trick to making money trading consistently, said Dick, is to play both long and short sides. And he should know: He's made a living trading futures for over 40 years – which, statistically, is practically a miracle. Here’s what Dick told us on the first day of his course:
“Most of you will not succeed as traders. I can teach you everything I know, but most of you will not follow my advice. And those of you who will try won’t have the emotional discipline to stick with it.
“Learning to trade is like learning about weight loss. Every weight loss book out there says basically the same thing, yet only 12% of dieters lose weight, and only 2% will have the discipline to lose it permanently. For futures traders, the success figure is roughly 5%. Main problem for dieters and traders alike is not the lack of knowledge – it’s the lack of discipline to do the right thing.”
I appreciated Dick’s honesty. After all, his 4-day course was not a pep rally, and setting realistic expectations was key.
The reason successful traders win when 90% of others don’t is because the winners have the mental toughness to stick to their trading rules. Dick’s trading rules, for the most part, are very “conventional.” But two of them stuck in my mind as different – and very wise:
- Dick likes to take only what he calls 80/20 trades – that is, only those trades where his odds of winning are at least 80%.
- His second rule is: be defensive. Offense will take care of itself. Take small gains and "come back for seconds."
I can relate to both of these – and so can you, most likely. Some people say that speculating in the markets is just gambling. Not so, says Dick. The difference between a trader and a gambler is control. When a gambler throws the dice, he gives up control over his future. A good trader never does, choppy markets or not.
(FYI, Dick Diamond's November session filled up fast. Reserve your seat for the next 4-day trading course March 15-18, 2009.)