I want to talk a little more about how conditioned minds can prosper in trading. You’ll be relieved to know that I’m going to use a trader rather than a scientist as the example this time.

Jim Leitner runs Falcon Management in New Jersey. He has taken $2 billion profit out of the market in his career. Jim gave an interview to Steven Drobny for his book The House of Money. Jim’s mind has been conditioned by a huge amount of experience in trading, as follows:

• While studying international finance and Russian at graduate school, Jim worked half days as a “monkey” – a money broker trainee adding data from around the world to the big board for the brokers to see.
• While still working as a monkey, he started broking – calling small banks in the Midwest. He did this for two years.
• He then took a big salary cut to get more experience, working at J.P. Morgan, trading the Eurodollar market. Jim became an expert on euroswiss francs, eurodeutsche marks and europesetas.
• He then became an FX trainee with J.P. Morgan and then a currency forward trader.
• After a few years, Jim was hired by the Bank of America to run forwards, exotics and all currency trading outside the major currencies.
• He moved to Shearson Lehman as a proprietary trader.
• He moved to Banker’s Trust and spent five years trading currencies.

With all this experience behind him, Jim was asked whether he has an innate trading skill and can “just tell” when prices are out of line. He answered:

“I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time. After doing it for years I’ve developed a mental database of where things should be, such that when something makes an irregular move, it shows up on my radar screen. I used to have so much fun playing around in the market and knowing that I knew my markets better than other people.”

So here again, is an example of a conditioned mind prospering where others fail. Where others might claim an innate skill or a gut feel for trading, Jim Leitner attributes his success to conditioning of the mind – a mental database – built up from many years’ trading.

Jim Leitner’s hedge fund, Falcon Management, has a website. You can find out their address and their phone number but nothing else.

I’m off now to condition my own mind.

I’ve heard experienced traders talk about trading on “gut feel”. Inexperienced traders need to be cautious about this sort of trading – if they don’t want to see their trading accounts clobbered.

What exactly is gut feel? I see it as the way our previous experiences have stacked up to guide our decision taking.

You’ll need to forgive me for bringing science in here, but scientists and traders have quite a few things in common – one of which is that we’re constantly trying to analyze data to construct the most accurate or financially beneficial models of our worlds. The astronomer James Christy’s discovery of Charon – Pluto’s moon – is a great example of using previous experiences to see the true picture.

After Christy discovered Charon he looked back at other people’s work and he realized that Charon had already appeared on many other images of Pluto – but people hadn’t seen it.

So why hadn’t the people who had analyzed the images before – and we’re talking about professional astronomers here – realized Pluto had a moon? It turns out that Pluto and Charon were closer together than anyone had ever expected a planet and its moon to be. The astronomers who had seen images of Pluto and its moon together had discarded them, believing the images were distorted because Pluto appeared to be “elongated”. The “elongation” was, of course, Charon.

The astronomers’ minds had been conditioned to interpret the images incorrectly. Here’s what Christy said about the discovery (from Planets Beyond by Mark Littman):

“When I first saw these exposures on June 22, 1978, I was looking with the mind and eyes of an astronomer who had examined roughly 50,000 images in recent years. Many of these images had been of double stars exposed in the course of the U.S. Naval Observatory’s extensive double-star program. I had seen dual images blended together in all possible circumstances by all combinations of image distortions. My mind was now attuned to two celestial bodies disguised as one. Now I could think: Pluto has a moon.”

Christy’s mind had been conditioned by years of experience to see the possibility that the elongation in images of Pluto was actually its moon.

In our day-to-day lives, our minds are conditioned and tuned – just as Christy’s was – on the basis of our previous experiences. When we use these accumulated experiences sub-consciously we call it gut feel.

The better the mind has been conditioned, the better the prospects of gut feel actions having a successful outcome.

When we’re trading, if our minds have been conditioned by years of observations and experiences during different phases of market behavior they can reach better conclusions than if they’re less experienced. The sort of gut feel that can sweep across stocks, commodity and FX markets and pick up more than its fair share of good trades doesn’t come quick and it doesn’t come cheap. It takes years of experience with plenty of costly mistakes along the way.

I recall a discussion I had around 5 years ago with a semi-sucker.

This particular semi-sucker had misunderstood a trading book. He believed it should be possible using money management techniques to beat the casino at roulette. Provided he could cut his losses (by leaving the casino when he was losing) and let his profits run (by continuing to play when he was winning) he was “bound to make money”.

Now, I know this gambling strategy sounds superficially similar to Livermore’s strategy of quickly closing losing trades and allowing winning trades to run: but there’s one crucial difference. Livermore’s strategy – through his tape reading and trend following – had positive mathematical expectation. ^*

The suckers who play roulette in casinos do so under the handicap of negative expectation. It’s the casino owners who enjoy positive expectation – why else would they be in the business? The direction of money flow is from a casino’s customers to its owners.

Money management can’t turn a game with negative expectation into one you can win – it can only keep you playing longer. All that our semi-sucker friend could hope to achieve was more nights at the casino. Eventually, the casino would take all of his money.

The same outcome awaits the sucker who begins trading when his mathematical expectation is negative. Unless he is lucky, money will flow from him to people who have better trading strategies than he does. If he wins through good luck, the more often he plays, the likelier it is that his luck will run out.

The good news is that some markets are more forgiving than others. Given the long-term uptrend of the major stock indices, it’s often possible to turn a profit on long stock trades, even if you have poorer than average trading skills. Your profit will, of course, be lower than if you had simply put your money into an index-fund. And, with below average skills/knowledge/strategy, you’re more likely to end up with a big loss than a small profit – especially if you trade frequently.

^* Mathematical Expectation: Your chances are 50/50 when you bet on the toss of a fair coin. If the coin is loaded, however, and it landed heads more often than tails, then betting on heads has positive expectation and betting on tails has negative expectation.