I had an email from Brett Smith (not his real name) who is seventeen and is wondering about what courses he should be taking in future if he wants to trade stocks.

It’s flattering to be asked questions by someone starting out in life but I should say here that I don’t want to get into the habit of giving advice like this and I’d hope not to get more emails of this kind. If I do, maybe I’ll just refer them to this post or put them on the blog (with the privacy of the writer respected) and ask for answers.

Anyway, treating Brett’s email as a one-off, Brett had noted my Ph.D. in Physical Chemistry and asks if I could have been successful without “all the math and physics”.

Part of my reply was this:

People who don’t have my background will trade differently from me. The most successful trader I knew was a truck driver. He had no formal education to speak of and he’d spent most of his life enjoying himself and bringing up his family. In his sixties he realized he didn’t have enough money to retire. He was aware of people making big money in the stock market so he started reading about it and then he plunged in.

He ignored the sort of advice I’d give beginners about being cautious and he traded more like Jesse Livermore, putting large chunks of his capital into single trades in stocks that, for one reason or another, he’d decided were going to rocket. He grew his money at an average of fifty percent per annum for five years (not during the dotcom bubble) using no leverage.

I prefer not to shout about this sort of thing because people who take this approach to money management run a serious risk of being wiped out before they’ve learned enough to make a profit. It also attracts unrealistic dreamers to trading and they will certainly be wiped out.

It illustrates the point though that you don’t need letters after your name to be a successful trader and you don’t need to follow my advice either.

My background influences the way I work. In the end I probably put more emphasis on numbers and modeling than people with a different background would. In the beginning my background was a hindrance. I’d not learned to be skeptical enough about the written word. I’d criticize but always believe the fundamental truthfulness of peer-reviewed scientific journals I’d read. I started off by believing the fundamental truthfulness of quarterly and annual stock reports too. That cost me money.

There’s space for everyone in trading – provided they have a well-thought out and tested strategy. The main requirements for success, in my opinion, are that you need to:

• be able to think clearly and sometimes originally for yourself
• take responsibility for your own decisions
• learn from your mistakes
• keep a grip on your emotions
• have faith in your methods and your own ability (when you have drawdowns, you need to have confidence that it’s temporary.)

Clearly these describe the capabilities of a minority of people but it’s certainly not restricted to people with letters after their names.

That’s part of my reply, but if anyone wants to add to it, please feel free…

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.

1. Market commentators say money’s going to be made by anyone who goes long volatility. You decide it’s time to:

2. Tomorrow is your birthday and you’re feeling good. To celebrate your birthday, you’re going to:

3. It’s vacation time. You’re on a tropical island and a street vendor offers you a bag of peanuts for 50c. You:

4. Selling short is inherently riskier than going long because:

5. The 3-6-3 rule is:

Check out what sort of trader you are on Spot the Sucker.

In his 1987 letter to shareholders, the masterfully quotable Warren Buffett said, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

In the same letter, he said, “If you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”

Four Grades of Sucker

The equally masterful quote-smith, Jesse Livermore, categorized four grades of sucker:

The Beginning Sucker: has read little and knows little.

The Semi-Sucker: has read books about trading - usually written by higher-grade suckers. He can recite wise stock market sayings. He does not realize that reading books is not the same as trading experience. He loses money more slowly than the beginning sucker because he has learned some basic trading rules.

The Wall Street Fool: knows enough to make a profit if he sticks faithfully to his trading rules. The excitement of the market overpowers the fool; he trades more often than he should and loses his advantage over the market.

The Higher Grade Sucker: makes his money from selling trading books because he can’t make money in the markets.

Although Buffett and Livermore are at opposite ends of the financial spectrum in terms of buy and sell criteria, they wholeheartedly agree that if you don’t have some advantage over average market participants, you’ll lose money.

There are a lot of intelligent players in the markets and plenty of fools too. Unfortunately, too many stock market books try to persuade their readers that fools predominate, lulling the semi-sucker into a false sense of security. If only you will do what it says in the book (often with too little detail to put together a truly effective trading strategy) you’ll be successful.

Before you trade, you should have some idea of where your advantage is coming from. You should paper trade to verify your advantage.

Then you need to trade for real – this is hardest of all because once you have your own money in the markets, your emotional involvement increases. The emotions – greed and fear start kicking in - cause difficulties for many traders. Some find the advantage they thought they had evaporates.

So, do you call yourself a beginning sucker, a semi-sucker, a Wall Street fool, a higher-grade sucker or a successful trader? The best test is the direction of your trading account balance over several years. As an alternative, though, you could try passing the Stock Market Sucker Test.

A few days ago I wrote about the ludicrous Foolish Four technique of investing. The thrust of my criticism was that random number patterns in historical data can fool people into thinking they’ve found a new, profitable technique for trading. The new technique of course fails instantly when anyone tries to apply it to “live” data.

So when I’m testing trading methods, how do I avoid this sort of mistake?

I do this by testing the method on different data sets. I test on different stocks in different markets – say USA, Canadian, UK and Australian – in different time frames. I initially develop a method using old data – say from 1995 through 1999. Then I see if it’s successful in a different time frame – say 2000 through 2004. Finally I apply the method to more recent data. By going through this type of process, I get an idea of how robust the method will be and I am able to minimize the risk of being tricked by a chance pattern.

Of course, working like this has its drawbacks. You can’t do it in 15 minutes a year and you need to be able to count. But it does have the merit of seeming to work!

I’m not an economist. I’m just a simple scientist turned stock trader who tries to take money from the markets whether they’re going up, down or sideways. Admittedly the latter isn’t so easy – but it can be done. It’s just not so profitable so I trade up or down in preference to sideways.

I’ll begin with an apology to economists. If an untrained economist were to write an article about physics or chemistry, it’s likely he or she would be given short shrift. So don’t take what I’ve got to say seriously. My opinions don’t matter – all that matters is my ability to take a steady flow of income from the markets.

And now for a little history…

On March 10 1988, an opposition MP goaded British Prime Minister Margaret Thatcher at “Question Time” about the way her Treasury (run by Nigel Lawson) was using interest rate policy and intervention in the foreign exchange markets to keep sterling trading in a tight band with the deutschemark. Mrs. Thatcher actually deeply disapproved of Lawson’s exchange rate policy and she replied - famously:

“Adjustments are needed, as we learnt when we had a Bretton Woods system, as those in the EMS have learnt that they must have revaluation and devaluation from time to time. There is no way in which one can buck the market.”

Unfortunately for United Kingdom taxpayers, Mrs. Thatcher’s successor, John Major, did not subscribe to her views. Under his government the UK joined the European Exchange Rate Mechanism at an unrealistic level. George Soros and others pounced on sterling, shorting it at considerable cost to taxpayers - whose money was recklessly wasted as the government sought to prop up sterling on FX markets.

Soros told the Times: “Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont [Treasury Chief] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell.”

Moving on a few years came the Greenspan Put. Following the collapse of Long-Term Capital Management, Federal Reserve Chairman Alan Greenspan – who had previously offered an opinion that stocks were overvalued – cut interest rates. Traders called Greenspan’s position “The Greenspan Put” because a put option gives investors the right to sell their stocks at a set price. Greenspan’s actions were seen as a guarantee to the market that he would keep cutting interest rates to prop up the stock market.

We can see the damage low interest rates and reckless loans have done to the economy. US consumers are expected to be the engine of world economic growth – even if they have to get into serious debt to do so. Every time consumers stop to get their breath back, they’re told to wake up and get out spending their money again (or more likely someone else’s money).

Today Ben Bernanke has talked about stimulating the economy again – through cutting interest rates and cutting taxes. This despite the fact that both inflation and government debt are already higher than anyone thinks is prudent.

It now seems all the more credible that the Fed. Chairman is trying to write the Bernanke Put. With the steep falls in stock prices today it seems the markets are telling him that - even with all the intervention in the world – they’ve realized that American consumers and taxpayers cannot go on borrowing forever to fund the expansion of their own and overseas economies.

Perhaps Ben Bernanke should pay heed to those famous words I’ve quoted from Margaret Thatcher?

Anyway, whatever happens, my job is simple. I just try to stay on the right side of whichever stock or market I’m trading. I’ll leave it to smarter people to fix the economy.