have beenhorribly wrong to stick to this disciplined approach.
There’s a big difference between calling yourself a technical trader andunderstanding the market structure, along with the charts and price action.Aaron Reinglass, an old friend of mine, is a perfect example of the seasonedtechnician who incorporates fundamentals into his analysis. Aaron is alwaysfond of saying that if a person doesn’t know how or why he or she madea proﬁt in the market, then there’s a good chance he or she will eventuallylose it.
Reinglass is the son of Auschwitz survivors, who had a big inﬂuenceon his worldview. A skeptic by nature, he’s an excellent technician withan uncanny way of ﬁnding the hidden news story that could make a largemarket impact. He occasionally comes to me with an article or story froma major publication or the Internet supporting or opposing an opinion wediscussed the previous day. The most memorable thing he ever said to mewas at the beginning of the move down in stocks during late 2000 andearly 2001: “Remember, Jack, drinking doesn’t cause hangovers—stoppingdrinking causes the hangover!” What he was trying to say was that thecharts were conﬁrming what we had suspected all along: that the marketwas in serious trouble. I’ve borrowed that line from him and used it, withhis blessing, on many occasions.
The real question that all students of the markets should ask is whethercharting the markets gives them a true edge in trading or not. As I talk toaudiences around the country, one question that seems to come up againand again is whether I use technical analysis and, if so, what disciplines Ifollow. It seems fairly obvious that the market observer will notice certainpatterns that develop over the course of a trading session. You might arguethat the market will do whatever it wants (the random walk theory, whichwe’ll discuss in Chapter 7) and that charting the price action is after-the-fact analysis. There are moving averages that can range from intraday toyearly, which give traders an idea of moving value by setting an averageprice.
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Charting price action is a little different in that traders are looking forcertain patterns to reemerge so that they can be proactive in placing whatthey consider to be high-percentage trades. These charts can be generatedfrom a tick-by-tick account of the action to a time frame of any choosing.This type of analysis is the most commonly used by beginners and has itsown ﬂaws. Certain types of market study such as point-and-ﬁgure analysisand pivot point methodology are destined to fail because of their popularity.Being the easiest way to begin a trading career, these simplistic approachesbecome self-fulﬁlling prophecies for professionals that feed off of the retailaccounts.
It’s only logical: If the entire retail world is looking at the same chartand deducing the same analysis from the price action, then they’re boundto do the same thing collectively. Another of the best-kept secrets on theStreet is that the professional trader makes a great living off the uneducatedretail investor who uses simple support and resistance levels to get in andout of positions. This is almost the same as telling the world what you’redoing and thinking as a trader.
EDUCATION IS KEY
I have always made it my personal goal to educate our customers in thenuances of technical analysis. I ﬁnd it ironic that educated people will openaccounts with brokers who offer the most simplistic type of work. Pivotpoint analysis is the ﬁrst thing that a runner learns when starting on theﬂoor of any exchange. It takes the high, low, and close from the previousday and comes up with a pivot for the following day’s session. It soundsgreat except for the fact that the entire world is looking at the exact samepoints. That’s my biggest complaint with most of the work available to thegeneral public—if the work is held by the masses, then it’s destined to failbecause, as we know, 90 percent of the trading public loses money. I tellbrokers and customers to try not to do what the rest of the world does.
Being a contrarian doesn’t only mean having a contrary opinion onthe market condition; it also means knowing when to use the self-fulﬁllingprophecy that much of this work becomes. In other words, the chart andpivot points become magnets for the professionals who can gauge when theretail public puts on positions and how much pain they can tolerate from alosing trade. In my opinion, the most important thing any new traders cando is ﬁnd a discipline they can understand and watch the way price actiontreats the levels brought on by the work. Understand that it’s vital to observethe work over a prolonged period of time rather than a short time frame.This is necessary because any one methodology can be proﬁtable for a givenperiod; it’s the ones that are consistent that make the best trading tools.
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As for me, I think I have been exposed to too many traders who wouldconsider themselves from the school of the random walk theory. Bing oftensaid that the charts sometimes needed to be thrown away, and I found thathe was absolutely correct. I’ve noticed that sometimes technical analysisis a handicap rather than a tool. Vinny and Denny referred to chart pointsas voodoo, but both of them, along with Bing, realized that at times it’simportant to look at what might be considered a road map of where themarket has been. That’s the difference between the greatest traders in theworld and the wannabes—the ability to look upon a chart as the past ratherthan trying to predict the future by prognosticating.
Most gifted traders have this ability to react to the market conditioninstead of trying to predict the future by using a mathematical equation.It’s almost counterintuitive that to be a proactive trader it’s important to bereactive. Identifying a pattern, or the lack of a pattern, gives good tradersan understanding of how they should react in order to position themselvesfor the next major price move. I have come across many talented techni-cians, such as Aaron Reinglass, in my day, but the work of Doc has alwaysattracted me. His work on structural analysis of the market incorporatesmy fundamental views. The difference between our respective ways of in-terpreting the same work is that Doc sees the work as a precursor to marketfundamentals, whereas I see his work as a justiﬁcation for my fundamentalview. But how can I argue with someone who has predicted some of thebiggest moves in market history?
So does technical analysis help you become a successful trader? Some-times. At other times, the best work available won’t help you make a singleproﬁtable trade. Those who have survived years in the market will say thatin order to succeed, a trader must know how to incorporate a solid un-derstanding of the fundamentals of the market with the available technicalinformation. The truth is that all traders must develop their own style basedon their individual personality and tolerance for risk, which varies fromtrader to trader. When someone asks what trading style would be best forthem, I’m reminded of Bing’s advice to me when I was starting out: “Do yourown homework and above all make your own mistakes. It’s the only wayyou’ll learn!” This was true in 1986, and it’s still true today.
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C H A P T E R 7
Random WalkTheoryThe Market Is Nothing MoreThan Organized Chaos
T he ﬁrst Wednesday of every month was when the Chicago Mercantile
Exchange (CME) board of directors would meet. This was preceded bya strategic planning committee meeting on Monday and an executivecommittee meeting on Tuesday. Leo Melamed, chairman of the strategicplanning committee, asked me to sit on his committee and Scott Gordon,then chairman of the CME, asked me to be a member of the executivecommittee. The strategic planning and executive committees constitutedthe board within the board, the group that set the policy and the agenda forthe upcoming board of directors meeting. Every facet of the policy-makingprocess was of great interest, but the highlight of the month was when Iwould get a chance to sit and talk with some of the greatest minds in theworld.
Before the board meetings, lunch would be served in the executivemeeting room just down the hall from the boardroom. During those lunches Iwas able to meet and have dialogues with Senator Paul Simon and ProfessorMerton Miller. During one of our lunches, the subject of the rallying stockmarket became the topic of discussion. Everyone had an opinion on whythe tremendous movement in tech stocks was happening. One of the moreinformed opinions came from Ward Parkinson, who had founded MicronTechnologies but had since left the day-to-day activities for a semiretiredlife in the western United States. Parkinson observed that the world wasgoing through a technological revolution that could make the industrialrevolution look small in comparison—a very insightful comment from aman who was an integral part of the deployment of technology to the massmarket.
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As the discussion turned to Dr. Miller and his thoughts on the market, Inoticed an interesting change in his appearance from the relaxed posture henormally assumed to one that was upright and serious. I had a feeling he wasabout to say something of signiﬁcance. (Either that, or he was simply tiredof sitting in the same position.) Fortunately, he was serious, and he talkedfor the next 20 minutes about the movement of equities and the randomwalk theory. I sat in awe, listening to what many have paid thousands ofdollars to hear—Merton Miller’s Nobel Prize–winning thoughts on the mar-kets and the economy.
Coming from the University of Chicago business school, Merton wasa classic random walk theorist. In fact, it was largely his work that wasused as the basis for what we consider today to be the random walk theory.During this particular speech, he made many cogent observations aboutthe euphoric condition the market was then experiencing, but the one con-sistent theme was that the market will do whatever it wants and that themarket is organized chaos. He told me that the ﬁrst serious work on randomwalk theory was done by Paul Samuelson in 1965, explained in an articleentitled “Proof That Properly Anticipated Prices Fluctuate Randomly” andthe other academic works that followed.
As we left the lunchroom for the boardroom that day, I walked withMerton and asked him whether he considered himself a random walker.His response was pure Merton: “Jack, my boy, every theory and inventionevolves over time. Who remembers today that steam engines were originallyinvented to pump water out of coal mines?”
A Random Walk Down Wall Street was written by Burton Malkiel in1973 and put into print the fundamental premise that it is impossible tooutperform the market on a consistent basis. In other words, all the technicalwork in the world will not help in the grand scheme of things because in theend, investors are better off buying and holding rather than trying to time themarket—it is too efﬁcient. Malkiel’s work, which was adopted by a majorityof the academics at the time, questions the validity of both technical analysisand fundamental analysis.
To the trader who spends hour upon hour staring at charts looking fora chance to identify a pattern, the thought of randomness in price actionis tantamount to heresy. The random walk theory also suggests that anysuccess in timing the market is nothing more than sheer luck. The law ofaverages would also suggest that if enough people are trading the market,some will make money—but in the long term, these individuals still can’toutperform the market.
Listening to Merton talk about random walk theory was very insightful.It gave me an idea of what is being taught at the major business schoolsand, better yet, how they are being taught the theory. I don’t think thatMerton subscribed to the idea that all price action is random. He found that
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most technical analysis was a waste of time because price movements ona daily, intraday basis are random. Prices have no memory—they have nopast or present—that’s why they can’t be used in analysis to predict wherethe market will be in the future. He went on to say that any movement inprices is due to information that hits the market at that moment. As soon asthe information becomes available, the prices are adjusted accordingly. Theonly difference is that the speed at which information is disseminated to-day gives the entire trading universe access to much the same informa-tion, creating a more level playing ﬁeld. Merton asked me, “How many mu-tual funds have outperformed the S&P 500 index consistently over the last20 years?” He had a point—fund managers were having a difﬁcult timematching the averages, let alone outperforming them. In the long run, in-dexing the market would prove to be the most proﬁtable.
One of the ﬁrst things that hits someone who ventures to any of thefutures exchanges that still use the open outcry method is the chaotic con-dition that prevails during the trading session. When I ﬁrst began to trade, itwas virtually impossible to detach myself from the noise and emotion thatwere all around me. I wondered if there was any reason for the price action,or was the movement in the market simply a product of the order impacthitting the market at any given time?
The concept of the random walk is one that many traders have a difﬁculttime digesting. The problem lies in the fact that pattern recognition is thebasis for every type of analysis, whether it is technical or fundamental. Itseems fairly clear that a fundamental approach to the market relies on thepast to understand the present and, hopefully, result in a proﬁtable future.A technical trader looks for the same pattern to repeat itself, thus ﬁnding ahigh-percentage trade from the available information.
WHAT DO MBAs LEARN ABOUTPRICE FLUCTUATIONS?
But what is it that MBA candidates are taught about market analysis? Hav-ing encountered a vast number of individuals with MBAs from a variety ofbusiness schools across the nation, I have come to understand the natureof what they are taught in this approach to the market. The two big schoolsin the Chicago area are the University of Chicago Graduate School of Busi-ness and the Kellogg School of Management, which is part of NorthwesternUniversity. Both have sound reputations and are consistently ranked amongthe world’s best. The one thing that hits you immediately when talking to agraduate from either school is the different attitudes toward the market thatare the foundation for the respective market approach and understanding.
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Graduates from the University of Chicago reveal Merton’s inﬂuence whenthey speak.
Much of what these MBA students are taught about price action centersaround random walk theory. Kellogg graduates look at the market using asynthesis of theories that include some randomness sprinkled with long-range pattern recognition. When I interviewed perspective employees, Icould quickly identify which ones were Kellogg graduates and which onescame from the U of C business school. Candidates from both schools founddifferent paths to the same place. They explained price movement from twodifferent perspectives, but their results were the same. They became whatI called randomentalists.
A randomentalist is a student of the market who blends random walktheory with a fundamental approach to market analysis. When I ask any ofthese so-called random walkers what they think about market action, theconversation inevitably turns to the fundamentals driving market pricing.But this is inherently anti–random walk. How could the observation of newsand events, the backbone of fundamental analysis, be of any help wheneverything, including news and events, is random? This question brings upan even more important point: Has the market evolved to the same stageto which random walk theory has evolved? Could it be that the theory waschanging with the marketplace?
When random walk theory dominated the academic and institutionallandscape, individual traders and investors were at a tremendous disadvan-tage compared to the larger broker-dealer community. Small traders hadaccess to information through one source: their brokerage house. Over thelast 25 years, not only has the ﬂow of information changed the world oftrading, but it has altered random walk theory itself.
Random walkers held the view that news and information were pricedinto the market so quickly that the individual trader had no chance at timingthe market—it was too fast and efﬁcient. What the theory never accountedfor was the technological revolution that allows the power to shift fromthe institutions to the smaller trader. Both brokerage costs and speed ofinformation give the individual trader the same advantage as the pros. Thefact that this is coupled with instantaneous execution capability has madeeven the most diehard random walker do some serious soul-searching.
Why has some of the randomness been taken out of random walk the-ory? Is the theory no longer credible, or has it, as Merton suggested, evolved,much like the steam engine did? Most individuals don’t understand that30 years ago, when the theory was popular, the market was completelydifferent. Both transaction costs and speed of execution created a bifur-cated market in which the institutions preyed on the smaller trader. Whenprice aberrations were created, it was nearly impossible for the individualto compete with the larger institutional trading desk.
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RANDOM WALK THEORY AND TECHNOLOGY
With the proliferation of electronic trading and competitive brokerage rates,the trading universe changed, undergoing a very dynamic evolutionary pro-cess. It is interesting to note that the brokerage community hates randomwalk theory. They’re in the business of selling analysis and ideas, yet yearafter year over 50 percent of the listed mutual funds underperform the mar-ket (the number was closer to 90 percent when random walk theory wasintroduced in 1973). There are so many different products today, such asexchange-traded funds (ETFs), that give investors true indexed investmentsand make it that much more difﬁcult for portfolio managers to ﬁnd strate-gies that outperform the benchmarks. But does that also suggest that thereremains no randomness in price action?
In January 1986 I was on the phone with Bing when word hit the wirethat the space shuttle Challenger had blown up at its launch in Florida.Immediately the market began to sink, with selling coming into the S&Psfrom all corners of the pit. Both Bing and I were short the market, but wenoticed something very strange about the sell-off. It was not following thenormal pattern of support and resistance that other breaks in the markethad taken. What should have been a panic- and fear-driven break was aconfusing volatile trade with staccato-like movements in the market thatchanged directions abruptly, seemingly for no particular reason.
Any textbook advice about trading would say that in times of disaster,sell ﬁrst and ask questions later. Those who sold on the shuttle disasternews quickly found that the market does not always do what it’s supposedto do. On the contrary, the market does whatever it can to hurt the mostpeople possible. That’s what the average person never really understands.The market ﬁnds a way of disappointing the day trader because of therandomness of intraday price aberrations.
When it comes to returns on the capital at risk, there are two differentform: risk-adjusted returns and absolute returns. A random walker wouldlook to incorporate a buy-and-hold strategy, believing that it’s impossibleto time the market effectively. History has taught us that this strategy hasoutperformed the market on an absolute basis, but the problem is that itdoes nothing to compensate for the risk associated with investing. The buy-and-hold method takes all the guessing out of the market but does nothingabout the risk.
Portfolio managers who incorporate market timing into their moneymanagement strategy ﬁnd that it’s possible to move capital in and out ofequities, creating exposure during rallying markets and putting money intoU.S. Treasuries during market pullbacks, and thus adjusting for risk. Thatis an example of a risk-adjusted return. Today, products ranging from ETFsto futures allow market timing in an efﬁcient manner.
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As an earlier chapter mentioned, there is a correlation between riskand reward. The higher the assumed risk, the greater the potential reward.The concept of risk/reward is best played out between the true randomwalkers and those who believe market timing takes much of the risk out ofthe position. Many proponents of the Dow theory have proven through ex-tensive research that using market-timing techniques increases the perfor-mance of a portfolio while reducing the risk associated with the exposure.Stephen Brown of New York University, William Goetzman of Yale, and AlokKumar of the University of Notre Dame published a study in the Journal ofFinance in the fall of 1998 showing the results of a study in which the Dowtheory was tested against the buy-and-hold (random walk) theory from1929 to 1998. It showed that the use of a market-timing approach such asDow theory outperformed buy and hold by almost 2 percent over that timeframe. The strategy allowed the investor to be shielded from risk associatedwith market exposure during downdrafts. Although the last few years haveseen the Dow theorists underperforming the random walkers by 2.5 per-cent, the debate is still heard among academics in virtually every businessschool.
It’s hard for someone who witnessed the trending market of tech stocksin the late 1990s to fully subscribe to the notion that the market is tooefﬁcient to be timed. In fact, market timing became very popular during thelast great bull run in stocks. The only problem lies in the fact that individualshad access to all the right information but didn’t understand what they werelooking at. Anyone who watched the action of the initial public offering(IPO) market for technology stocks during that period would have had toconclude that the outcome of a tech IPO was highly predictable.
RANDOM EVENTS CREATE THE TREND
There’s an old saying on the ﬂoor: “The trend is your friend.” Anyone whohas ever been successful trading in the markets will tell you that trendsdo exist, and anyone not in tune with the trend, whether to follow or be acontrarian, is a fool. The late 1990s taught many people that there just mightbe something to market timing. This period saw an explosion of derivativesproducts such as the ETFs and other investment vehicles that made enteringand exiting positions very easy.
One of the best examples of the randomness of events dictating theﬂow of the market was at the inception of the ﬁrst Gulf war. As SaddamHussein amassed his forces along the Kuwaiti border, the markets werelooking ahead to the unemployment number that was to be released later,along with any data that would show the economy coming out of recession.
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As I talked with the traders and portfolio managers available to me,no one seemed to care about what was happening in the Persian Gulf andthey thought any aggressive moves by Iraq would be immediately stoppedby the threat of U.S. intervention. History taught us that Iraq miscalculatedthe way the United States would respond and opened the door for decadesof problems in the region. As the U.S. State Department negotiated withIraqi diplomats, there was one trader from First Boston, Andy Elner, whosuggested to me that this was a larger problem than originally thought. Inhindsight, he was the only one who saw the storm coming.
In the days before the electronic marketplace, the pit used to explodewith activity anytime there was a news item or event that would affectprice action. Something big like a surprise move by the Federal Reservewould generate hours of frantic trading, with volume nearing capacity inthe open outcry session. But since the creation of the S&P contract, no onehad experienced the United States at war. More important, how would themarket react to the country in a state of war? As the deadline for the Iraqisapproached, everyone became a political science expert.
The talk across the ﬂoor was of the possibility of war and the ancillaryimplications for the entire market. I talked with many of the traders I wascovering from First Boston and other institutions about the direction themarket would take in the event of war. I painted different scenarios, from along drawn-out campaign to a short in-and-out strategy. Without exception,everyone was convinced that the equity markets would decline signiﬁcantlyand the run into short-term Treasuries was assured. In other words, theywere putting on the “economy deterioration spread.”
One morning a press conference was announced with Jim Baker, sec-retary of state under President George H.W. Bush, in which he would talkabout the ongoing dialogue with the Iraqi delegation. In a scene reminiscentof the movie Trading Places, in which everyone stops trading to listen tothe crop report, the entire S&P futures market was silent, waiting for theheadline or a hint of what was being said. At this time on the ﬂoor TVs werenot allowed, nor were they part of the exchange landscape (a situation thathas since changed now that large TV monitors have been placed on everycorner of the exchange ﬂoor).
A local in the pit would look for what was referred to as the “leak” from adesk that would give them an idea of what was said and how the ﬂow wouldtrade off the information. As Baker approached the microphone, the orderﬂow around the pit ground to a halt. Every trader off the ﬂoor within rangeof a TV set was watching carefully to get a clue about what was going tobe done next. Being on the telephone myself, I asked the traders to turn upthe volume so I could hear what the rest of the world was being told. Bakertalked about the frustrating dialogue between the international communityand the Iraqi government, then he mentioned Kuwait. Prior to the press
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conference, the understanding had been that the international communityled by the United States had given Iraq an ultimatum to leave Kuwait (whichthey had recently invaded) or face the consequences.
Listening on the phone, I could hear Jim Baker talking, and then ithappened: When Baker uttered the word “regrettably” in describing the Iraqianswer, the market erupted like a volcano! All I could hear on the phonefrom that moment on was “Sell me 100!” I had three traders yelling orderssimultaneously. Sell! . . . Sell! . . . Sell! Unfortunately, there was not much bidwhen we tried to sell the futures—everyone had had the same idea. Finally,after a 10-point drop, the market found buyers and the orders were ﬁlled.The traders had put on the short position that they were convinced was awinner if the war started. The move in the S&P futures went from roughly310 even down to 303. The market has never seen that level again. Not onlywas it the low of the move that day, it was also the low of the move for therest of the decade.
VICTIMS OF RANDOMNESS
The traders had thought out their strategies very carefully and yet theybecame victims of the randomness of the market. The panic selling thattook the trade down to the low was the result of completely miscalculatedanalysis. The logic that many apply to everyday life cannot be transferredto the market condition. In the words of Dennis DeCore, “The market iscompletely illogical!” And that makes sense—if the market were indeedrational, then everyone would be able to proﬁt from the price aberrations.Understanding that futures trading is, in essence, a zero-sum game (forevery winner, there is a loser), then we know that everyone can’t makemoney all the time. I’ve always called it Bouroudjian’s law: The market willdo whatever it can to hurt the most people.
One of the most intense episodes of randomness to hit the marketwas in the mid-1990s when the Federal Reserve chairman at the time, AlanGreenspan was speaking at a conference during the evening hours and re-ferred to the stock market as being in a state of “irrational exuberance.” Theovernight Globex session for the stock index futures went crazy. The futuresbegan to sink and between the night trading session at the Chicago Boardof Trade (CBOT) bond pit and the electronic S&P 500 futures contract, off-hour volume records were broken. Prior to Chairman Greenspan’s speech,the stock market had been experiencing a period of growing euphoria dur-ing which portfolio managers were just beginning to discover the world oftech stocks.
This was the ﬁnancial world that existed before the speed of informationdissemination that we enjoy today. Greenspan’s speech sent shock waves
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throughout the entire capital markets universe. Fixed-income securities,along with equities, experienced volatility that had not been felt for years.In fact, the last great test of volatility came during the start of the ﬁrst Gulfwar, and the market had steadily moved higher from that point.
Random events are the basis for random walk theory. The speed and ef-ﬁciency of the marketplace don’t allow anyone to anticipate an unexpectedevent. By deﬁnition, it’s something that is out of the norm. One of the biggestarguments against random walk theory is the invention and evolution of theoptions marketplace. When random walk theory became all the rage in theearly 1970s, the capital market structure was much different. Options, forexample, were a new product line not understood by many traders. Fur-thermore, there were only call options for investors to trade; the conceptof listing a put option contract on an equity came years later.
The use of these products gave traders who used the Black-Scholesmathematical models the ability to make winning trades consistently withlittle risk.Once the academic world began to see the power of quantitativeanalysis in pricing options, it became clear that random walk theory hadfaults. How could events drive the market randomly when traders were ableto use the randomness for a calculated high-percentage trade? It becomes adilemma for the devout random walker who feels the market is too efﬁcientto allow traders to capitalize on such events.
AN EDUCATED OPINION
One thing that the average investor doesn’t fully understand is that randomwalkers believe that an educated opinion is the only thing a person needsin order to invest. When other traders ask me how I feel about the market,I always tell them what I think, then follow it up by asking, “What do youthink?” A surprised look usually crosses their faces when I ask that question,and they often respond by asking why I care about their thoughts on themarket. I tell them that their educated opinion is as