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are wrong and/or (2) to make more on your winners than you give back onyour losers. Indeed, it is no exaggeration to suggest that every action youtake in your trading/investment activities should be oriented toward one orboth  of  these  goals.  This  includes  any  market  research  you  conduct(which, if done correctly, impacts both), all the efforts to maximize yourexecution efficiency, and all risk control activities. Think about it. Each ofthese is almost by definition geared toward either improving your win/losspercentage  or  your  ratio  of  performance  of  winning  trades  versus  losingtrades.  I  often  find  it  is  useful  to  view  portfolio  management  activitiesthrough such a filter, perpetually asking the question of what specific partof the performance ratio I intend to influence by each action. If, from thisperspective, you are able to reorient your efforts in such a way that eithercomponent of the equation increases in value, I’m confident that the asso-ciated results will become apparent to your bottom line.
In  terms  of  interpreting  your  performance  ratio  score,  as  previouslyindicated, I assert that in order to be successful, there is a minimum levelof  competence  that  is  required  in  this  regard.  Specifically,  the  absolutelower bound that would be compatible with success is somewhere around0.5. One fairly intuitive way of thinking about this is that a score of 0.5 canbe  achieved  by  being  correct  in  your  market  view  exactly  half  the  time,while making precisely as much on winning trades as you give back on los-ers.  Although  there  are  some  combinations  of  performance  below  thisthreshold where I could envision at least some transient profitability, forthe most part, over the long term, unless you are north of 0.5, it is safe toassume  that  something  is  amiss  and  that  unless  you  take  some  steps  toevaluate and correct the problem, the prospects for a long and prosperoustrading career are not overwhelmingly favorable.
By the same token, if your score is consistently above a certain thresh-old, say, 1.0, it would imply some combination of accuracy above 50% andan  impact  ratio  above  1.0  such  that  sustaining  it  almost  guarantees  anextended, successful run as a portfolio manager. If your performance con-sistently exceeds this threshold, my best advice to you is to increase yourcapital usage. Whatever approach you are taking, it is certainly working toyour advantage, and you should make every effort to maximize the dollarreturns you can generate under these conditions.
METHODS FOR IMPROVING PERFORMANCE RATIOS
Once you have identified a condition of underperformance, the next cru-cial  step  toward  correcting  the  situation  is  to  try  to  isolate  the  specificcauses;  and  a  review  of  the  components  of  the  performance  ratio  is  anexcellent place to start.
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Performance Ratio Components
If the numerator is low (say, below the 50% threshold), it suggests that youmay need to be more careful in your position selection process. Try chang-ing or enhancing the research you conduct before putting on a trade. Makesure  you  have  a  detailed  plan  for  each  transaction,  covering  everythingfrom  the  catalyst  you  are  attempting  to  monetize,  to  the  time  frame  inwhich you expect the catalyst to occur, to the price target you are seekingif you are right, to the level at which you will commit to liquidating if thingsfail to go your way. 
I have argued that unless you have not only (1) a clear hypothesis butalso  (2)  target/objective  prices and  (3)  stop-out  levels in  mind,  you  havenot, in most cases, done the work necessary to justify putting on the trade.It is also quite useful to keep track of these statistics for all your transac-tions and to use an independent source (e.g., other traders, a broker, etc.)to  check  rationality  of  these  parameters.  You  may  even  wish  to  monitoryour  performance  across  all  three  factors,  specifically  seeking  statisticalanswers to the following questions:
• Irrespective  of  whether  you  made  money  on  the  trade,  are  the  cata-
lysts you expect actually occurring?
• If so, are they occurring during the time frame you expected?• Were  you  invested  when  the  catalyst  took  hold;  and,  if  you  were,  atwhat percent of what you considered as your full position going intothe trade?
• If not, what blew you out of it, and what could you have done to avoid
this outcome?
• Did  the  security  you  traded  hit  its  target  price  (again  irrespective  of
your P/L on the transaction)?
• If not, did it hit your stop-out level?
As  is  the  case  with  so  much  of  our  tool  kit,  your  performance  withrespect to all of these factors is likely to vary along with your overall suc-cess as an investor. This provides the opportunity to compare intervals offavorable results with those that produce results that are less than optimalacross the specific components of the decision-making process. You mayfind that any deterioration in your win/loss ratio can be specifically attrib-uted to one or more of the named factors and that in each case there is atleast a nominal remedy. For example, if the catalysts you are identifyingare  simply  not  playing  out,  then  you  must  very  clearly  reexamine  yourselection model in order to determine how and why it diverges from eco-nomic reality.
In  turn,  there  may  be  myriad  reasons  for  this  divergence,  includinginternal ones (your views of key events differ from those of the investing
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public in general) and external ones (the fundamentals of the markets youtrade  have  changed),  or  some  combination  of  the  two.  Similarly,  if  yourtime frames are off or if the risk/reward ranges you have established areconsistently inaccurate, there may be systemic reasons for this as well. Inany event, it’s useful to know what’s breaking down in your model whenthings that worked previously are now working against you.
One critical factor in the management of your performance ratio that Iencounter repeatedly as the cause of sustained breakdown is the inabilityto effect a timely liquidation of positions that are not working out favor-ably. Note that a failure to remove positions that may once have been goodideas but no longer hold their original promise can adversely impact bothyour  win/loss  ratio  and  your  impact  ratio  performance.  This  happens  tonearly everybody from time to time and is typically attributable either toa  failure  to  adhere  to  established  stop-loss  levels  or  to  inaction  on  posi-tions that hover in a trading range long beyond the point where any rea-sonable  hope  for  catalyst  either  materializing  or  producing  the  desiredprice movement has disappeared.
What happens here is that positions you should have long since liqui-dated can remain on your books—due to benign neglect or wishful think-ing,  or  some  combination  of  the  two.  To  guard  against  this,  you  shouldfrequently review your entire portfolio and make sure that you have a goodreason for being in each position. You should also pay close attention tothe length of associated holding periods and to your cumulative unrealizedP/L. In each case, ask yourself whether the trade you have on is one youwould execute at prevailing market prices. If the answer is yes, keep theposition. If no, get out of it. No matter how diligent you are in managingyour  book,  my  experience  is  that  there  will  routinely  be  positions  in  theaccount that, at best, are no longer driven by the catalysts originally iden-tified and that, at worst, offer not the foggiest indication of why the tradewas made in the first place. The benefits that you will gain by being metic-ulous  about  scrubbing  these  positions  out  of  your  portfolio  can  be  sub-stantial, often turning bad years into decent ones, decent ones into goodones, and good ones into outstanding ones.
The process of identifying inefficiencies in the denominator of the per-formance ratio is much the same as the one that applies to the selection-winning percentage component in the numerator, though the root causestend to differ substantially. Again, the main culprits typically include ele-ments of the selection process, execution management, and risk control.However,  in  the  case  of  the  impact  ratio,  which  measures  unit  gains  onwinning trades versus unit losses on unprofitable ones, we would expectthe  breakdowns  to  assume  different  forms.  For  example,  if  your  impactratio  is  falling,  it  may  very  well  have  to  do  with  the  selection  process.Rather  than  focusing  on  whether  your  general  view  of  the  markets  is
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accurate, in this case I would instead look at the manner in which you areprioritizing and sizing your trades as a function of the quality of the oppor-tunity. At any time there may be a specific number of trades you think willwork.  However,  due  to  reasons  of  capital  constraints,  limited  mentalbandwidth,  and  so  on,  you  may  only  be  able  to  execute  a  percentage  ofthese trades. Moreover, you will have decisions to make in each case aboutsizing, timing, modes of execution, et cetera.
Plainly,  you  will  want  to  both  prioritize  and  parameterize  theseprospective opportunities on the basis of what you stand to gain if you areright versus what you will lose if you are wrong. If your performance ratiosuggests room for improvement—particularly if your winning percentageremains acceptably high—it may be that you need to fine-tune your selec-tion process such that it more efficiently captures not only the price direc-tion you expect in your positions, but also magnitude. If it indeed turns outthat  you  are  right  most  of  the  time  in  the  markets  but  are  subsequentlyexperiencing only small gains when you are right versus large losses whenyou happen to be wrong, there are a number of tools at your disposal toassist you in achieving improved unit performance. For example, a betterunderstanding  of  charts,  including  such  key  concepts  as  support  andresistance, may help you to better monetize ideas where your directionalcall is correct, while minimizing the pain you take when the market movesagainst you.
Maximizing Your P/L
The  other  likely  root  causes  of  performance  ratio  degradation  are  moreintuitive and relate to the critical topics of execution management and riskcontrol. In order to maximize the amount of money you make on winnersas a multiple of your P/L on losing transactions, you should operate withthe following objectives.
Cut Your Losers/Let Your Winners Ride. As mentioned throughoutthe book, this concept can be thought of as the key objective of all tradingactivities. If you are successful in this regard, there are very few externalfactors that will constrain you from prospering as a trader/investor. More-over, there’s not a great deal of science needed in the management of thiseffort; instead, you should simply operate under the following premise: Ifyou’re wrong, get out; if you’re right, let the market achieve its new equi-librium before you contemplate liquidating.
Note that by cutting and riding, you will not necessarily capture everysingle bit of price movement in the names you are playing. Indeed, therewill be times when getting out when the market moves against you meansyou  will  fail  to  capture  the  perfect  inflection  point.  By  the  same  token,
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letting your winners ride may mean you repeatedly find yourself in a posi-tion where you may have held onto a trade beyond the point of maximumprofitability. Nevertheless, by consistently adhering to the discipline of cut-ting your losers at the earliest logical opportunity while resisting the temp-tation  to  liquidate  a  winning  trade  at  the  first  whiff  of  profitability  butwhile there is considerable upside according to your original hypothesis,over the long run, you will be much more successful than you would underany other approach. So don’t worry about whether, on an individual trade,your strategy didn’t follow the precise road map of the pricing action in theinstrument you are trading. The approach I recommend will keep you inthe game, which is the important thing. 
You may accept this logic without great difficulty and still face a for-midable  challenge  with  respect  to  its  application.  The  secret  lies  in  theplanning that you do before you first put the trade on. Every rational tradethat  you  do  should  feature  both  a  target  and  a  stop-out  level.  In  turn, these  should  be  situation  specific,  tied  to  everything  from  your  tradingstyle,  to  overall  market  conditions,  to  the  specific  catalysts  you  areattempting to monetize in the names you have been trading. If you main-tain  this  discipline  in  your  trading,  then  your  course  is  clear.  Cut  yourlosses when your securities hit your stops, and let your winners ride untilthe  market  hits  your  price  target.  If  there  is  reason  to  stay  in  the  tradebeyond the thresholds in question, liquidate it anyway and reinstate it withnew parameters. This will increase your transactions costs, in all of theirunholy forms, but I encourage you to consider these costs as part of therisk management investment.
Diligently  Manage  Your  Executions. Different  trading  and  invest-ment strategies have different sensitivities to the executions process. Forexample, the results associated with high-velocity trading strategies tendto  be  more  dependent  on  the  executions  process  than  are  buy-and-holdinvestment approaches. Similarly, the executions process will be a muchmore  critical  driver  of  profitability  in  complex,  structured  transactionsthan  it  might  be  in  plain  vanilla  markets  with  ample  liquidity.  However,portfolio managers should seek to attack the executions process with asmuch effort and energy as they apply to any other element of their invest-ment program. 
There are several reasons that attention to execution is so important.First,  there’s  real  money  involved;  and  the  difference  between  an  activeand  aggressive  executions  program  and  a  passive  one  involves,  at  mini-mum, several percentage points of performance—no matter whether youare managing a small nest egg of a few hundred dollars or a multi-billion-dollar institutional investment program. Second, by managing your portfo-lio with an objective to capture every single available tick, you develop a
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level  of  discipline  that  positively  impacts  such  critical  portfolio  mecha-nism  as  risk  control  in  a  way  that  can  only  be  beneficial  to  your  overallreturns.
“Watch your pennies, and the dollars will take care of themselves,” mygrandmother used to say; and what’s more, she lived by these words. Shedid  not  become  a  great  portfolio  manager,  but  she  never  blew  up  either.Will your grandchildren be able to write this about you?
Third,  by  declaring  war  in  the  executions  portion  of  your  activities,you are, in effect, giving the market its props, demonstrating that healthysense of respect for the game that is vital to your ultimate success. By con-trast,  those  who  treat  the  executions  portions  of  their  portfolio  manage-ment process as being a secondary or administrative aspect of the overallprocess  place  undue  faith  in  the  accuracy  of  their  position-selectionefforts. Think about it. Are your ideas always so good that they place youin such a profitable position that you can afford not to attack the execu-tions process with every bit of zeal and intelligence you can muster? Notin this world, and perhaps not in the next. 
A TALE OF TWO HEDGE FUNDS
It  was  the  best  of  times,  it  was  the  worst  of  times.  It  was  a  quarter  thatexceeded  expectations,  it  was  a  quarter  that  disappointed  us  all.  It  was  aninterval of irrational exuberance, it was a season of lost fortunes and dashedhopes. We were all going to be fabulously wealthy, we were all on our way todestitution. In short, the period was so far like the present period that some ofits  noisiest  authorities  thought  it  would  make  an  interesting  and  useful  casestudy. I’m talking, of course, about the late 1990s and the associated explo-sion  in  long/short  equity  strategies—particularly  among  hedge  funds.  Let’sconsider the case of two competing participants in the hedge fund arena: Juliusand Augustus. Julius is an honorable if ambitious man, and one of the world’smost renowned stock pickers. For several decades, his market conquests filledhis investors’ coffers. His research efforts were legendary, and once he got aninvestment opportunity in his crosshairs, he seldom missed his target. As oneprofitable year followed another, Julius soon found that he was managing anenormous amount of capital. Prudently, he redoubled his research efforts, hir-ing some of the best minds in the industry to help him figure out what thingswere worth. When he got a good handle on something that was undervalued,he would instruct his minions to grab every share they could get their grubbyhands on. Nothing pleased him more than to see the market moving againsthis position while he was building it up, as he viewed these dynamics as noth-ing more than an opportunity to improve his average. He did not particularlycare  about  the  daily  fluctuations  in  his  portfolio;  he  was  always  playing  for
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larger themes, and he made or broke his bones on the basis of whether or nothis hypotheses played out.
In summary, it was fair to say that he was not particularly price sensitive.If he thought he was right, he didn’t care what it cost him to put on a position.Moreover, if his conviction was high enough, he would typically scale his posi-tion to a level of market visibility, and past liquidity thresholds, in such a wayas  to  remove  any  ability  to  limit  losses  if  his  hypothesis  somehow  failed  tomaterialize.
While  Julius’s  approach  was  all  about  being  bold  and  aggressive,Augustus, like the Roman emperor from whom he drew his name, derived hisbrilliancy more from tactics. He could be as assertive as Julius when he thoughtthe  timing  was  right,  but  he  was  much  more  careful  about  the  details.  Herelentlessly worked every order to make sure he got the absolute best price hecould, given his vast set of resources. He guarded his moves in the market witha military secrecy. He never put a position on that was so big he couldn’t liq-uidate  it  at  what  he  considered  to  be  acceptable  loss  levels.  When  he  waswrong, he got out; and when he got out, he squeezed every dime he could outof the liquidation process.
The successes of both Julius and Augustus are a matter of market legend.For my money, I prefer the model namesake of the son to that of the father.Great ideas are elusive to come by and even more difficult to generate consis-tently over the long haul. Effective execution of strategy is something that iswithin the grasp of every market participant, every day. Get this part right, andit’s a fair bet that like Augustus (and unlike Julius), your portfolio will avoid theindignities of a violent death, suffered at the hands of individuals and entitieswith whom you worked side by side, for lifetimes.
Note that the concept of effective executions management is a scienceall its own and worthy of more attention than I can devote to it in thesepages. The world’s brokerage firms employ hundreds if not thousands ofprofessionals  in  this  task.  The  exchanges  themselves  are  nothing  morethan  executions  and  clearing  mechanisms  for  the  trades  you  execute.Moreover, the largest and most effective portfolio managers in the worldemploy teams of highly trained individuals whose explicit and sole respon-sibility is to achieve efficient execution of the transactions that comprisetheir portfolios. However, most traders will have to undertake this task ontheir own, for which the following general guidelines can be helpful:
• Watch  the  screen  as  actively  as  possible. Whether you are activelymanaging an existing execution, looking for an entry point, or trying toliquidate, I know of no better approach than watching each name on a
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tick-by-tick basis. Charts are also very useful guideposts, as are certaintechnical measures like the volume executed at each price. The moreactive you are in watching the pricing action in your names, the betteroff you will be.
• If  possible,  use  multiple  execution  sources. While  professionaltraders  and  portfolio  managers  are  trained  to  distribute  their  tradesacross multiple brokers and counterparties, it is typically easier for therest of us to simply call our brokers. Subject to constraints involvingyour level of trading activity and the amount of time and attention youare able to contribute to these tasks, it is beneficial to have multipleoutlets for your executions, which will bring competition into the mix.It will also give you a much better understanding of what constitutesquality execution and what does not. You may find it useful to makeyour  execution  sources  aware  that  they  don’t  have  exclusivity  withrespect to your account. In addition, particularly for larger accounts, itis often productive to make a habit of liquidating your trades with bro-kers and counterparties other than those where you originally put thetrade on. Specifically, this will protect you against the unfortunate butcommon practice among the brokerage community of profiting fromtoo close a knowledge of your portfolio management activities.
THE FRONT-RUNNERS
You may be surprised to know that there is a whole segment of investment thathas sprung forth from the practice of knowing where the buy and sell ordersare in the market and the trading positions that anticipate the filling of theseorders. This is nice work if you can get it. Think of the advantages of knowingin advance that, say, a large mutual or pension fund is buying a sizeable blockof Stock A and selling an equal quantity of Stock B. In most market conditions,Stock A will go up and Stock B will go down. Moreover, even if this script does-n’t play out precisely, Stock A is likely to outperform Stock B; and you can makevirtually riskless profits by buying the former and selling the latter. My obser-vation is that these types of portfolio rebalancings occur all the time and can-not  be  done  on  a  large  scale  without  involving  many  brokers  and  traders.These people face a significant conflict of interest as their obligations to pro-vide  the  best  professional  service  to  the  funds  that  are  their  clients  must  bebalanced  against  the  temptations  they  face  through  the  prospect  of  tradingagainst their clients’ positions.
Strictly speaking, the practice of “front-running” is illegal. Specifically, thepending transactions in the marketplace for a given security fall under the gen-eral heading of inside information, and market participants are prohibited fromtrading on the basis of such information. In addition, almost all financial firms
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have  explicit,  written  policies  against  such  trading  and  work  very  hard  toenforce these policies. However, there is a massive “gray area” where the linebetween the highest levels of ethical behavior and the rights of market partic-ipants  to  capture  every  legitimate  market  edge  they  can  unearth  is  not  well-defined.  Consider,  if  you  will,  those  cases  where  brokers  have  not  specificknowledge  but  rather  strong  reason  to  suspect  that  trades  that  are  likely  tomove the market are about to occur. Are they bound not to act on this infor-mation? Instead of trading, can they disclose what they know to their other cus-tomers  so  that  the  benefits  they  derive  are  indirect  and  commission-related?Further, whether told by their brokers directly or not, other market participantswho are active traders may surmise that a significant trading or order patternis underway. What are their obligations? Perhaps they have been shown a largeblock of securities for sale by a given firm and then go to another brokeragefirm to trade ahead of this order. 
All of these patterns fall within the mosaic of what sophisticated marketparticipants refer to as front-running. My experience is that while most market-based entities strive not to cross ethical boundaries with respect to issues thatfall  under  the  general  heading  of  front-running,  some  form  of  this  activityalmost certainly takes place in many guises every single business day. Broker-age  firms  live  off  information  flow,  which  in  many  cases  is  as  important  ascommissions.  Most  large  banks  and  broker/dealers  have  proprietary  tradingarms; and though these groups are typically prevented from transacting basedon information derived from the trading patterns of their customers, some slip-page  is  inevitable.  These  firms  also  have  market-making  operations  whosebusiness it is to provide liquidity to the markets and who cannot provide thisessential  service  unless  the  associated  trading  they  undertake  themselves  isconsistently profitable.
For all of these reasons, it’s pretty safe to assume that as an individual oran institutional investor your trading patterns offer profit opportunities to yourcounterparties and that these opportunities will, with varying frequency, come atthe expense of your P/L. Of course, the magnitude of this problem is a direct,positive function of the size and the visibility of the capital that you are manag-ing. To be sure, front-runners care much more about the activities of the WarrenBuffetts of the world than they do about the trading patterns of you or me (well,at least you; these guys tend to watch my every move like a hawk). However, itwould be a mistake to assume that this type of conflict doesn’t exist even amongthose  providing  services  to  seemingly  insignificant  accounts  of  individualinvestors. If you don’t operate in a manner that precludes market professionalsfrom accurately anticipating your every market move, it’s a fair bet that there’ssomeone out there who will try to take advantage of you in this regard.
Guard the privacy of your book as jealously as other aspects of your per-
sonal life that are nobody’s damned business.
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• Evaluate  the  quality  of  your  executions  relationships  in  a  holisticmanner.If  you  are  able  to  utilize  multiple  execution  sources,  youneed to be aware that there are many criteria across which you shouldevaluate these service providers. One very important measuring stickis commissions charged; and while I would be the last guy to tell youthat you should actively seek to pay higher commissions, I would nev-ertheless point out that the lowest commission rate does not alwaystranslate into the cheapest execution cost. In particular, it is importantto also take into account the extent to which your orders get executedat the best available prices. Traders refer to anything inferior to bestexecution, rather quaintly, as “slippage”—a factor that can be a majordrain  on  your  P/L,  irrespective  of  whether  you  are  an  active  tradermanaging  large  pools  of  capital  or  not.  However,  for  reasons  thatshould  by  now  be  obvious  to  the  careful  reader,  the  larger  and  themore active you are in the markets, the larger the potential impact ofslippage, and the more carefully you will need to watch it. 
Unfortunately, slippage is not the easiest factor to track for anyonenot  positively  flush  with  resources  to  apply  to  the  task  of  tradinganalysis. One very straightforward way of evaluating noncommissionexecutions  costs  involves  splitting  individual  orders  across  multipletransactions agents and recording executions performance for subse-quent statistical analysis. This can be a very useful exercise, but it willbe far from costless. It will force you to track and perhaps maintainpositions  across  several  brokerage  entities,  in  the  process  possiblyremoving  otherwise  useful  opportunities  for  effecting  margin  effi-ciency, cross-collateralization