good as mine.
One of the best options traders I know is Greg Hadley, who is a longtimefriend from the TKE fraternity house at Loyola. Hadley would ask me timeand time again what I thought of the market, hoping to gain some insightand achieve a winning trade. He made me realize that a trader who doesthe due diligence necessary to risk capital has an opinion that is educatedand should be taken seriously. After all, how many people put their moneywhere their mouths are on a daily basis?
For some reason, this shocks many traders. The very idea that an av-erage investor could offer an educated opinion that is as relevant as onefrom the professional trading community is foreign to them. One reason for
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this might be because people are inherently lazy. They want other peopleto do their work for them, and most prefer to sit back and have others tellthem what to do with their money. If you do your homework and follow thegeopolitical events of the day, then the opinion derived is based on solidinformation rather than a reading of the tea leaves. Experience is the bigdifference between a professional and an amateur. When nonprofession-als ask me about trading, I always tell them that it’s important for them tounderstand that they are amateurs (what many call retail investors) in aprofessional world. Even with the same information the “market opinion”of a retail investor cannot be as insightful as that of the seasoned pro. Itwould be as if I went into a health care profession after reading about it fora few months, believing I could do whatever a doctor can. It takes years tofully grasp the nuances of the market to get a better understanding of theorganized chaos that unfolds daily.
One of the advantages of having so many solid customers and reli-able contacts in my network is that it enables me to see how the vari-ous business schools outside of Chicago approach the market condition.To many of us in Chicago, looking outside of the area for insight into thecapital structure has always seemed unnecessary because of the amazingamount of intellectual capital produced at the University of Chicago andNorthwestern.
But we forget that there are many other great business colleges and uni-versities across the country and abroad that build a foundation for tradersbased on random walk theory. Talking with many of these individuals seemsto indicate that most business schools teach this theory because academiahas been dogmatic in its approach to the capital markets structure. One thingis evident, however: Graduates of these incredible institutions emerge withthe ability to think in a clear and analytic fashion regardless of their beliefor nonbelief in random walk theory.
One of the ﬁrst stories I heard about the speed of market efﬁciency andrandomness was during the 1967 war between Israel and its Arab neighbors.The event was well before I began to trade and since I was only six yearsold at the time, I can hardly remember it. Nevertheless, people who werethere explained to me the chain of events. As hostilities began to escalatein the spring of 1967, futures prices for commodities began to rise. Thelogic behind a rise in commodity prices during hostilities is that demandwill outstrip supply if the conﬂict is prolonged, which creates upside pricepressure for most products. On June 5, the Israeli air force attacked airﬁeldsin Egypt, Syria, Iraq, and Jordan, acting in a preemptive strike before theanticipated attack.
The news of the attack sent the capital markets into a volatile whirl.Commodity prices began to surge at the CBOT, with grain prices goinglimit up (the most a price can move in a given day). The action was
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no different at the CME, where they were trading the meat markets.Over the course of the years, the two exchanges had found niches trad-ing different types of agricultural products. The CBOT was trading thenonperishable commodities such as corn, soybeans, and oats, while theCME was trading perishable commodities such as pork bellies and livecattle.
The news of the war between Israel and the Arab nations moved thefutures markets into states of limit-up days; that is, they raised the dailylimit, then locked, with no trading and a growing book of bidders hopingto buy anything. There are many reasons why a trader would want to buya market locked limit up if possible, but the most important one is thatit gives traders the edge. A market that is locked limit has a high degreeof probability to open higher the following day, maybe even another limitmove. This was the case during the Six-Day War—all the markets moved upin unison, taking both the grains and the meats to limit move session aftersession.
After the third day, with the pork belly pit ﬁlled to capacity and locked ina limit-up position, the market found a large seller. It was Ralph Peters! Hewas holding his long grain positions, but he began to sell the huge holdings hehad acquired in the pork belly market. After covering an enormous positionfor a large proﬁt, he began to sell into a short position. When asked byone of his clerks why he would sell out a limit position then ﬂip into ashort trade, the answer was simple: Neither the Jews nor the Arabs eatpork!
Word of the trade started to spread across the ﬂoor, and within minutesthe entire market was ﬁlled with frantic activity as traders came to realizewhat Peters had just understood: Not all commodities are the same. Theevents that trigger moves in one market can have an entirely different effecton another market, based on the fundamentals. The randomness of thetrade took the price up with the other markets and then turned it lower ina split second. The market went crazy! Not only had the world been longthe belly market, but there were spreads between the various commoditiesthat turned into instant volatility.
Anyone who was caught in the whipsaw of the Six-Day War and lostmoney was a classic victim of randomness. The volatile nature of the eventswas a case study in the randomness of prices and constitutes a great exampleof random walk theory at work. Even in today’s market, events will takethe price of certain markets into artiﬁcially high price action only to fallback to the norm. The only difference is that today’s market is ﬁlled withmore participants and is saturated with information through the use of theInternet and access to professional trading techniques. What took a fewdays for traders to realize during the Six-Day War in 1967 would take onlyseconds today.
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NON-RANDOM WALK THEORY
There is another school of thought that takes random walk theory andturns it upside down. In 1973, Andrew Lo, who holds a Ph.D. in economicsfrom the University of Chicago, wrote a book called A Non-Random WalkDown Wall Street. The one thing that makes Lo much different from hispredecessors is that he incorporated the use of technical analysis into theefﬁcient market model. He had an attraction to technical analysis and tried,with some success, to disprove the effectiveness of random walk theory.Knowing that most of academia was subscribing to the theory, Lo concludedthat most ﬁnancial markets are predictable to some level. He went on toclaim that the predictability of the market was not a problem based oninefﬁciency or irrational price action, but, rather, the predictability of themarket is what makes the wheels of capitalism move. It’s simple—if liquidityproviders thought there was no way they could capitalize on the inefﬁciencyof the prices, then there would be large problems in capital formation andthe entire market structure would suffer.
Lo concluded that the markets can be efﬁcient at times but participantscan proﬁt during these periods with ongoing research and constant innova-tion. Simply put, traders that do their homework can thrive in any marketenvironment.
Lo maintains that beating the market is not easy, nor should peoplethink they can walk into a market condition that is emotional and expectresults without hard work. Lo says that ﬁnding above-average returns on anindividual’s portfolio is akin to a company trying to maintain a competitiveadvantage in a marketplace. If a company—any company—were to launcha new product line, the company would need to support the launch in everyway possible. Management must be ﬂexible and adapt to the ever-changingconditions, or else competitors will steal the market share.
Money managers and traders ﬁnd themselves in much the same boat—if they don’t remain ﬂexible and innovative, then they will not be ableto outperform the market. As dynamic as the market may be, a tradermust be just as dynamic. Just because a market strategy worked yes-terday and today does not mean it will work tomorrow. In an interviewwith Technical Analysis of Stocks and Commodities, Lo summarized hishypothesis:
The more creativity you bring to the investment process, the more re-warding it will be. The only way to maintain ongoing success, how-ever, is to constantly innovate. That’s much the same in all endeavors.The only way to continue making money, to continue growing andkeeping your proﬁt margins healthy, is to constantly come up withnew ideas.
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I remember asking Merton Miller about Lo’s work, and I found it fasci-nating that of all the economists’ work that Merton had come across aboutthe market condition, it was Lo he liked. He pointed to the fact that he wasable to incorporate the changing world and the efﬁciency of the market intoa cohesive approach to market structure.
An important conclusion of Lo’s work is that innovation will always pro-duce a high-percentage trade at times. More important, Lo’s work foresawthe technological changes that allow the aberrations information to be dis-seminated with unimaginable speed and reliability. Even today, as we wit-ness the evolution of the entire futures market into an electronic universe,the changes needed to maintain a trading edge are still very apparent.
But one thing is certain: The time frame used to study both approachesto investing has been short. Even though the last few years have seen themarket timers effectively outperform the random walkers who use the buy-and-hold strategy, history dictates that there will be a reversion to the mean.Random walkers will tell you that eventually those who time the market willnot be able to maintain above-average returns. They will end up as mostmutual funds on Wall Street end up—underperforming the major marketaverages.
The only thing that would give investors a glimmer of hope is that infor-mation has become more readily available for those wishing to participate inthe market. The widespread use of the Internet and electronic trading plat-forms gives the average investor the tools and the technology to compete intoday’s markets. The real question is whether the average investor knowshow to use what is available. The last few years have seen an explosionin trading and investing, but little emphasis is put on education. Maybe it’sbecause, in the words of Woody Allen, “Those who can’t do, teach . . . andthose who can’t teach, teach gym!” Unfortunately, most of the new ama-teur traders in today’s market are being taught by those who can’t do . . . orteach . . . or teach gym!
As I think back on the many great traders and portfolio managers whomI’ve encountered in my career in the futures industry, it is clear that a major-ity are from the random walk school. I remember Bing telling me that I wasgiving him only half the story, and I realize now that he was a true product ofthe efﬁcient market theory. He came out of Harvard Business School, wheresubscribing to something other than random walk theory was looked uponas economic heresy. He was telling me, in his unique way, that the charts arenot the reason the market is moving higher or lower. The market is movingbecause of events that are unknown to us.
The same was true for Vinny and Denny, who called market technicalwork “voodoo” but still had a certain amount of respect for what they con-sidered to be a self-fulﬁlling prophecy. Even Scott Weisblum, a product ofWharton, had a certain disdain for the technical work, relying instead on
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the fundamental analysis of the various stock indexes and the technologicaledge he created for himself. All of these remarkable individuals were greattraders in their own different ways but they shared one important charac-teristic: They understood the basic concept of the efﬁcient market theorybut likewise understood the need to incorporate change and innovation intotheir trading techniques.
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C H A P T E R 8
The Psychologyof theMarketplaceThe Highs Are High . . . butthe Lows Are Lower!
M y wife, Donna, aside from being a wonderful spouse and mother, is a
great RN. Twenty years ago when we were ﬁrst married she workedat a hospital on the north side of Chicago that was frequented bytraders and their families. I had heard time and again how wonderful my wifehad been and the tender bedside manner she showed in the postsurgical unitwhere she worked. One morning as I walked onto the trading ﬂoor I wasapproached by a clerk in the options pit who informed me that one of ourbrokers had left for health reasons. “Babe” was in his late 50s and sporteda ponytail and an earring. He was a huge man in girth and had a laugh tomatch. As it turns out, Babe needed to go into the hospital for opens heartsurgery (something I found out about later). Three months later I saw a manwalking onto the trading ﬂoor who was barely recognizable . . . it was Babe!He had shed half of his body weight, some 150 pounds, and was very frailin appearance.
I didn’t recognize him until he came up to me and began to speak. Havingseen Babe in action in the trading pits, I knew that he was one of the toughguys. He was old-school and the look in his eye reinforced the attitude. Hewas known as a trader and broker you did not mess with, but now, at leastphysically, he was half the man I remember, and he had a look on his facethat confused me. He spoke slowly: “I thought I was dying. Your wife savedmy life! She held my hand and told me it was going to be all right whenI thought I was gone.” As he was speaking to me, I could see that he wasbeginning to cry. His tears deeply affected me. “I don’t think I would havemade it if it wasn’t for her,” he continued. “God bless her,” he said, andhe walked away. I quickly called my wife and asked her if she remembered
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him. Donna had always been sympathetic to patients’ need for privacy, evenbefore the HIPAA rules, and she never shared tales from her work with me.But she knew exactly who I was talking about and asked me how he wasdoing. I told her that he looked frail but was feeling better. Then I sharedwith her the comments that he had made in regard to her care.
As I was telling her the story, it dawned on me that I could make acustomer a billion dollars and I’d never get that type of response. I willnever have any customers tell me that I saved their lives because of what Ido for a living! I told the story to Bing and he commented that the tradersaround Babe would be affected by his experience. Not only did it force Babeto leave the pit, it also changed the way those closest to him approachedtrading. Market psychology made a delicate shift in the S&P options pit andespecially in the minds of a few traders in Babe’s circle. The appetite forrisk was greatly diminished, and two of Babe’s colleagues retired within theyear.
THE MARKET PSYCHE
One of the ﬁrst lessons learned about the markets by anyone wishing toparticipate is that the market has a psyche all its own. As a beginning trader,I didn’t realize at ﬁrst that certain external factors drive the attitude ofthe traders on both a micro level and a macro level. On a micro level,certain incidents and phenomena that are strictly local in nature have adirect impact on the way the local community treats daily trades. Theseinclude the death of a child or spouse or a near-death experience undergoneby someone within the group. A macro event is more akin to the World TradeCenter events of September 11 and the treatment of the markets not only byour locals, but by the entire capital markets universe. As market observers,we must try to understand the impact of market psychology.
In the summer of 1989, as the markets seemed to be back on track afterthe disastrous October of two years earlier, the S&P pit became more active.The order ﬂow that had diminished started to grow again, along with thevolatility that brings day traders and other players into the session. Feelingthe market in all its euphoria allowed me to get caught up in the excitement.It’s very easy to get wrapped up in the world around you, especially whenthere seems to be a celebration around the globe. The Berlin Wall wascoming down, and on a personal note, my ﬁrst child was due in the fall. Itwas a great time to be trading in the markets!
My work had taught me that we were about to experience what I wouldrefer to as a “rally of biblical proportions.”Why not? The United States wasthe leader in the world’s technological revolution and possessed the greatest
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entrepreneurial spirit history had ever seen, and now we had won the ColdWar. If there was ever a bullish scenario, that was it! I started to put on smallpositions, allowing my account to slowly grow to a level I felt was sufﬁcientto take a shot at larger trades. I had worked the position up to a dangerouspoint where I was long too many S&P 500 contracts and had overlaid theposition with a long call position. This is what many professional traderscall a Texas hedge, which is having the same exposure with two differentpositions. I remember going home one night during this period thinking thatI should lighten the number of contracts in my possession when I returnedto the ﬂoor the next day—after all, it was earnings season and, as bullish asI was, anything could happen.
Walking onto the ﬂoor early the following day, I quickly ran to the CQGmachine to get the levels I would use to slowly cover a portion of the largeposition I had pieced together. The market was called slightly lower but notso low that it would drastically impact the proﬁt of the trade. Before theopening bell, United Airlines (UAL) announced a disaster in its earnings.The Street was not prepared for the disappointment. The opening call in themarket began to get lower and lower until I realized that we might be in fora full meltdown when the market opened. The UAL news shook the entirestock market right down to its core.
What followed would be called the “UAL crash” because it was UAL’srelease of earnings that became the catalyst for the major break in stocksthat year. My position got decimated! I had turned what was a winning tradeinto one of the largest losers I had ever faced. I walked off the ﬂoor, aftercovering the trade, and ran into my old friend Bobby Gault. Gault was agifted ﬁlling broker in the S&P pit and he would play an important part inmy life later. But on this day he could see the frustration and disappointmenton my face. Knowing I was a relatively new trader, he took me aside andtold me something that I have never forgotten. “Remember,” he said, “it’sonly money, and we can always get more. Family is what is important!”
Bobby has been a big part of my life for the past 20 years, but it wasthat comment that I will carry with me forever. There was a shift in the psy-chology of the marketplace right before my very eyes (and trading account)and I hadn’t been able to identify the change!
EUPHORIA IN THE MARKETPLACE
If anyone is looking for a case study to show the impact of market psy-chology, the late 1990s and early 2000s would be the perfect time periodsto examine. The late 1990s were an extraordinary time when a tremendousamount of wealth was made and distributed among certain sectors of the
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economy that had never experienced it before. The entire market was cele-brating, and the party was in full gear. Everyone was making money. I wouldget into a cab and the driver would tell me about the fortune he was makingin a particular stock. Of course, this was followed by a period when thestock market bubble burst, sending many retirement accounts, along withmany trading accounts, plunging to near worthless status. Trading arcadesbegan to close, and any talk of brokering the markets was like selling snakeoil. The year 2001 changed everyone forever—but more on that later.
In the mid-1990s when the markets were making new highs day afterday, it was clear to those of us participating daily that we were experiencingsomething special. We felt we were part of a historic move in the markets,one that would be studied for years to come. As students of the market,we had read about and heard about major moves up and down in stocks,but none of us ever would have thought that the entire stock market wouldclimb to the levels it did.
It was a perfect situation in which to examine a market that was goingthrough the feeling of euphoria. The post–Cold War effect was in full force.The world of capitalism was experiencing the fruits of victory, having spreadthe seeds of industry and proﬁt around the world. Everyone was turning intoa capitalist—even the Chinese, who considered themselves communists,were really living with a suppressed form of capitalism based on an under-ground economy that was growing faster than the gross domestic product ofsome G7 nations. Those of us in and around the equity quadrant at the CMEwatched in amazement as the number of customers grew geometrically.Retail accounts were ﬂocking to the stock index trade like never before,creating a period of prosperity for all segments of the membership—locals,brokers, salesmen, and futures commission merchants (FCMs).
A deeper look at the mid- to late 1990s is a great way to exam theeuphoric psychology that was rampant among the investing public duringthat period. It was a time when anyone who had a stock trading accountwas buying the market on tips and ﬁnding that 75 percent of the time, theymade money. The one thing to always remember is that making money isinfectious. In fact, the most difﬁcult thing to do is to go from a middle-classlifestyle to living like a rock star and then go back to that middle-classexistence. It had reached a point where everyone I met was talking aboutthe stock they had bought or were going to buy, and more important, theseanecdotes about trading proﬁtably were coming from nonprofessionals.
I was hearing these stories from cab drivers and grocery clerks. Buthow could I fade the crowd (be a contrarian), even when my gut instinctstold me that I must? I looked at some of the fundamentals and began to stayaway from some of the outrageously priced technology stocks, keeping myinterest, and money, in biotech and exchange memberships. I would be acontrarian to the Nasdaq market by not participating at all except to put on
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an occasional day-trading position. I felt that even though I was bullish themarket, the euphoric conditions surrounding the tech boom were makingit difﬁcult for me to hold anything long term.
One morning on CNBC someone asked me what chart points showedresistance in the Nasdaq index, and I replied, “The time has come to throwaway the charts!” I borrowed this line from Bing to let the world knowthat charts had nothing to do with what was going on, and any seasonedprofessional looking at the charts would have to agree.
I wrote earlier that the life of a moneymaking local is a charmed lifeindeed! During the run in the stock market it seemed that everyone wasleading a charmed life. It had reached a point that anyone buying a stockwith four letters was making money. It’s no surprise that the entire countrywas feeling the euphoria created by the rising market. The media evengave the phenomenon a name: the wealth effect. Not only were brokers andtraders making money, but the boom time also had a large impact on thebusinesses and service industries around the nation.
Every day there were stories of people who had never traded equitiesin their lives ﬁnding a stock and holding it to the tune of millions of dollars. Iwas hearing these stories everywhere I went. One morning Dennis DeCoretold me that his barber had just given him a stock tip. As a professionaltrader and a natural contrarian, Denny took the event as a signal that a topin the market was very near. His prediction was six months ahead of thestart of the massive decline in equity prices—his gut feeling was absolutelycorrect!
FEAR AND GREED
It’s been said that the market is driven by two basic human emotions: fearand greed. Each of these emotions has a way of changing the dispositionof the market in a short period of time. In fact, it could be said that theemotions that drive market psychology are the lifeblood of trading. Bothfear and greed have a way of taking the trader out of the trade. For tradersto become successful, they must ﬁrst ﬁnd a way of detaching themselvesfrom the raw feelings that accompany every position they put on. I havemade thousands of trades in my career and there is always a little bit of fearthat pulsates through my body every time I buy or sell the market. As muchas you try to convince yourself that it’s not money, that they’re simply pointsin the market, you can’t help but think about the monetary implications.
What we experienced during the late 1990s was an abandonment of fearin the marketplace. If anything, the fear seemed to be replaced by a certaincomplacency that led the investing public into a false sense of security when
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it came to the equities they owned. And why not? We were being told by thetech companies and the media that we were in a new paradigm. All the oldrules about the way markets were priced and the way we were supposed tointerpret their proﬁts were being rewritten. We started to look at pro formanumbers and took them as gospel. The market euphoria had taken investinginto a new age: the technological revolution.
Back with my ﬂoor brokerage operation, things were going better thanever. I had a wonderful crew made up of John Fiandaca and George Sereleas,along with their staff. The business had become so lucrative that it came tothe attention of both Fiandaca and Sereleas that the pit brokerage comingoff the customer order ﬂow was lost revenue. They both came to the samerealization: They could stay and work the brokerage business with me orthey could go into the pit and pursue their fortunes.
John Fiandaca, a second-generation Italian from the northwest side ofChicago, was the ﬁrst to try his luck in the pit. An all-state wrestler, whichcame naturally to the youngest of four brothers, Fiandaca is one of thoserare athletes who was able to transfer the determination amateur wrestlingrequires into the right pit psychology. He decided he wanted to be a spreadﬁlling broker, which means he wanted to start his new venture in the mostdifﬁcult part of the trading pit, the back month area, which is a fractionof the size of the rest of the pit. This was always considered prize realestate because the action of ﬁlling a spread requires two different legs tothe trade—in other words, double commission.
Every broker group tried to put a body in the spread area so they couldmuster enough market share to justify a presence. Fiandaca was no differ-ent, except that he had captive business in hand when he entered the pit—namely, the spreads that were coming off the desk. This was enhanced bythe promise of Adrian Byrne and John Scarnavac at CSFB to give Fiandacaan opportunity to compete for the business.
What happened next is pure CME at its best. Fiandaca stood at the heartof the pit with a look of unmistakable determination on his face. Whereothers were being shoved and tossed around like toy soldiers, Fiandacawas as solid as the Rock of Gibraltar. We began slowly making sure that theorder ﬂow was executed properly; after all, the business was taking a largerisk in using an undercapitalized broker. I made a point of telling customers,and Fiandaca himself, that we would do whatever we could to protect himand his new brokerage business from the error risks associated with pitexecution.
Before the rollover—the quarterly expiration period when the contractsare physically rolled from the expiring month to the next front month—wascomplete, we noticed something amazing. The service and the ﬁlls comingfrom Fiandaca were better than anything we had ever received before. Thenit struck me—there was a lack of competition for the business in the back
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month conﬁguration. One of the problems was that there was not enoughroom for everyone to stand, but even more important was that prior toFiandaca’s emergence there were only two groups that controlled the vastmajority of the order ﬂow in the area. Together, between the desk andFiandaca, we had done something we never expected: We made the spreadbrokerage execution more efﬁcient through competition.
Sereleas was a different story. The son of a Greek doctor, he cameto work with me a couple of years after receiving his MBA from De PaulUniversity in Chicago. His main responsibility was servicing Scott Weisblumin the S&P MidCap and the Russell 2000 markets. Earlier in this book, Imentioned the talent that Weisblum showed as a trader for the Cooper NeffBNP group, but he wouldn’t have been so successful had it not been for thepresence of Sereleas as his eyes and ears on the ﬂoor.
This was one of the largest customers on the desk, and it was thoughtthat anyone handling the account would make sure that the smaller midcapand Russell pit (they are both located in the same area) were attending tothe needs of our customer. After all, Weisblum had become the biggest userof these products on a daily basis in the world. A born thinker, Sereleas wasnot by nature an emotional