to do to understand the contingencies onyour portfolio’s horizon. If not (i.e., these events are seemingly random),then  you  are  probably  trading  the  wrong  markets,  as  there  are  pricingdynamics  at  play  that  are  beyond  your  ability  to  comprehend.  Effectivetrading and investing programs are based on causes and effects that lendthemselves to scientific evaluation. If these conditions don’t exist in youruniverse of tradable instruments, it’s hard to see how you can ever attain,much less sustain, an exploitable edge.
SEEK TO MAXIMIZE YOUR PERFORMANCE AT THE MARGIN
As  at  least  a  partially  trained  economist,  I  try  to  look  at  behavior  at  themargin as the driving force behind all economic activity—including tradingand investing. This means that attention to small details will help reach biggoals. Slice your commission costs by a fraction, improve your price exe-cution by a small increment, control your downside exposure in terms ofthe pennies as well as the dollars—all of these steps can mean the differ-ence between success and failure over the long haul.
It pays to devote close attention to the marginal behavior of the marketin general. Success in the marketplace, as in baseball or football, is often amatter, of inches, as opposed to yards. Understand that the pricing of finan-cial instruments is seldom driven by dramatic events but rather by minuteshades of perceptional differences between buyers and sellers. A companybeats earnings estimates by a fraction, and, bang, the entire equity marketmoves. Unemployment rates move a couple of tenths of a percent, and theentire interest-rate market can assume a different tenor. A central bank cansignal a shift in its perception about the merits of holding gold stocks, andthat commodity can change in value by breathtaking amounts.
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These are just a few examples of the manner in which seemingly minorchanges  to  the  market  landscape  can  have  a  dramatic  impact  on  prices,which, in turn, will materially impact portfolio performance. If you remainin  tune  to  these  patterns  and  apply  them  to  your  trading  activities,  youstand the best chance for success over the long term.
SEEK NONMONETARY BENEFITS
We all know that we’re in this for the money, and I certainly wouldn’t rec-ommend  any  trading  strategy  that  doesn’t  feature  profitability  as  its  pri-mary objective. However, I would submit for your consideration that therewards that accrue to enlightened market participation can be measuredin ways that transcend sheer financial gain. I believe that trading and port-folio  management  are  among  the  purest  and  most  clinical  of  intellectualtests,  with  success  requiring  perhaps  the  most  diverse  set  of  cognitiveskills of any activity you are likely to undertake. The successful portfoliomanager must wear many hats, including those of quantitative and qualita-tive analyst, prognosticator, personal advocate for fair pricing, risk man-ager, accountant, and financier. In undertaking this responsibility, you aretrying  to  see  into  a  future  where  current  inefficiencies  in  the  pricing  ofassets correct themselves and where conceptual trends become economicrealities.  At  the  same  time,  you  are  engaged  in  a  hypercompetitive,  two-way  auction,  where  the  agents  against  whom  you  are  competing  for  thebest price are out for blood and know no mercy.
When viewed from this perspective, I believe it is necessary to eitherembrace  the  intellectual/competitive  challenge  of  portfolio  managementor risk failure on a large scale. The individuals I admire most in the mar-kets (who, not coincidentally, are also the most successful) are those wholove  the  battle  for  profitability  that  is  the  essence  of  the  effort  and  whoattack it with the full measure of energy, creativity, wisdom, and whimsythat they can bring to bear. These traders bring the joy of the contest intoall  of  their  market-related  activities.  They  are  not  always  successful,  butthey  appreciate  their  adversary  and  know  that  they  are  at  all  timesenriched by the journey they have undertaken.
Perhaps more important, they have fun. They thrive on the excitementbrought about by the uncertainty of their endeavors; and win or lose, theyappreciate the very human aspects of the struggle in which they are engag-ing. At any success level, there is joy in the effort. Of course, most of theseindividuals  are  professional  money  managers  who  operate  under  thehappy advantages of knowing that they have an edge as well as a honedmethodology through which to exploit that edge. Armed with ability and
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ambition, they rise each morning eager not only to enhance their financialposition but also to relish the new elements of discovery that each new dayin the markets brings. Indeed, I know a number of professional managerswho have generated hundreds of millions, and in some cases billions, ofmarket  revenues  who  still  derive  the  same  type  of  thrill  from  the  singletrade that they did when they first started out, before their fortunes weremade and their celebrity established. I envy these people, not only becausethey are materially successful, but also because they have found a way tospend  their  professional  lives  in  an  activity  they  love  and  for  which  thepotential monetary rewards are, for all intents and purposes, limitless.
Like any other endeavor, there is a fine line between focusing on anactivity that is your passion and operating under the shackles of a debili-tating  obsession.  Trading  and  investing,  breathtaking  in  their  scope  andrequiring such intellectual passion to achieve a form of mastery, are pre-cisely the types of activities that can foster obsessive behavior. I have wit-nessed many a market participant who is consumed with his or her port-folio management responsibilities to such a point that critical elements ofa  well-balanced  existence  are  shut  out,  and  even  programs  that  are  suc-cessful from a financial perspective begin to exact an unacceptable cost.This, in my experience, is a very risky condition, one that market partici-pants of all types should seek to avoid. Not only is it unhealthy, but it isprobably unsustainable over the long haul. Therefore, if you find yourselfdoing nothing but trading, analyzing, and thinking about trading, it’s prob-ably not a bad idea to take an objective review of the situation with an eyetoward making some lifestyle changes. Some of the telltale signs that youhave gone overboard with your commitment to the markets are:
• Majority of free time is spent on market-related activities.• Health  is  deteriorating  (e.g.,  large,  unintended  weight  gain/loss;changed eating habits and exercise program; inability to sleep; etc.).• Personal  relationships  are  deteriorating—particularly  with  spouses,
children, and significant others.
• Unable to focus attention on non-market-related topics.
I’m not a doctor, and I don’t play one on television; but I believe thatthese  symptoms  represent  an  inner  voice  telling  you  to  slow  down.There’s  simply  no  reason  to  grind  yourself  down  into  such  a  state.  Ifyou’re doing great in the markets, save some of your energy for tomorrow.The markets will open on time, I promise. If you’re struggling, then youprobably don’t need me to tell you that pressing matters won’t help. Rec-ognize  that  at  some  point  there  are  diminishing  returns  to  your  efforts,and  seek  to  not  go  beyond  this  point  of  energy  dissipation.  If  you  can’tresponsibly  risk  the  amount  of  capital  you’ve  currently  committed  to
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trading without this type of all-consuming focus, reduce your capital. Tostate  the  matter  quite  simply,  it’s  not  worth  ruining  your  health,  endingyour marriage, or killing yourself over a few extra dollars in the markets.If the sacrifice you are making for success is too great (and only you arein  a  position  to  make  this  determination),  either  find  a  different  way  tomake money, or cut down on your expenses. The price you will pay forredlining  it  indefinitely  is  far  greater  than  what  you  will  experience  bylearning to live on a budget.
While we’re on the subject, when the burdens of portfolio managementbecome so onerous as to take all of the joy out of the exercise, it’s proba-bly time to stop trading. While one might think of this as a rather obviouspoint, you’d be surprised at how many traders fail to grasp it. No one butyou can make this call; but I submit that when the time is appropriate, it isa call you must make. Take a month or a year off. The markets will be herewhen you get back. More important, you’ll be ready to attack them withrenewed energy and focus.
Finally,  I  encourage  you  to  take  pride  in  what  you  do,  not  onlybecause it is difficult, but also because it is important. I stand (perhapsin the minority, but firmly so) solidly behind the conviction that tradershelp  make  the  world  a  better  place  by  assuming  risks  that  other  eco-nomic  agents  don’t  want  and  by  contributing  to  the  mechanisms  bywhich  economic  assets  are  efficiently  priced.  If  you  doubt  that  theimpacts  of  these  services  are  real,  I  suggest  you  examine  thoseeconomies  that  don’t  have  market  mechanisms  that  are  driven  bytraders competing to buy and sell assets at the best available price. I’veseen the effects of this and know that they can be devastating, with sell-ers having to dump assets at prices below cost and buyers being forcedto pay outrageous amounts for needed commodities whose availabilityand production costs give lie to the amounts at which their controllersmake them available.
PURE GRAIN
I  have  only  one  more  anecdote  to  share;  and  when  I  tell  you  to  skip  it  if  youwish,  I  do  so  with  a  Grateful  (yes,  Grateful)  nod  to  Ken  Kesey.  In  my  formercareer as director of risk management for the Chicago Mercantile Exchange, Iwas frequently called on to discuss our methods with financial planners fromaround the world who sought to establish or to enhance futures markets in theirown  countries,  and  thus  reap  the  benefits  that  we  in  the  United  States  haveenjoyed for so long due to the advanced state of our market mechanisms. Bythis  time,  many  countries  with  even  the  most  rudimentary  market  economies
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had  built  functional  futures  markets,  so  the  discussions  tended  to  centeraround whether this or that form of risk assessment, financial control, or marginoffered the best efficiencies. However, one day, more than 10 years ago, I wasasked  to  meet  with  about  a  half  dozen  market  economists  from  the  formerSoviet  Union.  These  were  hard-boiled  men,  some  brilliant,  all  well  educated,some of them having suffered the evils of Stalin and Hitler and lived to tell thetale.  They  were  not  Westernized  in  their  mannerisms;  but  they  were  polite,appreciative, and supremely focused on bringing about a better tomorrow fortheir people and their country.
Their task was to help create a market economy out of the ruins of a bureau-cratic military dictatorship that had crumbled under the weight of its own inep-titude a very few months earlier, leaving no discernible economic system in itswake. In the interim, a handful of localized market mechanisms had sprung up,but these were mainly outlets for the enrichment of corrupt local officials andthe enhanced control of mob organizations. Things were truly up for grabs inRussia;  but  of  all  the  problems  that  economic  planners  faced,  none  was  morepressing than the stabilization of the agricultural economy. This staple of Russ-ian social order had deteriorated to the point where the growers of grain couldonly sell their output for a fraction of its production costs, while consumers wereforced  to  pay  murderous  sums  for  the  right  to  buy  these  products.  Often,  abushel of grain that could not be had for less than $6 at a local market, wouldnot fetch more than a quarter of this price when sold by farmers a scant hun-dred miles away. As a result, perfectly good farms were going fallow right nextto urban areas where widespread hunger ruled the day.
My  Russian  agro-economist  friends  had  organized  a  rudimentary  futuresmarket (or so they tried to tell me, for they spoke very little English and I under-stood exactly zero Russian), which stayed open two hours a week for the pur-poses  of  fixing  a  regionwide  price  for  commodities  such  as  wheat  and  corn.They had all kinds of questions written down in their notebooks, ranging fromhow futures market financial settlements worked to how the process of deliv-ery  could  be  organized  in  an  efficient  manner.  Each  time  they  asked  a  ques-tion, I was able to bark out a very elementary answer, which I knew failed tograsp  any  of  the  subtlety  of  the  sophisticated  U.S.  market  processes.  Never-theless,  I  got  the  impression  that  they  understood.  They  would  then  debateloudly (in Russian) among themselves for up to an hour while I sat there tryingto keep my wits about me as I waited patiently for their next inquiry.
We spent the whole day together in this manner, during which time I believemy  collective  comments  spanned  a  total  of  less  than  five  minutes.  In  spite  ofthis,  we  had  developed  something  of  a  bond.  At  the  end  of  the  session,  theleader of the group opened a black satchel and handed me a bottle of Russianvodka, heartily shaking my hand and slapping me on the back. Then they left,happily continuing their heated debate (or so it would seem) down in the eleva-tor and into the street. For all I know, their debate continues to this day.
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I remember thinking to myself at the time that the country these men rep-resented was at least a generation away from enjoying the kind of market ben-efits taken for granted in the United States for most of the twentieth century. Icould only hope that I’d done something small to push them further down theright track.
I still have that bottle of vodka, though there’s more air inside of it nowthan there was when I received it as a gift more than 10 years ago. Every nowand then, I pour me a glass, which I prefer to drink straight at room tempera-ture when no one else is around. And I think of my buds, and I hope they arewell. I also hope that they have made some progress on their mission. I don’thear much about the Moscow Commodities Exchange; and, given the amountof  attention  I  devote  to  the  markets,  this  isn’t  a  great  sign.  Perhaps  thesethings take more than a decade; perhaps they require a generation or two.
I’m not much of a drinker, but I sure do enjoy that vodka. I like to thinkthat this is partly due to the fact that it is distilled from the fruit of the soil tilledby my very own ancestors who had departed the motherland around the timeof the War to End All Wars. 
And  I  can’t  help  but  wonder:  If  there  were  a  functioning  Moscow  Com-modities  Exchange  at  the  time  of  their  departure,  maybe  they  wouldn’t  havehad to go.
The  benefits  of  risk  transference  provided  by  traders  are  inestimable.Most of us have been schooled on examples of this, such as the wheat farmerwho is able to use futures markets to lock in today’s prices for next spring’sharvest, and the makers of Swiss watches sold in the United States who areable to guard against the declining value of Swiss francs. These are real andmeaningful instances of traders taking on the burden of specific types of riskthat  exist  in  the  economy  but  are  unwanted  by  those  who  would  assumethem in the normal course of their business. Absent the willingness of marketparticipants to accept these risks, the outcome is clear: Farmers produce lesswheat, and fewer Swiss watches get shipped across the Atlantic.
The  macroeconomic  benefits  of  these  market  mechanisms  haveexploded in the past couple of decades and represent no small contribu-tion to the economic prosperity we have enjoyed over this time period. Inparticular, with the advent of equity- and fixed-income derivatives such asindex futures and interest-rate swaps, the rewards of a trading economyextend to the core capital markets. Companies can now use these productsto accompany the issuance of new equity and debt, thereby eliminating thefear  that  their  financial  costs  will  increase  dramatically  by  the  time  thefunds are needed. As a result, the economy produces new goods, services,and jobs at a pace unimaginable one short generation ago.
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All of these benefits accrue to an economy because traders are there,willing  to  assume  the  risks  that  are  inherent  in  essential  economicprocesses such as capital formation but that, if not transferred to specula-tors, represent onerous contingent liabilities to the creators of new prod-ucts and processes. Without traders of all shapes and sizes, the nature andscope of these liabilities can increase prohibitively and can mean the dif-ference  between  creating  a  new  company,  building  a  new  factory,  devel-oping a new product or standing pat. Certainly, the potential rewards to themarket  participant  are  sizeable  and  in  some  cases  arguably  stand  in  dis-proportion to the hazards he or she assumes. However, if you really exam-ine the situation of the trader, asked to bid competitively for the right toassume these exposures and often armed with little beyond his or her witsand  intestinal  fortitude,  perhaps  the  opportunities  that  accrue  to  tradersmay seem a bit less outrageous. Moreover, every single market participantrepresents  a  piece  of  this  gigantic  puzzle,  and  most  are  hardly  earningking’s ransoms for their efforts.
Thus, you should take some satisfaction in the vital role you are play-ing  in  the  market  economy  as  a  trader/investor.  On  a  minute-by-minutebasis, it may seem that you are in a very personal struggle, with all hazardsand associated rewards belonging to you and you alone. However, there ismore at stake than the number at the bottom of your account statement.You are contributing in your own fashion to a critical process that benefitseveryone, and those who tell you that your efforts have no value are sim-ply flat-out wrong.
APPLY LIBERAL DOSES OF HUMILITY AND HUMOR
The  beautiful  thing  about  the  markets  is  the  fact  that  they  represent  thecombined  input  of  all  economic  agents  who  act,  at  least  in  theory,  toprotect  their  own  interests,  based  on  a  universally  available  informationset, which they are able to process in a rational manner. This is a formida-ble force that cannot, in my experience, be overcome in a sustained fash-ion by the efforts and talents of individual humans. 
This does not mean that the market always spawns rational outcomes.Particularly when viewed over short time periods, economic assets can bepriced at levels that when reviewed from the perspective of time make usstand back in amazement that they could ever have been the product of thecollective,  rational  thoughts  of  humans  guided  by  their  own  economicinterest. Ironically, these new perspectives often come rather quickly, suchthat the same parties that contributed directly to the irrationality are theones  that  are  the  most  retrospectively  dumbfounded  when  consistent
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pricing themes return to prevalence. From Dutch tulips in the seventeenthcentury  to  U.S.  virtual  bookstores  at  the  end  of  the  twentieth  century,markets  have  demonstrated  their  mastery  over  every  individual  humanattribute. They are governed unilaterally by neither wisdom nor whimsy,but they will give an occasional nod to both.
In order to be successful in light of these realities, it is necessary to behumble. If you attempt to beat the market, the overwhelming odds are thatyou will lose; so the best thing to do is not to compete with it. Even if youdo come up with a formula that allows you to anticipate price movementswith  greater  accuracy  than  other  participants,  this  edge  is  at  risk  everymoment of every day as other economic agents travel the same path of dis-covery that has led you to your happy state of affairs. Therefore, I urge youto avoid underestimating the challenges associated with generating supe-rior  risk-adjusted  returns  in  the  future,  even  if  you  have  done  so  consis-tently in the past. I know many traders who thought, with some justifica-tion,  that  they  had  the  game  licked  for  good,  only  to  find,  slowly  orabruptly, that the rules had changed in ways to which they could not suc-cessfully adapt. 
Avoid taking failure personally. The market often does stupid things—particularly  through  the  filter  of  either  hindsight  or  self-interest  (i.e.,because you are positioned the opposite way). When these stupid eventsoccur, there is often a tendency to project your anger onto the markets asthough they act in some direct effort to cause your unhappiness. 
These dynamics can conspire to cause traders to spiral into irrationalportfolio management in an effort to correct what the individual in ques-tion views to be a cosmic injustice. Of course, when this happens, the indi-vidual  projects  this  negative  energy  not  on  the  markets,  but  rather  onthemselves—with disastrous P/L implications that can turn difficult trad-ing intervals into catastrophic ones. This is often a sign that a given port-folio manager has hit the end of the line in terms of the productive part ofhis or her trading journey and may need (at least temporarily) to find non-market-related venues to get kicks. Guard against this kind of thinking atall costs lest you become the victim of your own evil schemes.
As a final note, it occurs to me virtually every day that a bit of self-effacing humor is essential to success in the markets. When you begin tothink  about  the  confluence  of  events  of  your  lifetime  (as  well  as  thosetied to the social evolution of humanity) that have placed you in a posi-tion where you are devoting the flower of your time and energies to theodd little task of attempting to buy economic assets at below their valueand sell them at levels above this threshold, it’s hard not to recognize thenote of absurdity of it all. From here, you can layer on everything fromthe  billions  and  billions  that  are  spent  each  year  to  maintain  marketinfrastructures,  to  the  behavior  of  those  with  whom  you  interact  on  a
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day-to-day basis in your trading activities; and you soon realize that eventhe most imaginative fiction writer could never dream up the stuff thathappens every day in real life. The whole thing can be pretty hysterical,all the more so because each and every one of us is part of this absurd lit-tle  pantomime.  Perhaps  among  the  most  entertaining  elements  of  theentire  dynamic  is  how  grimly  many  market  participants—particularlythose  who  count  themselves  among  the  most  successful—view  theprocess of trading and investing. Some of them view themselves as latter-day Leonardos, others as the second coming of Napoleon. Learn by theirexamples, maintain your sense of perspective, and you’ll likely make outjust fine.
BE HEALTHY/CULTIVATE OTHER INTERESTS
I am not your mother, but I am here to tell you that if you really want tonail it in the markets, you should get plenty of rest, drink a lot of fluids,eat  all  your  vegetables,  and  exercise  often.  In  addition,  it  certainlywouldn’t hurt to read a book every now and then that’s not market related(if pressed, I might recommend either Gibbon’s The Decline and Fall ofthe Roman Empire or Faulkner’s Absalom, Absalom!) and do whateverelse that successful people do to enrich their lives. Learn to play a musi-cal instrument; or if you already play one, join a band. If you have a band,go out on tour. Volunteer at a soup kitchen. Write a poem to a girl who hasnever had a poem written to her. Coach your kid’s little league team; andif you’re already doing that, try pulling a double steal in a tight situation.Tip generously to all service providers who can’t live on their nondiscre-tionary income. If all else fails, play solitaire (preferably with real playingcards), but don’t bother to do this if you’re going to cheat. There’s more tolife  than  trading,  so  fill  your  lungs  and  exhale  as  often  as  possible.  Rollaround in the dirt every once in a while, for this is the stuff of which youare made.
A  vigorous  (and  hopefully  routine)  roll  in  the  hay  can  also  bestow  a
world of benefit.
With that, I reckon I’ve told about everything I know. I hope that likeHuck  said  about  Mark  in  reference  to  Tom,  I  mainly  told  the  truth.  Andnow, ladies and gentlemen, I suggest you prepare yourselves, for the bellis about to ring.
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Optimal f andRisk of Ruin
I’ll  bet  you  thought  I  was  really  done  this  time,  didn’t  you?  Well,  I
thought I was, too; but in the midst of my leave-taking, I found one crit-ical  task  left  undone,  namely,  the  act  of  paying  appropriate  tribute  tothe body of research that laid the groundwork for the approaches I haverecommended  for  the  efficient  setting  of  portfolio  management  riskparameters.  Of course, this is one of the cornerstones of Trading Risk andis a process that if not handled effectively is likely to cause more damageto a portfolio than just about anything else that I can think of—at least offthe top of my head.  Specifically, I refer to two concepts: optimal f and riskof  ruin,  which  point  those  interested  in  risk  taking  toward  the  sizing  ofexposures in such a way as to render them consistent with both objectivesand constraints. These concepts, which can be thought of as analogues tothe  Inverted  Sharpe  Ratio  and  Percent  of  Risk  Capital  methodologiesdescribed in Chapter 5, can be used contemporaneously to form a useful(and aesthetically pleasing, for those who like symmetry) upper and lowerbound for exposure assumption.  Optimal f is designed to identify the levelof investment in individual positions that is consistent with maximum prof-itability, as based on user-defined inputs of prospective transaction prof-itability. The mathematics of risk of ruin can be applied to manage expo-sures such that risk takers don’t lose more than that they have designatedup front as their risk capital, again as typically measured on the level of theindividual transaction.
If  these  concepts  sound  familiar  to  the  (by  now)  legions  of  TradingRisk devotees, it is because, as mentioned earlier, they are very similar tothe tools laid out for exposure parameterization in the core of the text. If
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