hoping that everything was inorder in case investigators came to examine our records. My compulsion to
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save everything paid off; the records from all the trades made in the Nikkeipit for the account in London were all there.
Nick Leeson, a single trader, had accumulated losses that surpassed800 million pounds sterling. The problem had been uncovered. The losseswere hidden in an account that was ﬂoated around the global market timezones and collateralized with Barings’s customer funds. It was the largestscandal to hit the British banking system. On February 23, Leeson jumpedon a plane to Kuala Lumpur, hoping to hide from the world. Within days,the bank went from being one of the strongest and most stable to failure.It was astounding; a combination of an atrocious trader and equally badrisk management techniques caused one of the greatest failures in bankinghistory. The positions Leeson accumulated had spanned various time zones.Futures and options contracts in the United States, Japan, and Singaporewere all booked on the Barings ledger. What was supposed to be an arbitragemethodology between the various exchanges turned into speculative excessthat was simply wrong in direction.
In short, Leeson had made a huge bet with house money, and not asingle supervisor understood what he was doing. There was no real riskmanagement or accountability that would have seen the concentrated fu-tures and options positions and stopped the bleeding before the institu-tion failed. The Nikkei went from the 21,000 level in June 1994 downto 15,720 by March of the following year. The index lost a whopping25 percent of its value, and Barings had enormous exposure, being longthe market.
News of the incident hit the Chicago markets like a hurricane. Not onlywas Barings in trouble, but so were the exchanges that handled the bulkof the transactions, Osaka and Singapore. The institutions collectively cre-ated the collateral that guarantees every trade made through the exchange.Together, they are the clearinghouse. The CME and the Simex have alwaysshared a close relationship, from the inception of the Simex. Those of uswho did business on both exchanges realized that the clearing mechanismat the Asian exchanges might be in jeopardy if Barings were to fail. TheNikkei pit in Chicago went crazy!
Over the course of the next week, a huge chunk of open interest wasmoved from Singapore and Osaka to the Chicago markets. There was onlyone big problem—the Chicago Nikkei futures market was denominated inU.S. dollars, while the Simex and Osaka products were denominated inyen. Any positions that were moved from the Asian exchanges to Chicagohad inherent currency risk associated with them. So along with everyNikkei position that was moved over to Chicago, there needed to be a cur-rency hedge constructed to protect against a ﬂuctuation in the yen-dollarrelationship.
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RISK MANAGEMENT
Those traders who were able to understand and decipher the events ofthe day put on high-percentage trades, being short the market, knowingfull well that Barings would have to liquidate the huge long positions es-tablished by Leeson. Traders made a fortune selling Nikkei futures in an-ticipation of large orders covering the concentrated long position. Manyseasoned traders had come to realize what Barings was painfully learningﬁrsthand: Without the proper risk management, anyone, and any position,can carry you out. I was always taught to respect the market because itis much bigger than I could ever be. This was a lesson that Leeson hadforgotten. For Barings, it became the perfect storm—a trader with in-credibly bad luck, a shortsighted risk management methodology that al-lowed improper trading, and upper-level managers who had no clue whatwas happening. Traders have known that they can, without the propermanagement of their market positions, lose everything very quickly. Butwhat people don’t understand is that the public eventually paid for theentire debacle. One way or another, whether it is investors in the bankor shareholders of the institution, the problem trickles down to the aver-age investors. It’s inevitable—they are on the bottom of the ﬁnancial foodchain!
The ideas and concepts that surround risk management are as oldas time. From the ﬁrst insurance policy written in Greek antiquity to themodern-day electronic marketplace, the notion of managing exposure hasbeen fundamental. We all learn to manage risk in our lives on a daily basiswithout really knowing it. We invest our money in savings accounts, whichare insured by the good faith of the U.S. government, and we pay insur-ance premiums for everything from our health to our cars and homes. Bynature, humans instinctively want to protect themselves against exposureand uncertainty—and uncertainty is nothing more than ignorance of futureevents.
If we were not ignorant of what might lie ahead, then what need wouldwe have to manage the unexpected? Every lesson learned by traders andinvestment professionals around the world centers around the principlesof risk management. Each dollar invested by an individual is accompa-nied by a certain amount of risk embedded in the investment. For exam-ple, people who feel secure investing capital in traditional ﬁxed-incomeassets run the risk of missing big positive returns they might have got-ten if the same capital had been invested in equities. Many times overthe years, bonds have consistently underperformed the equity markets.Even a ﬁxed return on an investment might look negative if it doesn’toutpace inﬂation.
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UNDERSTANDING RISK
Risk is very easy to understand. Everyone has taken some sort of risk inlife, whether it was rolling dice in a board game as a child or deciding whatjob to take. There is a certain amount of risk in every aspect of our lives.Consider that every day we take a calculated risk when we leave the comfortand security of our homes. I’m sure many of the residents of New Orleansfelt the same as Hurricane Katrina approached—conﬁdent and secure inthe safety of their houses. As human beings, there isn’t a day that goes bywhen we don’t take a series of risks. The severity of the risks depends onthe individual appetite for risk. The risk in walking across the street andperhaps getting hit by an automobile doesn’t seem to be in the same categoryas putting on a position in the market and looking to ﬁnd a winning trade.Yet we must conclude that the abstract nature of risk is constant—it’s thedegree of risk assumed that is dynamic.
When people ask me about the markets, they usually want to knowwhat they can read or study to become better traders. I tell everyone thatthe best traders I have ever encountered understand the nature of risk. Riskis the heart and soul of everything that is done in the capital markets. It isthe oil that lubricates the machine we call capitalism. It is the essence ofthe market. I have made understanding risk a professional mission through-out my career. Whether it is executing customer orders or trading my ownaccount, understanding the essence of the market forced me to take a cer-tain amount of calculated risk. The bottom line is that in order to start thejourney toward understanding risk, it’s imperative to put a certain amountof capital at risk.
The only way to learn is by experiencing the feelings associated with theapplication and registration of risk on the rest of the basic human emotions.Only by having a gut-churning ﬁrst trade will anyone experience the realmarket essence. But that doesn’t mean jumping into a trade without theproper guidance or homework. Think of it like swimming: You can readabout it all you want, but eventually you must get into the water and feelwhat it’s like to be wet. I see trading in much the same way. I can readand prepare myself all I want, but eventually I must get wet—very wet!—tounderstand the market.
UNDERSTANDING REWARD
The concept of reward is, much like risk, one that everyone easily under-stands. A certain amount of greed is inherent in human nature; it’s a basic
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instinct. The idea of reward, or proﬁt, has been a motivating factor through-out the history of humankind. From antiquity through modern times, proﬁthas been responsible for every major advance and achievement in every civ-ilization. Even the art of the ages, in many cases, was motivated by proﬁt.I’m fortunate to have the Chicago Art Institute directly across from my of-ﬁce. Occasionally, when I have some time, I wander through the halls mar-veling at the wonderful Impressionist collection and the array of masters ondisplay. Whenever I look at these masterpieces I realize that there is a highdegree of probability that the work was commissioned by a wealthy patronof the times. Even the glorious sounds of Beethoven and Mozart were theresult of artists willing to create in exchange for reward—the one maindifference being that, unlike the exploits of traders, art lives forever!
Many in the industry refer to the risk-to-reward ratio, which impliesthat the amount of risk taken should be in proportion to the amount ofreward that is possible. To some, risking capital on trades is unacceptable,so they turn to brokerage, which is commonly called the “sell” side of thebusiness (trading is considered the “buy” side). Those who end up on the sellside have an entirely different appetite for risk than the end users of theproducts. The brokerage community transfers risk and has an implied riskin execution built into every transaction.
The average individual is under the misconception that brokers assumeno risk. Again, nothing could be further from the truth. I have known count-less brokers who have had their net worth disappear because of an errormade by a clerk. Imagine losing everything you own in trying to executean order that generates $2 per contract! During the heyday of the Nasdaqbubble, the dollar volatility of errors made being a broker or servicing thecontract a near-death experience. It was very common for my desk to take$50,000 swings on orders that were on 10 contracts for which I received $20in commission. It was obvious to everyone, including myself, that the risk-to-reward ratio was completely skewed. It was hard to justify servicing thecontract; in fact, it had reached a point where the brokers began to chargeextra for any ﬂow in and out of the Nasdaq 100 futures pit.
For the locals who were in the Nasdaq pit at the time, nothing couldhave been better. The contract had a wide bid and offer, and any edge inthe market was very proﬁtable. My concern, as the chairman of the equityindex committee at the time, was that brokers would quit selling the prod-uct, destining it for mediocrity at best. The S&P market had just started totrade the smaller e-mini version of the product with growing success, andmany of the exchange leaders understood that a migration to the electronicplatform would help save the Nasdaq contract. The risk-to-reward ratio wasso severely skewed in the direction of the end users that neither the brokersnor the exchange reaped the beneﬁts. The contract had a daily volatility thatother contracts never experienced. It had become, as many on the board
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heard me say, the equivalent of selling Cadillacs for $1,000 apiece. In short,we had a wonderful risk management vehicle but had completely miscal-culated the effect of a bubble on the contract. We were selling a highlyleveraged product that was going through huge intraday dollar volatilityand found very little in the way of commission dollars generated.
You cannot separate the concept of greed from that of reward—theyare intertwined. A person cannot seek proﬁt unless there exists a bit, even ifit is very small, of greed at the root. It might sound odd, but even those whoare altruistic or do volunteer work seek a higher spiritual reward. They areworking through metaphysical greed as opposed to the materialistic greedthat drives capital markets. We have been taught from childhood that greedis a bad thing. The mantra “Greed is good” originated in the 1987 movieWall Street. My view is a little different. I feel that greed is neither goodnor bad—it just is. Greed exists in our daily lives, regardless of whether werecognize it, and it’s up to the individual to use greed for good or for badpurposes.
Traders whose greed takes them from being calculating market partici-pants looking for high-percentage trades to raging maniacs are an exampleof greed turned upside down. Insider trading and other violations of secu-rities laws are extreme examples of greed gone awry. But investors whosegreed drives them into the capital markets with investments that createbusinesses and jobs help strengthen the economy and make society betteras a whole. In this case, greed is used for something good. Every tax breakand policy change that has legislated capital back into the hands of the in-dividual has, on anecdotal evidence, proved to serve the country better inthe long run. This was clear when President Kennedy lowered rates in theearly 1960s and it was clear again when President Reagan did the same inthe early 1980s.
The problem is that high taxes force investors into unproductive invest-ments. No longer are traders looking for proﬁts; a high tax base forces themto look for shelters. During the Carter years, the high tax base, coupled withan anemic market condition, made capital preservation the most importantthing among investment professionals. No longer was it important to ﬁndreturns in the equity markets; keeping up with inﬂation was more impor-tant. Preserving the capital at hand was more important than taking risksin a sick market. With inﬂation out of control and interest rates at recordhighs, Reagan came into ofﬁce with a fresh idea—give the money back tothe masses and see what happens. Supply side!
Whether you are a Republican or a Democrat, you can’t ignore thatonce tax rates were reduced to lower acceptable levels, the ancillary effectwas to free up capital that launched the tech boom a decade later. Theunproductive investments and tax shelters of the Carter era were legislatedout of existence. The idea was simple: Give investors a chance at reward
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from investments made in the capital markets. I think it’s no coincidencethat the bull market that changed history began in 1982 during Reagan’sadministration. Supply-siders understood it best; use greed to help generatethe largest recovery the economy has seen since the Great Depression.The redistribution of capital from the government into the hands of theprivate sector gave investors hope and conﬁdence in the economy—enoughconﬁdence to become sufﬁciently greedy to invest billions of dollars in thestock market and create stock ownership by the general public in recordnumbers.
IS THERE ANY PLACE FORLUCK IN INVESTING?
If everything we do is a calculation of risk and reward, is there any place forluck in the equation? I’ve heard many traders say they would much ratherbe lucky than good. This implies that no matter how good you might be as atrader, there needs to be a certain amount of luck involved. It’s a known factthat traders can be correct in their opinion on the market direction but loseevery dime because of timing or, even worse, an error that ruins them. It’ssafe to say that I fall into the same camp as many of my fellow traders whofeel that there has to be a bit of luck involved when navigating the roughwaters of the capital markets. Too often I have found myself on the wrongside of an error minutes after I should have known, only to realize that themarket had come back and changed what would have been a huge ﬁnancialloss, if it had been caught immediately, into a scratch. That’s what I meanby luck.
I don’t want readers to get the impression that you can throw a dart ata stock table and pick a winning stock, although some might suggest thatit’s as good a strategy as any, but all investors need to have chance workingto their advantage at one time or another. I would venture to guess thatoutside of the ﬁnancial services industry, and perhaps in every professionglobally, success depends on a combination of hard work and a little bit ofgood luck.
Traders know better than anyone how luck and risk are intertwined.One interesting fact about most traders I have described in this book is thatthey are all, with the exception of Steve Helms, gamblers. This is not to im-ply that all traders are gamblers or that gambling and trading are in any wayconnected, but the fact that the ones I’ve mentioned here are gamblers leadsme to a few conclusions. Every great trader I have met who gambles—BingSung, Dennis DeCore, Don Sliter, or whoever—is a great gambler. Eachhas had a history of winning in casinos and has, at times, competed in
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tournaments hosted for high rollers. Each plays one game that he has mas-tered. Bing plays baccarat, Dennis plays blackjack, and Don is a craps player.If there is any connection whatsoever between the two worlds, it’s thefact that great traders understand risk but are also good at money manage-ment. The discipline it takes to be a great trader is the exact same that isneeded to recognize when to walk away from the tables in a casino. It reallyboils down to one common denominator—smart money management.
They all understand that casino gambling, by its nature, puts the playerat a mathematical disadvantage. The odds are always in the favor of thehouse. How, then, do some individuals consistently make out better thanothers?
Smart money management is not something that comes naturally tomany people, but it must be learned by anyone who wants to succeed asa trader or investor. Money management is what investing and trading arereally all about. The ﬁrst lesson in trading is to limit your loss. Why is it thenthat so many traders are carried out of the marketplace because of a lossgone wild? The reason is that trading is one thing, and managing money andpositions is entirely different. The reason the greatest traders in history areremembered is because they ended up proﬁtable. No one remembers thetraders who once made it big, only to lose their net worth later. Yet manygreat traders have found themselves on the wrong side of the markets afteryears of proﬁtable trading, only to come to the conclusion that smart moneymanagement would have been a much better alternative.
One problem is that traders who make large sums of money trading acertain size cannot go back to trading in smaller increments. A trader whonormally trades 10 contracts at a time, which would be worth $2,500 perS&P point, ﬁnds it very hard to go back to trading one-lots, worth $250 perpoint. The trader no longer thinks of it as making $250; he or she now thinksof it as losing $2,250. A trader who can avoid the trap of market ego cansurvive a long career. It becomes a balancing act—the ability to managewealth in an intelligent fashion without letting ego or emotion interfere.
SMART MONEY MANAGEMENT
Money management—or wealth management—is a topic, like most top-ics covered here, that is worthy of an entire book. There are many ways tomanage wealth that are both easy to understand and effective. I ﬁrst learnedhow easy proper asset allocation can be when Bing taught me the methodol-ogy behind a properly balanced portfolio. Coming from a liberal arts back-ground, I was much more comfortable debating the merits of Kant or Hegelthan learning about proper portfolio diversiﬁcation; nevertheless, I listened
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and learned. Bing told me how Harvard’s endowment fund had allocated itsassets. A certain percentage was in bonds, another in equities, and the restin alternatives that had no correlation to the rest of the Harvard assets.
Bing would say that a portfolio needs to be adjusted according to theworld around you. He taught me that it was very important to maintain con-trolled exposure and allocate properly into the different asset classes. Heshowed me how a bond portfolio allocated a certain amount into municipal,corporate, and U.S. Treasuries, creating a ﬁeld of duration of yield that couldextend as far as the trader wished. The most important thing is that he mademe conceptualize the management of money.
A basic tenet of wealth management is that the more you have, themore you can lose. There’s no way around it. Therefore, learning how tomanage the exposure that you create for yourself becomes vital. But it’salso important to remember that risk comes in many guises. Some risks arehidden, such as the unexpected risk of a geopolitical event, while other risksare expected, such as taking a futures position with a stop-loss order to limitthe loss. Both risks need to be managed, and both risks can be managed.The long-term geopolitical risks can be addressed in a number of ways, suchas options strategies, that give traders and investors downside protectionwith full upside potential. The smaller nanorisks that a trader or investorencounters daily can also be addressed by products in the marketplace thatare less complicated.
A trader with exposure in one sector of the equity market can use theother sectors as a way to manage the risk of the trade. For example, if atrader is stuck in a long position in the Russell 2000 futures but realizesthat the MidCap 400 futures are at a historic high in the spread between thetwo, then the trader may opt to sell the MidCap futures against the Russellposition instead of covering the trade. This ﬂexibility gives the trader theoption to spread into a position in order to cover extreme exposure or legout of the spread when the market allows.
SIX SIGMA
During the 1990s a new method for managing risk was adopted. It was calledsix sigma. I ﬁrst heard the term from friends working at General Electricduring the reign of Jack Welch, and I soon came to realize the importance ofthe method when Jim McNulty, former president of the CME, discussed thetopic with the board of directors. The exchange was considering demutual-ization at the time, and effective and efﬁcient management was needed tomake the CME more appealing. McNulty embedded the methodology intothe corporate culture. In statistics, a sigma refers to the standard deviationfrom the mean of a population. Standard deviation describes the likelihoodof your next data point deviating from the mean of the whole data set. Six
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sigma is all about variance reduction. The sixth sigma refers to the likeli-hood that only 3.4 out of every 1 million data points will appear outsidethe sixth standard deviation. That translates into fewer than four errors permillion transactions.
Technology and math had taken risk management three full standarddeviations in either direction, something that was unheard of less than ﬁveyears earlier. What had been a methodology for training management teamsin the corporate world was now the rage in the trading rooms all across theglobe. Risk management had reached a new level; it helped create what wehave today—comfortably controlled exposure.
Six sigma thinking went far beyond the boardrooms and the tradingdesks of the global institutions; it became a way of thinking for an entire agegroup. An whole generation came of age listening to the gospel of six sigmaas preached by corporate America. But what can the individual learn froman abstract management theory that seems out of date today? The answerlies in the fact that numbers never change. As long as you can imagine amove three standard deviations in either direction of the present marketprice, then it becomes important to have a methodology to cover exposureall the way through. What good is knowing the problem unless you proposea solution to whatever it might be?
I believe that the introduction of six sigma thinking forces the practi-tioner to think analytically. The same logic and reasoning that give a traderthe courage and conﬁdence to put on a trade are found in six sigma method-ology. In short, it produces the high-percentage trades and helps maintaincontrolled risk in the portfolio.
DISCIPLINE
There are four basic elements that you must fully understand in order to bea good trader or investor. We’ve discussed the ﬁrst two, risk and reward.The third is discipline. Traders and investors can at some point lose thediscipline that had led them to a certain amount of success. I have seen toomany former traders think they had enough wealth to retire, only to realizeyears later that they didn’t have nearly enough to last the rest of their lives.A good example is the windfall in CME stock that many members re-ceived upon the demutualization of the exchange. Depending on the typeof seat you owned, you were allocated a set amount of stock in the newlyformed public company. The CME seat, which allowed the owners andlessees to trade everything at the exchange, was given 18,000 shares. TheIMM seat, which allowed owners and lessees to trade the ﬁxed-income andequity futures and options, was given 12,000 shares, while the IOM seat,which gave rights to the equity and options markets only, was allocated6,000 shares.
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After the initial public offering (IPO), many of the traders decided thatthe allocation of stock was an extension of their trading as opposed to theinvestment in the exchange. Some of the best locals in the business couldn’tunderstand the difference between the speed of trading, which helped themacquire wealth, and the long-term investment in the exchange, which servedas more of an annuity. There were some full CME seat owners who weregiven 18,000 shares of stock and sold everything at the IPO price of $35 ashare. As of the writing of this book, shares of CME were priced around the$450 level. The idea that the equity in the exchange was used as a bankrollto trade made no sense whatsoever. Traders who understood the businessplan of the CME and saw the vision being created by management and theboard held on to a large portion of their positions, only to ﬁnd a windfallproﬁt years later.
There have been many seminars and lectures by market experts trying,mostly in vain, to explain how traders and investors become disciplined.Why is it that some individuals have a difﬁcult time with discipline? Afterall, are we all not subject to discipline of one type or another over thecourse of our lifetimes? Whether it be school or a job, the discipline ofdoing something well day after day can be hard work. I ﬁnd that disciplineis learned over the course of time. I have a hard time explaining my conceptof discipline to my children, but I am absolutely sure that one day they willunderstand what it’s all about. Maintaining a focus on any subject, let alonethe markets, is nearly impossible in a society laced with distractions.
Even traders have found that sensory overload can be an obstacle totrading. It is way too easy to put on a baseball game or ESPN during thetrading session while watching the markets with one eye. Traders who losefocus lose their discipline. When traders lose discipline, the next step isusually a losing trade—it’s inevitable! Of course, there’s always the chancethat a trader will not be completely concentrating on market conditions andwill still come out a winner. But those are the exceptions rather than the rule.When I reﬂect on the qualities that the best traders seem to share,discipline and courage are the two that stand out. It’s unfortunate that theretail public doesn’t understand the need for ﬁscal discipline when tradingthe market. It pains me to see retail-based accounts lose day after day, onlyto send in more hard-earned money in an attempt to recover the losses theyendured. It can become a vicious ﬁnancial cycle. The missing ingredientin most of the retail accounts that end up consistently losing money is acompete lack of discipline. To put it bluntly, how many times does one needto get hit in the head with a hammer before realizing that it hurts? What’sironic is that many of these account holders are very successful in theirchosen professions. More than likely it was a disciplined effort that madethem reach their goals, yet when it comes to the markets, discipline seemsto escape them.
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The ﬁnal element that a trader must understand in order to be proﬁtableis courage. There are different types of courage. It’s hard to use that wordand not think of the men and women in uniform ﬁghting wars and riskingtheir lives for a better America. I have found that the meaning of the wordcourage has changed in my mind over the last 22 years. I was told thatyou need a combination of fear and courage when entering a trade. I havealways looked upon large traders as having a great deal of courage. Afterall, they were taking huge ﬁnancial risks and making it work. It’s obviousto anyone who has ever traded that courage cannot be taught—it must beexperienced. You cannot teach other people to be courageous; either theypossess courage or they do not! I have seen great traders who could notmuster the courage to trade larger size. It amazed me how some of the mostgifted members of the exchange never seemed to feel comfortable tradinganything more than one contract at a time.
I used to think I knew what courage really was, then the entire worldchanged. A combination of events made me ask myself, “Do I really knowwhat courage is?” When the country went through the trauma of September11, courage took on a whole new meaning. The deﬁnition of courage that Iwas using to describe traders who were trading large size could not be usedwhen describing the heroics of the ﬁreﬁghters and workers who perishedin the towers. Nor could I use the same deﬁnition to describe the courageneeded to go to the Persian Gulf and ﬁght for our country. Dan Scarnavac,a friend and colleague on the ﬂoor of the CME, fought in the ﬁrst Gulf War.When he trades, he does so with little fear. Where others are terriﬁed oflosing money, Scarnavac has quiet courage when he establishes positions.It only makes sense—how courageous do you have to be to put on a tradewhen you’ve faced enemy ﬁre in a hot battle zone?
I’ve tried to teach what I think are the most important characteris-tics of being a trader. Mostly young interns—those who listened and un-derstood the importance of risk, reward, discipline, and courage—usuallywent on to successful careers either in the capital markets or in other pro-fessions. The best student I ever encountered