While the names Benjamin Graham, Warren Buffett and Peter Lynch are known by nearly everyone that frequent these boards, there are several traders who put up exceptional returns but were less interested in the spotlight and even declined interviews for many years. One name that comes to mind is Ed Seykota, maybe one of the only traders that also wrote and starred in musical rendition of his trading strategy "The Whipsaw Song". Seykota has taken a more active approach in helping other traders since the mid-90s by showing them how significant a role psychology plays in one's trading. Through listening to his interviews I've found Seykota to be extremely blunt, but quite witty when it comes to discussing what works and what doesn't in the markets. This does not imply that Seykota's strategies are the only ones that work, but his core beliefs and strategies that he used to turn a client account from $5,000 to $15 million in less than fifteen years in the futures market have stood the test of time. This helped him to make money not only for the year in 1987 but also both in the month of October, and the day of the crash as well. While most traders were busy puking up long positions and trying to find any bid to sell into on Black Monday, Seykota was busy profiting from the other side of the trade.
Ed Seykota conceived and developed the first computerized trading system to trade commercial accounts in the futures markets. After difficulty agreeing with management who would continuously override the signals given by his system in the interest of generating more commissions, he decided to go out on his own. Seykota is a mechanical trend following trader who built the majority of his systems around exponential moving averages, with some reliance on pattern recognition. I always find it funny when commenters make fun of these moving averages and completely discount them, as several traders have made fortunes incorporating these "simple" tools into their strategies. The basic principle behind trend following is to ride your winners and cut your losers, but it's always easier said than done. In this article, I will go through many of Seykota's core beliefs that allowed him to put up incredible returns during his trading career, as well as examples of how these would be put in practice today.
The Three Rules For Successful Trading
"The elements of good trading are 1. cutting losses, 2. cutting losses, and 3. cutting losses. If you can follow these three rules, you might have a chance".
(Source: Market Wizards by Jack Schwager)
There seems to be an ongoing misconception out there among individual traders that one must be right most of the time to take a profit out of the markets. This could not be further from the truth. Some of the best traders of the last century had win rates of less than 50% and still managed to become multi-millionaires and even billionaires in the financial markets. The way they were able to achieve this was by being very quick to admit they were wrong, as well as stubbornly holding on for the bigger move on occasions when the market was proving to them they were right. The reason this works is that most trend followers work with a win/loss ratio of 1.50 or better, meaning that their average winning trade is at least 1.50x the size of their averaging losing trade. With a win/loss ratio of 1.50, you would not be very popular among casino operators at the blackjack tables. This is because each time you lost the casino would take $50.00 from you, but each time you won you would make $75.00 from them. It's not hard to see how this type of operation could put a dent in a casino's profits the longer they allowed you to sit at the table.
While cutting losers may not make sense to most individual traders, it is the most critical thing a trader can learn to do. Losses pyramid against traders and losses and wins are not equal in the stock market. A trader that loses 50% on a trade now needs a 100% gain to get back to break-even. Unfortunately, most traders do not realize this. This would be like an NHL team that loses their first game of the week on Monday night and now needs to win both their Thursday night game and Sunday night game just to be back at .500 for the week. If one can understand how difficult this would be for an NHL team to have a winning record in this type of situation, they can hopefully appreciate how holding losers can be a massive detriment to a trader's success also.
The key in trading should be cut your losers ideally before they even move into the double-digit column, and certainly in the low double-digits. A stock that is down 15-20% from an entry is giving you a loud and clear signal that the market does not agree with your position.
New Gold (NGD) has been below one of its critical weekly moving averages for nearly five years now and has never been a buy or remotely close to one based on any system I would trade. This is because if a stock is not at least above this key weekly moving average, it doesn't even make the cut-off for me to do more research on it. When you place yourself in stocks that are clear losers, you are joining the company of many others who are down on the stock as the stock has only been a winner for day-traders, the majority are left holding the bag. This makes it very difficult to make money on the stock as many of the traders and investors that are stuck in the position are looking for any strength to pull the plug.
One of the arguments I constantly see about why an individual trader should not take a loss is, "It's down so much there's no point in selling it now".
Just because a stock is down 90%, does not mean it can't fall another 90%. The comment below stated, "The market is always riskier when higher and safer when lower". This could not be further from the truth. The lower you are in a stock, the worse off you are as you are likely long in a bear market. The higher you are in a stock, the better off you are as you're likely in a bull market. This statement seems to suggest that all-time highs are about the riskiest time possible to be invested in a stock. Does a stock not have to make several all-time highs to get from $50.00 to $100.00? It must first make a high at $50.00, then at $60.00, then at $70.00, then at $80.00, and so on. Amazon (AMZN) has made well over 500 all-time highs now since its IPO, the argument that it's riskier when it's higher is the silliest presumption I've ever seen made.
The point is that while we constantly hear the saying "cut your losers", very few people actually follow it. If you don't cut your losers, you will not be able to pay for your winners.
Riding The Trend
"I consider trend following to be a subset of charting. Charting is a little like surfing. You don't have to know a lot about the physics of tides, resonance, and fluid dynamics in order to catch a good wave. You just have to be able to sense when it's happening and then have the drive to act at the right time."
(Source: Market Wizards by Jack Schwager)
Trends tend to persist in all parts of life, and they also exist in the stock market. As Seykota discusses with his quote, you don't need to be an expert to be aware of the existence of a trend, just like you don't have to be an expert in the physics of tides to be a good surfer. Successful trend following is buying when you recognize a trend, and holding on until that trend has finally come to fruition and begins to change. Of course, once in a while, a trader is going to end up buying nearly the exact top in a market, but that's where risk management and stop losses come into play. It doesn't matter at what point you buy on a chart nor whether a stock's P/E ratio is 20 or 2,000 if you are still risking the same 5% from your entry and the same dollar amount on any given trade.
The key to enjoying enormous returns in the stock market is riding out your winners, and being stubborn enough to hold onto positions to capture as much of the trend as possible. It is not easy to sit on positions up 30% to 50% in a few months and resist the temptation to sell them, but this is what traders need to do to enjoy the largest returns. What's comfortable in the market rarely works, and this is why most traders will hold their losers (as it's uncomfortable to sell them) and will sell their winners before they ever get big (as they can't stomach the thought of that gain eroding).
Several analysts have been putting down Netflix (NASDAQ:NFLX) and calling it too expensive, too overbought, too risky, too small of a moat and a dozen other things since it touched the $50 billion mark on its market cap at just over $140.00 a share. This was only a few months after I had just gotten long the stock and I've been holding it since. While I did sell off a good chunk of my position during Q1 and Q2 of this year for an average gain of 200%, this was only because I felt the stock was finally getting to be a little too popular and a little too large in my account so I re-balanced my position accordingly.
The one time that Seykota did go against his rules and attempt to fight the market was the early 80s when he tried to keep buying back in at lower prices. It ended up being his worst year ever. Seykota had never seen a major bear market before so he continuously tried to pick bottoms before finally realizing how futile this exercise was. This is reminiscent of the analysts we've seen trying to pick the bottom in a myriad of mining stocks and the sector itself the past year, and how unsuccessful this practice has been.
Seykota On Prognosticators
"I usually ignore advice from other traders, especially the ones who believe they are on to a “sure thing”. The old timers, who talk about 'maybe there is a chance of so and so,' are often right and early. - Ed Seykota
(Source: Market Wizards by Jack Schwager)
One of my favorite quotes by Ed Seykota is his dismissal of soothsayers and prognosticators. All successful traders know that all we are dealing in is probabilities. If one has an edge and can turn over that edge multiple times, they have a great shot at being successful in the long run. The problem with the soothsayers and prognosticators is that they provide these fanatical calls that are often way out in the future and state with absolute certainty that they will occur. If the best professional traders of the past century could not consistently figure out exactly which trades would be winners and which would be losers next month, it's unlikely that a particular soothsayer has managed to figure out in which month the next financial crisis is going to occur. Regardless of this fact, we've had these same analysts calling this market the biggest bubble of our lifetimes for several quarters now and even predicting the exact month that they've landed on in which the bear market will finally show up. The most entertaining part about this is that while some of them have been calling this market a bubble since 2017, they've been busy slapping price targets of $100,000+ on bitcoin (OTCQX:GBTC).
No one knows what is going to happen either today, tomorrow, next week and especially not next year in the markets. We can have an idea what might happen and position accordingly based on probabilities, but stating absolutes makes one look like a fool. Whenever I see an analyst post a projection of where the market is going with certainty, I just hit the mute or block button. I've never been crazy about psychics, clairvoyants or soothsayers, and there are far better ways to waste my time than wading through their projections about when the financial markets will finally collapse, and what moon cycle will be the ultimate cause of it.
Ed Seykota is one of the lesser known traders, but he provides some insights into how the average trader can be successful. By keeping one's losses small, tuning out the soothsayers who always have a new prediction and holding onto our winners, traders may realize they can beat the market with less volatility. This is because most trend-following systems will move to mostly cash in the event of an impending bear market, or in some cases, move to short positions on the market. I have found Ed Seykota's principles to be instrumental in my development as a trader and I hope they've been eye-opening to some who have not studied him. I will end with a final quote from Ed Seykota:
“A losing trader can do little to transform himself into a winning trader. A losing trader is not going to want to transform himself. That’s the kind of thing winning traders do."
Disclosure: I am/we are long AMZN, NFLX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.