The Whipsaw Song“.
Although almost completely unknown to the investment world, Seykota’s achievements rank him as one of the best trend followers and traders of his time.
Seykota believes a trader’s psychology is the most important part of operating any trading system.
As a trend follower and money manager, he amassed millions in the 1970s and 1980s for his investors. He is basically a mechanical trend following trader who built the majority of his systems around exponential moving averages, with some reliance on pattern recognition.
Seykota has always kept a low profile and caught the public eye only after his interview in Jack Schwager’s ‘Market Wizards’ books.
He began his trading career in the 1970s, when he was hired by a major brokerage firm. It was in that brokerage firm that Seykota developed one of the first commercialized trading systems for managing money in the futures market.
After a few disagreements regarding the way management was interfering with his system, Seykota decided to part ways with them.
Investors over the years have learnt many invaluable lessons by following his trading philosophy. Let’s look at some of the trading rules that he mentioned in an interview with Jack Schwager.
Cut your losses
Seykota believes that the most important trading rule is to cut losses because protecting one’s capital is the primary job of a trader.
He feels making money should be the secondary goal in the priority list of traders and they should embrace trading losses.
He believes to stay ahead in the trading business, traders need to learn to lose like winners which means accepting losses the moment the market refutes their trade idea.
“If you make the mistake of hoping for the market to turn around in your favor, you’ve already lost. The best way to embrace trading losses is to have a plan. Combine that with small bets and you’ll be lightyears ahead of other traders. If you can’t take a small loss, sooner or later you will take the mother of all losses,” he said in an interview in Jack Schwager’s ‘Market Wizards’ book series.
Seykota also believes that losing a trading position is aggravating, whereas losing one’s nerve is devastating for a trading portfolio.
“The best way to ensure you never lose your nerve is to cut losses early. It’s one of the simplest ways to maintain your discipline and avoid emotional decision-making,” he said.
Ride your winners
Seykota is of the view that trading isn’t about having a win rate of 70% or 80% but it comes down to how much investors make when they’re right and how much they lose when they’re wrong.
He feels the only way to achieve asymmetrical returns is to ride one’s winners. Seykota feels trends tend to persist in all parts of life, and they also exist in the stock market.
“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. 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,” he said.
Seykota believes that investors make the mistake of holding on to their losers as it’s uncomfortable to sell them. On the other hand, they sell their winners before they ever get big as they don’t want those gains to erode.
Seykota is of the view that investors shouldn’t get influenced by soothsayers and prognosticators as they provide fanatical calls that are often way out in the future and turn out to be eventually wrong.
“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,” he said.
Keep bets small
Seykota feels that one of the best ways to keep emotions at bay while trading is to keep bets small by speculating with less than 10% of one’s liquid net worth.
“If you risk too much on any one trade, fear and greed will surely find you,” he said.
“Risk less than 1% of your speculative account on a trade. This tends to keep the fluctuations in the trading account small, relative to net worth. Risk no more than you can afford to lose, and also risk enough so that a win is meaningful. The solution is to risk just enough that a profitable outcome is meaningful but not so much that a loss forces you to lose your nerve,” he said.
Follow your trading rules
According to Seykota trading rules are vital and are critical to one’s success. He feels when traders sit down to place a trade, nobody tells them how much to risk or whether to buy or sell.
Seykota is also a huge believer in rules and everything he does is based on strict trading rules he’s outlined for himself which helps him stay calm even when things aren’t going his way.
“It’s a rule that defines how much you’re allowed to risk or what you’re supposed to do during a losing streak. They help keep you disciplined in a world without many boundaries,” he said.
Know when to break the rules
Seykota is of the view that a balance between following rules and breaking them is very important.
“Sometimes I trade entirely off the mechanical part, sometimes I override the signals based on strong feelings, and sometimes I just quit altogether. If I didn’t allow myself the freedom to discharge my creative side, it might build up to some kind of blowout. Striking a workable ecology seems to promote trading longevity, which is one key to success,” he said.
Seykota believes that the win rate for any trader is insignificant and what really matters is having an asymmetrical profit to loss ratio.
He feels finding a trading approach that fits one’s personality is vital and sometimes intuition and “gut feel” can become one’s most useful assets.
“I don’t think traders can follow rules for very long unless they reflect their own trading style. Eventually, a breaking point is reached and the trader has to quit or change or find a new set of rules he can follow. This seems to be part of the process of evolution and growth of a trader,” he says.
Reduce your trading risk
Seykota is of the view that the three primary components of trading are (1) the long-term trend, (2) the current chart pattern, and (3) picking a good spot to buy or sell.
He believes that investors should try to identify a point at which they expect the market momentum to be strong in the direction of the trade, so as to reduce their probable risk.
“Trading requires skill at reading the markets and at managing your own anxieties. Risk is the uncertain possibility of loss. If you could quantify risk exactly, it would no longer be a risk. Risk control has to do with your willingness to allow your stop to do its job,” he said.
Have a winning mindset
Seykota believes a losing trader can do little to transform himself into a winning trader as a losing trader is not going to want to transform himself.
But a winning trader will always be wanting to learn and would like to transform every bet into a profitable one.
Seykota is of the view that in the recipe for success investors shouldn’t forget commitment and a deep belief in the inevitability of success.
Leave emotions aside while trading
Seykota feels investors shouldn’t get emotionally attached to their trading bets as it may lead to huge losses.
“Dramatic and emotional trading experiences tend to be negative. Pride is a great banana peel, as are hope, fear, and greed. My biggest slip-ups occurred shortly after I got emotionally involved with positions,” he said.
Seykota is of the view that the market is always right and investors should make their trading bets without letting their emotions get the better of them.
“If you want to know everything about the market, go to the beach. Push and pull your hands with the waves. Some are bigger waves, some are smaller. But if you try to push the wave out when it’s coming in, it’ll never happen. The market is always right,” he said.
(Disclaimer: This article is based on Ed Seykota’s interview with Jack Schwager in the Market Wizards books series)