All trading careers have defining moments. For Bruce Kovner, retired CEO of global macro hedge fund Caxton Associates, it was his third trade that shaped his legendary career.
Kovner started his career as a spread trader - trading the same product across different contract months. Typically, the far month contract trades as a higher price than the front month. But Kovner discovered more forward contracts start trading at near-zero levels, so he bet the difference in price between the two contracts would widen over time. His first trade was textbook and the market reacted how he expected. And while he lost money on his second, it was only because he got in too early.
The third trade shaped how he managed risk forever - and became a reason he’s worth an estimated $5.2 billion today.
Think you have what it takes to be a Market Wizard?
This week our series of insights from Jack Schwager's Market Wizards focuses on Bruce Kovner. A disciplined and sober trader, Kovner made his millions in the interbank currency and futures markets. (Check out our last post “23 Invaluable Lessons from the World’s Greatest Traders.”)
Kovner describes the the third trade of his career as “far and away” the most painful. With only a $4,000 account, he built a position of 15 Soybean ($SZ) contracts, and was up about $45,000. Then his broker called to say that his July contract was limit-up and Kovner would be a fool to stay short on November. So Kovner made a spur-of-the-moment decision to lift the short side of his spread. That move cost him $23,000.
But it wasn’t the amount he lost that hit him so hard. It was his failure to understand how risky his position was that made him think he had blown his career as a trader.
In trading, you can’t profit without embracing risk. Kovner obviously knew that, but he didn’t know how gut-wrenching losing money would be. He had worked so hard to make the $45,000, then let more than half of it go with a mental error.
“Every so often, I take a loss that is significantly too large,” says Kovner. “But I never had a lot of difficulty with the process of losing money as long at the losses were the outcome of sound trading techniques.” At the heart of those sound trading techniques is a methodical approach to money management.
Here are a few of those lessons he shared in Market Wizards:
- Control your risk. Kovner reduces his exposure by studying the correlation of his positions: “If you have eight highly correlated positions, then you are really trading one position that is eight times as large.” Failing to understand that he says, is “the root of some of the most serious problems in trading.”
He remembers working with a trader who he says knew the market much better than he did. But Kovner consistently made money while the other trader ended up flat. That trader’s big mistake? “Position size,” says Kovner. “For every one contract I traded, he traded 10.” The trader may have doubled his money on two occasions, but overall he lost.
- Have a predetermined stop. An exit strategy is critical. Kovner always places his stop beyond a technical barrier because that represents a place the market won’t go - assuming he’s made the right calculations. If he has, he reduces his chance of being stopped out on normal market fluctuations.
Kovner also doesn't risk more than 1 percent of his portfolio on any single trade. Viewing risk as a percentage, instead of a flat number ensures that he can scale up or down as his account balance changes, minimizing the importance of any one trade.
(Watch “5 Key Lessons from Our Successful Funded Traders” for a detailed explanation about the benefits of a percentage-based risk management approach.)
- Respect the market. Kovner does not start trading thinking he knows more than the market. He starts with the assumption that “the price for a market on any given day is the correct price.” From there, he tries to figure out what events will impact that price.
In part, that means thinking through alternative scenarios and drawing conclusions about what others will do in each one. Is the market under-appreciating any event? Does his analysis challenge the consensus? And if so, when will the market realize it?
This isn’t the same as simply going on instinct. For instance, one time Kovner was struggling to decide if the Canadian dollar was going to go up or down. He had arguments on both sides. But then US / Canadian trade pact was announced, and the entire picture changed and Kovner was ready to move because the had two major elements: a change in fundamentals and a technical price breakout on the upside.
- Be disciplined in your decisions. Like most successful traders, Kovner says you want to stick with your game plan. Considering his “going bust trade” was a Impulsive decision, that makes sense. However, he also says you don’t want to lose money because your in a situation you don’t understand.
“When something happens to disturb my equilibrium and my sense of what the world is like, I close out all positions related to that event,” says Kovner.
What do you think of these takeaways? Put them in the comments below.