Insights From The Pros
What separates the pros from the would-be pros? Money management. Read on and find out why.
Manuel Ochoa has enjoyed a great deal of success as a trader and hedge fund manager, but he learned some very valuable lessons about money management early on in his career–the hard way.
As the following discussion will detail, after being wiped out in just one night, Manuel quickly realized that if he was to survive long term as a trader he would not only have to study the markets but the risk associated with them. What impressed me about Manuel is that he not only considers the chance of extraordinary events occurring that will cut into his equity, he actually plans for them and expects them to happen sooner or later.
Dave Landry (DL): Manuel, you seem to be known for your money management techniques. Did you always use strict money management or was this learned through experience?
Manuel Ochoa (MO): It was learned experience.
DL: At what point did you realize the importance of money management?
MO: In 1989, I was in college and had a personal account of $20,000. I had a large position in currencies. One night, while I slept, there was a big news development involving Britain’s Prime Minister. At 4:00 a.m. I get a call from a clearing broker notifying me that my account had a balance of -$2,000.
DL: That must have been a pretty humbling experience.
MO: Yes. Up until that point, I only thought about how much money I could make–I never thought about how much money I could lose.
DL: When you started trading again, did you immediately implement risk controls to keep this from happing again?
MO: I began to control risk more carefully but I noticed my equity swings were as much as 10% in one day. I knew I had to reduce risk even further or it was only a matter of time before a string of losses would wipe me out again.
| I think stop placement is the number one misconception when it comes to trading. |
DL: How do you define money management?
MO: I think it’s half art, half science–but mostly common sense.
DL: Let’s talk about the science of it.
MO: It’s a matter of stop-loss level placement, what size position you trade, how much risk, how much leverage (i.e., dollars controlled vs. account size). You have to know all of this ahead of time. You don’t want to be making decisions while you’re attempting to pull the trigger on a trade. It’s like swinging a bat: Half way though your swing, you can’t think, am I going to hit it high or low, to right field or left.
DL: Let’s break down these concepts. People seem to be first and foremost interested in where to place their stop-loss. (Note: Manuel can best be described as a swing trader; he normally holds positions for several days. This discussion on stops assumes the positions are held overnight).
MO: I think stop placement is the number one common misconception when it comes to trading. People think that the tighter the stop the less they are risking when in reality they often guarantee themselves a loss.
DL: For instance?
MO: People try to trade a high-flying stock like eBay with a $2 price stop. The stock trades in a range of over $30 in one day alone. People are kidding themselves if they think they can trade a stock like this with such a tight stop. In a case like this they will almost always be guaranteed a loss. The same applies to other markets.
Let’s say that someone is trading S&P futures and using very tight stops. In all likelihood, they’ll get stopped out hundreds of times in one year. I’d bet in many cases, at the end of the year, when you add up all those hundreds of small losses from tight stops, it comes to much more than a few large losses through somewhat looser stops.
Now, this is not to say that you should take excessive risk. You should have your stop far enough away that random noise won’t take you out. Suppose someone decides to dump a position or a sell program kicks off, this has absolutely nothing to do with the overall market or the reason you are in the trade in the first place.
| No professional money manager that I know risks more than 5% per trade; most keep it much lower that that. |
DL: Obviously, you can’t pace a stop too far away.
MO: True. In order to avoid being stopped out, you should have a stop that allows for the volatility of the past three to four days and make sure your stop is outside those levels. Otherwise you’re almost guaranteed a loss. You have to use the volatility of the market or you will almost surely get shaken out of good positions.
DL: How do you define the volatility?
MO: I have various techniques that I use but it can be defined with something as simple as the average range for the past three to four days. Again, the key is to make sure your stops are outside of that level.
DL: How much do you risk per trade?
MO: No professional money manager that I know risks more than 5% per trade; most keep it much lower that that. I think more important than how much you risk is how much you can lose above and beyond that risk. At least once a year, some extraordinary event will create a price shock and you’ll lose at least twice what you thought your max loss per trade was. Therefore, I never risk more than 2.5% on any given trade. That way, the worst that can happen to me on anyone trade is probably twice that amount (a 5% loss).
DL: So you not only consider your calculated risk but the possibility of an extraordinary event occurring?
MO: Exactly.
DL: Although you use a lot of discretion in your trading, you’re known as an expert on systems (computer generated signals). Can you elaborate on using systems testing when studying risks?
MO: System testing is great, or least it appears that way on the surface. People forget that these are just stats, historical estimates if you will, but they accept them as if they were fact. They fail to realize that they are only historical estimates.
DL: For instance?
MO: They look at worse loss on a single trade or the drawdown (string of losses) and think that’s as bad as it gets.
| Controlling risk is much more important than the system itself. |
DL: Is this from increased exposure to the markets?
MO: Yes, every decade and often much less, something really “bad” will occur: someone will get assassinated, a war will break out, or some sort of financial meltdown will take place. The system can never adjust for this. These things do and will happen. For instance, the crash in 1987 took out many professional option sellers in just one day.
The bottom line is that everyone is searching for a method or system that will generate enormous profits. What they fail to realize is that controlling risk is much more important than the system itself. No matter how good the system, without risk control it will surely blow up.
Dr. Paul Ruggieri, who writes TradingMarkets.com’s Medical Technology Insight column, is a surgeon who also has enjoyed great success investing in medical and biotech stocks. Paul strikes me as a man who really does his homework and has found his trading niche–he truly has a passion for medicine, research and investing in medical stocks.
Paul’s perspective is especially interesting because he approaches the market from a more traditional, non-technical vantage point. Although he doesn’t follow strict money management rules like many technicians, he does consciously avoid excessive risk through other means.
First, even though he’s willing to buy companies that have under-performed the market, he takes reasonably sized positions and does not buy stocks because they are “cheap.” He’ll only “bottom fish” in well-diversified companies that show promise. Second, in riskier, single-focus companies, he realizes it’s all or nothing. Accordingly, he takes a only very small positions and accepts the fact there is a high likelihood the stock will go to zero. Third, although he classifies himself as a long-term investor, he’s willing to take profits as approval for drugs nears versus holding out for top dollar.
Dave Landry (DL): What’s your basic approach to the markets?
Dr. Paul Ruggieri (PR): I trade stocks but I’m not a “trader” per se. I use fundamentals to select my stocks and consider myself more of an “investor.”
DL: So how you select stocks?
PR: For pharmaceutical companies, I look for drugs in the pipeline. I carefully study these drugs and their potential for success, the demand and size of the market for these drugs, and of course, the possible side effects.
DL: Being a technician who only keys off price action, I have to bring up the classic technical vs. fundamental argument. If a stock looks good to you at $100, wouldn’t it look even better at $75? Suppose it kept dropping: Is there a point where you just give up? For instance, a while back you liked Pfizer; the stock has recently dropped from 150 all the way to 110.
PR: On a stock like Pfizer, I feel that they have a strong pipeline of drugs. Although the stock has been dropping as of late, nothing has changed on a fundamental basis.
| I never take a position so large that it will have a material effect on my lifestyle. |
This is not to say that I buy something just because it is “cheap.” Merck , for instance, has made a similar move down like Pfizer. However, Merck has patents on drugs that will be expiring over the next few years and I don’t feel like they have enough currently in the pipeline to make up for it.
DL: Doesn’t this approach require you take a very long-term outlook?
PR: Yes, many times these drugs are years away from getting approval. I’m willing to wait.
DL: What about losses while waiting?
PR: I never take a position so large that it will have a material effect on my lifestyle. Also, by diversifying and holding positions in many medical companies, some of the drugs will get approval and some won’t, some sooner, some later.
DL: How do you know when to take profits?
PR: Clinical trials are based on a limited number of people. Even if the drug shows tremendous promise, once it hits the masses, there will likely be unforeseen side effects. This only stands to reason as the statistical base increases. Take Viagra, a huge drug for Pfizer.
| If I buy a very risky company, I know there’s a good chance it will go to zero. Therefore, I would only take a small position. |
DL: I was fascinated by your article on cloning technology. Genetically cloned goats that produce blood-clotting drugs, keeping cells alive forever. It’s pretty amazing.
PR: I have to admit I myself was amazed while doing the research. It’s almost scary–science fiction in nature.
DL: In the case of companies like these, with just one drug or process in the pipeline, isn’t it all or nothing?
PR: Absolutely.
DL: So, how to you trade these stocks?
PR: Take a company like Geron. They are a single-focus company concentrating only on developing a technology that will keep cells alive forever–a fountain of youth, if you will. They’re years away from perfecting the technology, let alone getting any type of approval. I think if anyone has a shot at succeeding, they do. However, I’m not going to bet the farm on the company. If I buy shares, I think there’s a very good chance that they will go to zero–and I’m willing to live with that. Therefore, I would only take a small position. I think the risk to reward is tremendous. I’m not looking for a small gain in these small, single-focus companies–I’m looking for a homerun.
DL: Do you ever think of becoming more active as a trader?
PR: Every chance I get, I follow the markets. However, I work out of two hospitals, I’m writing a book on surgery and spend many nights researching medical technology for TRADEHARD and my own personal investments. I know that due to time constraints, it’s not feasible for me to be an active trader. Therefore, I take long-term positions based on sound fundamental research. This approach has worked quite well for me.
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