Wednesday, May 09, 2007

What Makes a Professional Trader

I'm on the road this week working with traders at several professional trading organizations. It's always an enlightening experience to see how the best traders and trading firms operate. Here are a few observations that have hit me between the eyes over the past several days:

1) Many of the best traders follow and trade a variety of markets. They go where the opportunity is. When volatility dries up in one market, they have others to turn to. The small, neophyte retail trader often becomes pigeonholed in one market and overtrades it, desperate to turn a small account into a larger one. The professional trader may have a top-down or bottom-up perspective on markets (developing ideas from big economic trends or from individual company and sector results), but they have a framework for how to think about markets. Inexperienced traders lack such a framework.

2) Many of the best traders think big--as in big picture. Because they follow multiple markets, they are aware of the relationships among these markets. This enables them to develop trade ideas that connect one market to another, capitalizing on big picture themes. Knowing how interest rate differentials around the world affect capital flows is an obvious example of that. Another example is knowing how one asset is priced relative to others to capitalize on mispricing. The novice trader trades small patterns, losing sight of the context in which those patterns occur. They lack a framework for thinking about proper and improper pricing.

3) All of the best trading firms have risk managers. They stay on top of how individual traders (and the firm as a whole) are performing. They help traders adjust their position sizes to fit their portfolio needs, and they help traders during drawdown periods. It is very difficult for individual, solo traders to fill this role for themselves. The excellent traders spend significant time and effort on risk management: they know how much they want to gain and put at risk in each trade. Small traders tend to put a far larger portion of their capital at risk with each trade than large, professional traders.

4) Many of the best traders think small--as in very reasonable profit goals. This is very interesting. I never hear the pros talking about tripling their money in a year. It's the small traders, feeling a desperate need for a kill in order to make a living, who take those kind of risks. Many of the best traders I know focus on consistency and favorable risk-adjusted returns. I essentially never hear small, retail traders focus on risk-adjusted returns. I don't think I've ever met a retail trader who knows what his or her Sharpe Ratio is, for example. I don't think most newer traders could even explain the concept of VAR.

5) Many of the best traders use psychology to amplify strengths. This is one thing that a majority of "trading coaches" don't get. They are so accustomed to working with small, retail traders that their vision becomes limited to the kinds of problems that beginners have. On average, if a person lacks discipline, emotional control, etc., they don't get hired at a good firm. The best traders do experience drawdowns, but they work on themselves to identify and build strengths, not to develop simplistic "trading plans". A great deal of what's out there labeled as "trading psychology" could be relabeled as the psychology of the beginning trader. It's not that it's useless; it's that it doesn't speak to the seasoned professional. To the extent that trading shrinks emphasize positive thinking as the key to trading success, they don't understand trading--and what it takes to generate alpha--at all.

Ultimately, whether one is a professional or an amateur is a function of their approach to their work, not their setting. It is, of course, easier to live up to professionalism when you're surrounded by professionals. The best traders I know spend significant time generating trade ideas, researching markets, and staying on top of developments world wide. The ratio of time spent in preparation to time spent actually in trading has, in my experience, been a worthwhile measure of a trader's professionalism--regardless of setting. The best traders, like the best athletes, are always working on themselves, always refining what they do. In an important sense, they don't just use psychology to improve their performance. They work on their performance as a means of extending their personal mastery.

A small trader can approach his or her craft professionally. There are few models, however, for such professionalism--particularly when many of the "gurus" themselves do not begin to approximate what the pros are doing.


pwh said...

In response to your post as follows:

1. Many of the best traders follow and trade a variety of markets.

My comments - some of the most success traders also trade just one or two markets. For example, Paul Rotter trades mainly the Bund and Margie Teller trades mainly Euro Dollar futures.

4) Many of the best traders think small--as in very reasonable profit goals......I don't think I've ever met a retail trader who knows what his or her Sharpe Ratio is, for example. I don't think most newer traders could even explain the concept of VAR.

My comments - Both Warren Buffett and Charlie Munger have repeatedly stated in past BRK annual reports and talks they have given (re-produced in Outstanding Investor Digest) that they think stuff like Sharpe ratio, modern portfolio theory are pure bunk. So either Buffett and Munger are missing something or these buzz words are used by other so called gurus and trading coaches to impress other people.

AnaTrader said...


I concur with you on what you have observed on what makes a pro trader as opposed to a retail trader.

I have a vague idea of VaR (Value at Risk) as a neophyte trader; Value at Risk (VaR) is a measure of how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period .However, there is a Caveat on VaR.

VaR is not the panacea of risk measurement methodologies. A subtle technical problem is that VaR is not sub-additive.

That is, it's possible to construct two portfolios, A and B, in such a way that VaR (A + B) > VaR(A) + VaR(B). This is unexpected because we'd hope that portfolio diversification would reduce risk.Unquote

Hope I am making sense.

mOOm said...

I compute all that risk-adjusted return stuff:

But then I'm an econ prof as well as a trader...

I'd love to see more bloggers posting on their returns even, let alone risk-adjusted returns.

Jeff said...

Thank you for this fascinating post, Dr. Brett. I think it would be very enlightening for a lot of us if you' were to further expand specifically on which of those characteristics of the pros may be applicable to small traders, and how.

JMJAtlanta said...

Thanks again for another insightful post. I began to post a response, but instead I'll make it an entry in my own blog.

As for Mr. Buffett and gang, I'd put forth the argument that they are not traders. They are businessmen and investors. They need and use a different set of tools.

Just because I do some of my own car repairs, I'm not going to go around telling a mechanic that he wasted his money buying a Snap-on scanner.

We both do car maintenance, but we still do two different things.

Just my $0.02. I'm not trying to flame you pwh, just adding another perspective.

Jack said...

In my opinion what makes a trader a pro is that they consistently make money. It doesn't matter if you are trading from a laptop at Starbucks or the most sophisticated trading room at the most prestigious firm. If you are consistently making money you must be doing things like acting as your own risk manager or you wouldn't be making money over time. With all due respect Dr. Brett you seem to be thumbing your nose at other so-called gurus. If you accept my definition of a pro, then saying "many of the gurus themselves do not begin to approximate what the pros are doing" is fine if you are willing to show your personal trading statements. If not I am sorry but there is nothing the separates you from the other "vendors."

MikeH said...

Do you find that traders on the liquidity provider/scalper end of the spectrum also look at big picture themes, or would that interfere?

Musings of a Trader said...

Love your blog. Along the same lines, what do you think of the role of hope on the "little" trader's psyche as described in the following blog entry

Kathy said...

Hi Brett:
Thanks for the insider information. I have 2 questions:
1. Of all the pros you know how many use technical analysis and how many use fundamental analysis?
2. We know some pros trade billion dollar accounts. How about those small pros? What is the average account size of traders in small firms?

bennewong said...

pwh said Buffett and Munger think Sharpe Ratios etc are bunk. While it may be true (I haven't seen/heard it) in terms of the specific concepts, I believe they are very aware of the risks versus returns they take on with each of the investment decisions they make.

And I think this is what Brett was trying to say.

Mac said...

I agree with the previous comments and would like to add the following. The best professional traders are while may think in corelated assets also understand that correlation mostly works in stable markets and when volatility shows up all bets are off. The successful profesional traders always focus on the market they are trading and do not think in terms of other markets. This is a myth that seems to exist and is perpetuated by those wanting to sound intelligent. I know a lot of professional traders and to a fault they look at the markets in a very simple way and that is how much risk am i taking. The rest of all the explanations one hears is nothing more than mental masturbation and the need to sound intellectual.Its all about risk and most pros would argue that you can enter randomly in any market as long as you have planned exits, ie risk management.

Nikos Kouidis said...

Believe half of what you read, none of what you hear. Never study a theory before doing your own prior observation and thinking. Read every piece of theoretical research you can - but stay a trader. An unguarded study of lower quantitative methods will rob you of your insight.

My refutation of the VAR does not mean that I am against quantitative risk management
Thank you,

Jawbreaker said...

The best traders almost always take a very simplistic look at trading. They dont over analize or over commit to any given trend or idea. Also, while the best traders are aware of other markets they prefer to concentrate on 1 or 2 at most. Just my 2 cents. Tony dey

Brett Steenbarger, Ph.D. said...


Thanks for the many comments on this post. I just returned from a NY trip working with traders. Perhaps I can respond to a few issues that I may have not been clear on.

I didn't mean to suggest that Sharpe or VAR are ideal risk management tools. Indeed, there is a large literature on their limitations. The point is that the vast majority of highly successful professional traders I've known are aware of these tools and make use of sophisticated risk management. The vast majority of novice traders do not.

Of course, there are examples of successful traders who trade single markets. I know several personally, including the one I wrote about a while back. Nevertheless, of the very successful traders I've known (I'll define that as managing at least $50 million in capital and making $10+ million per year), the overwhelming majority have traded multiple markets and are highly aware of relationships among these.

Of course it is possible for small traders to be professional about their work, as I noted in my final paragraph. My experience, however, is that there are few information sources and services available for developing traders that help them with this professionalism. A simple perusal of the average content of the average trading conference sadly illustrates that reality.

I realize that this is an uncomfortable topic; this is why I posted it. I am working in trading firms where the traders have access to information, tools, and training far beyond what is available to the average individual trader. What is described as good trading practice in the popular trading literature is not what is practiced at highly successful trading firms.

And that is rarely acknowledged.


Joel said...

This begs the question of what trading practices are desirable in highly successful firms and are those practices due to the size of assets under management, or is it actually applicable to small investors?

AT said...

It's hard to accept that you are overmatched. Pros vs Joes.

paulm said...

Hi Brett,
you said "A small trader can approach his or her craft professionally" and, after a while, "I am working in trading firms where the traders have access to information, tools, and training far beyond what is available to the average individual trader". It sounds as a contradiction. I hope you could expand your explanation about this topic... Thank you


Brett Steenbarger, Ph.D. said...

Hi Paul M.,

Thanks for the opportunity to clarify. Small traders can trade in a professional manner in that they can exercise sound risk management and research markets soundly to find an objective edge to their trades. Still, it is not reasonable to assume that the independent, retail trader could have access to the depth of information available at trading firms that are making markets, interacting with multiple customers across markets, etc. Too, many opportunities in markets require large capital that is beyond most individual traders.


paulm said...

Thank you Brett. What you say is the reason why I think that day trading is so hard for a retail trader (poor sofistication) and long term trend following impossible to practice (not enough capital). Reading about Mark Greenspoon in your last book I was shocked in discovering that he has no formal training: talent apart, I understand that all the resources at Kingstree have had a fundamental role in his achievement but now that he know what to do, it seems that he could do it from his own home, alone, obviously at a smaller scale. At least, this is the impression I have had reading ... I wonder if you could post a comment.


Brett Steenbarger, Ph.D. said...

Hi Paul,

Because of the need for rapid execution and the low commissions of a member trading firm, I'm not sure a high frequency trader could do the same thing from home. If commissions are too high and executions are poor, the edge goes away--


ItaiTal said...

I agree with you !!!

Stuart said...

I trade one index futures market every day (dow jones), make 50% to 150% on margin every day, never risking more than 4% of margin on any one trade;

I write all my own code in Tradestation and exclusively trade cycles within the market I trade.

The methods and training is easily replicated and trained to others, providing they come into the classroom forgetting everything they know (everything you know is wrong).

Index futures reverse direction every time based on two numbers and one of two chart formations...every time...period.

While this blog has a lot of good advice, I dismiss all of the advice of this particular column as not applicable in any way to being succcessful to daytrade with limited risk and achieve the highest income possible.

Good trading & God Bless...

Brett Steenbarger, Ph.D. said...

Hi Stuart,

If you're making "50% to 150% on margin every day", you are certainly welcome to dismiss my observations! :-)


Stuart said...

RE: If you're making "50% to 150% on margin every day", you are certainly welcome to dismiss my observations! :-)


I'm not well-read in trading blogs, but yours is the best I've seen. You've got a technical 'bent' to everything without getting knee deep in details (see big picture=success).

Your recent analysis of 'tick' is excellent and you are right-on regarding how to judge the 'mood' of sectors, etc., particularly regarding money flow.

If you trade stocks for teenies; never trade against money flow/investor sentiment. Traders will avoid big losses, and don't risk more than what the retracement percentages say you should risk. Fib retracements rule trading, rigorous stop losses based on Fibs will always protect your equity curve.

Keep up the good work, Brett!

Stuart K.

Stuart said...

RE: "The successful professional traders always focus on the market they are trading and do not think in terms of other markets. This is a myth that seems to exist and is perpetuated by those wanting to sound intelligent."

This is a 90% true statement, at least regarding index futures daytrading.

Index Futures are controlled by mechanical trading systems owned by 'market makers' who control the bid & liquidity.

Remember when the NYSE had a 500 point drop early this year? I was daytrading the Russell 2000 at the time -- the Dow was running 20 minutes behind (because of volume) in computing current settlement prices; the NYSE IT dept put in a backup program, which erased the 20 minute backlog in about 5 minutes.

When this starting occurring, the E-Mini Russell 2000 plummeted another 100% of margin (5 handles) in 300 seconds - in perfect technical fashion. All short term traders were short at the time; Not a #$$#@ thing happened in the Russell but the Dow was correcting it's pricing backlog.

Therefore, the conclusion that can be drawn is that the Market Makers that control the bid on the Russell do track the Dow Index at the same time. So, in those once every 5 year instances, beware. The index e-mini market will always trade via perfect technicals of support/resistance but occasional cross-market hiccups will occur.

As an added note, Institutions on the other side of the market provided constant liquidity on the Russell so the E-mini market traded via normal bid/ask. Very impressive, indeed.

Stuart K.

Derrick said...

In my opinion, the more educated you are about each trade you make and why you're making it, the better your chances for long-term success. "Hope" just isn't enough for me....


lior said...

I'm a pro trader that live from trading at home. if there is one thing that separates us pros from everyone else its the way we think. you can call it in many ways - but in the end all pro traders thinking differently about trading from all the other amaturs, analysts , gurus and so on ... our thinking makes us discipled, risk management focused and psychological prepared.

Valuebum said...

This was a helpful article as I am a novice myself but it helped confirm that I am on the right track in my growth as a trader.

dq37xt said...

I agree that the best traders trade a variety of markets, but I also understand that one can make a very lucrative living trading just one market.

Great traders understand the relationship between the markets and can not be biased and how people react. I doubt that the pros have better infomation, they only react better.

Sharpe Ratios are garbage, just ask LTCM, with JWM's fund he founded since LTCM, down 24 percent this month, but I bet his sharpe ratio's were great too.

Engage in an outcome that is based on profit goals, understand realtionships and people react to the news.

Brett Steenbarger, Ph.D. said...

Hi dq37xt,

I agree; there are very successful traders that focus on one market or asset class. I find, however, that even then they tend to see relationships between their markets and others and factor those into decision making, especially when trading longer time frames.

That having been said, professional traders have a huge advantage in terms of access to information. Not so much the ones at prop firms, but the ones at larger financial institutions. The access to data, other professionals, and a wealth of research is mind boggling.


dq37xt said...

I wonder if you could expand on the wealth of research. If it is research done by Wall Street, I do not agree. Everyone knows to trade the news,IE money days, but some of the econ reports, like job numbers and unemployment stats are garbage. I would never trade against these reports, but I take them with a grain of salt. If you could expand on the research aspect, I would love to hear your thoughts.

Brett Steenbarger, Ph.D. said...

Hi DQ37xt,

Examples of research and information available to professional traders at hedge funds and investment banks that would not be available to the trading public would include face-to-face meetings with CEOs from major companies and sectors; a dedicated research staff performing quantitative research (predictive modeling); access to industry data from trade associations and specialized data suppliers; information networks that tell you what other firms are buying/selling; etc.


Sean said...

Stuart says he will "make 50% to 150% on margin every day"--am I the only one going to comment on this? Forgetting the margin factor because that will only amplify your return on investment, we will round your returns at an average of 100 percent a day. So lets say I gave you 10,000 dollars today. That means you should be able to give me 1,280,000 by mid next week. Actually, you know what, I'll just take my 163,840,000 by the end of the following week--feel free to take the standard 20 percent cut. I might even wait another week for the full billion. Not bad for 3 weeks of work. I think the response from the blog writer was sarcastic, but you would know that.

yoyo said...

Hi all,i'm sorry for this stupid question but could someone please explain the difference between a hedge fund and a PTG?thanks in advance for your help