Copyright © 2016 Joel Rubano

All rights reserved. No part of this book may be reproduced in any form or by any
electronic or mechanical means, including information storage and retrieval systems,
without permission in writing from the publisher, except by reviewers, who may quote
brief passages in a review.

ISBN 978-0-9976295-0-7

Library of Congress Control Number 2016908401

Excerpt from The Pricing of Options and Corporate Liabilities by Fischer Black and
Myron Scholes reprinted by permission of the University of Chicago Press.
Excerpt from Measuring Market Risk by Kevin Dowd reprinted by permission.
Excerpts from Technical Analysis of the Financial Markets: A Comprehensive Guide to
Trading Methods and Applications by John J. Murphy reprinted by permission.
Excerpt from Elliott Wave Principle: Key to Market behavior by Robert R. Prechter, Jr.
and A.J. Frost reprinted by permission.

Printed and bound in USA

First Printing June 2016

Published by Cephalopod Publishing

P.O. Box 920179
Needham, MA 02492

Visit www.traderconstructionkit.com
Common-sense Disclaimer

Readers of Trader Construction Kit must take the following into consideration:

Trader Construction Kit describes strategies and techniques employed by professional

traders in the financial markets, which involve the intentional, proactive assumption of
risk and the very real possibility of loss. No guarantees of any kind are expressed or
implied, and every reader must evaluate their own particular personal circumstances
before attempting to employ any information contained in this book.

Trader Construction Kit is intended to be the best first book for aspiring risk takers, but
cannot and does not represent the totality of the available information on any of the
covered topics. Readers must be prepared to continue their study to achieve a
professional level of competency.

Trader Construction Kit is a product of the laws, rules, regulations and operational
environment at the time of its publication in mid-2016. Future changes to the laws,
rules, regulations and operational environment could conceivably render any or all of
the information in this book obsolete, and readers must educate themselves on the
current state of play.

The author strongly believes that every trader has a responsibility to comply with all of
the laws, rules, and regulations of their particular market, and to operate in an ethical
fashion at all times. Trader Construction Kit does contain several examples of non-
conforming activities intended to illustrate clearly inappropriate behavior that
compliant market participants may observe, or that could potentially impact their
activities.
 Contents

0 Introduction .................................................................................................................... 1
1 Know Yourself ................................................................................................................ 9
2 Know the Enemy .......................................................................................................... 27
3 Fundamental Analysis.................................................................................................. 71
4 Technical Analysis ...................................................................................................... 115
5 Understanding Volatility ........................................................................................... 163
6 Understanding Risk.................................................................................................... 197
7 Developing a Cohesive Market View ....................................................................... 239
8 Directional Trading Strategies .................................................................................. 283
9 Spread Trading Strategies .......................................................................................... 329
10 Option Trading Strategies ......................................................................................... 371
11 Quantitative Trading Strategies ................................................................................ 443
12 Evaluating Trades & Creating a Trading Plan ........................................................ 477
13 Trading Mechanics ..................................................................................................... 511
14 Managing Positions & Portfolios ............................................................................. 533
15 Pricing & Hedging Structured Transactions .......................................................... 557
16 Navigating the Corporate Culture ........................................................................... 585
00 Conclusion ................................................................................................................... 607
Appendix – Resources For Continued Study ....................................................................... 609
Index ....................................................................................................................................... 611
 0
Introduction

Working on a trading desk is one of the most coveted careers in the world. The
competition is fierce and the lure of money and everything it brings attracts all kinds,
from high school dropouts to elite over-achievers who would otherwise make fine
mathematicians, brain surgeons, or fighter pilots. In stark contrast to the years of
preparation at a university, medical school, or military academy, a novice trader is
generally expected to do battle with the best (and worst) that the market can offer, in a
zero-sum game, with little or no practical training. No matter how beautiful the mind,
steady the hand, or steely the nerves, each newly minted trader is initially operating at a
significant disadvantage. When it is every trader for himself, few are inclined to help
their coworkers grow into competitors. In the rare cases when a well-meaning trader
does want to help, there has traditionally been a scarcity of relevant, practical resource
material. It is that informational void that I am attempting to fill.

This book was written for the aspiring trader, risk manager, or analyst struggling to
come to grips with the sound and fury of a trading floor. The goal is to explain simply,
methodically, and with maximum clarity how to be a professional trader.

I present as non-technical a treatment of the subject as possible and leave the underlying
mathematics, for those interested, to the original authors. I draw from the books
considered to be benchmarks in the field (as they have formed the foundation of my
technique) and will refer the reader to more specialized texts for deeper study.
2 Trader Construction Kit

Traders develop conceptual frameworks to help them understand the markets they
inhabit. There were not a lot of practical resources for understanding how to deal with
financial tumult when I was educating myself, so I sought lessons from other high-risk,
high-reward endeavors like gambling, sports, and war. A combative, conflict-oriented
model allowed me to contextualize and operate within the extreme volatility of the
markets I inhabited and, as a result, my pedagogy is frequently expressed in metaphors
of force, pressure, and stress.

I do not claim to be the World’s Greatest Trader. I am a fairly workaday, blue-collar risk
taker. I have been profitable across my career and never broken the law or blown up my
firm. I have traded my way across the United States from a Houston oil major to a
Boston hedge fund with stops at utility companies and energy merchants along the way.
Between jobs, I gambled on precious metals and agricultural futures from a Michigan
apartment and speculated on currencies from a seedy motel room in the California
desert. I have bought and sold power, coal, oil, and natural gas on an institutional scale
and dealt in financial swaps, over-the-counter forwards, exchange-traded futures, and
physically delivered options. The trading techniques I employ have been refined by years
of practical experimentation across variegated markets with real money on the line.
Being more Salieri than Mozart, I have had to try harder to work out how markets
operate, and as a result, perhaps understand the plumbing and wiring of the financial
system better than most.

Trading is a Process
Being a professional trader is about having a stable, robust methodology for examining
the market, developing trading ideas, selecting the best possible implementation,
efficiently executing the trade, and monitoring and optimizing the resultant position.
The market will be different every day, but a trader’s approach, once developed, should
be consistent.

In flowchart form, the idealized process would look like this:

Introduction 3

Figure 0.1 Flowchart of an idealized trading process.

4 Trader Construction Kit

This text discusses the process with each chapter addressing a specific aspect of the
whole. The chapters are also broadly grouped into five sections:

1. Introduction to the Industry

2. Developing a View on the Market
3. Evaluating Trading Strategies
4. Managing Positions and Portfolios
5. Being a Professional Trader

Introduction to the Industry, Chapters 1-2

Chapter 1 – Know Yourself

What does it mean to be a professional trader? What sorts of character traits are markers
for success, and what behaviors inevitably lead to ruin? Not all traders do the same
thing, and there are a variety of different decision-making styles and approaches to the
market that can be productively deployed.

Chapter 2 – Know the Enemy

How to identify and categorize the various types of firms present in the market,
understand their motivations and know the types of business activities they typically
undertake. We explore the transactional ecology, where some entities are seeking to
acquire risk for a profit while others seek to shed risk for a fee.

Developing a View on the Market Chapters 3-7

Chapter 3 – Fundamental Analysis

Explores how analysts collect data, process it, and turn in into actionable information.
How traders work with subject matter experts to develop a consensus of market opinion
which, when contrasted with internal projections, leads to a perception that current
prices are relatively too cheap or too expensive.

Chapter 4 – Technical Analysis

Studying charts of price fluctuations as a window into market sentiment and as a means
of understanding the probability and magnitude of potential price responses to market
events and new information.

Chapter 5 – Understanding Volatility

Learn how to observe and categorize the fluctuations in market prices, and how its
characteristics affect liquidity and trader participation.
Introduction 5

Chapter 6 – Understanding Risk

Explore how the market volatility combined with the trader’s positions translates into
risk, how to measure risk and understand the potential P&L impacts of normal and
extreme market fluctuations.

Chapter 7 – Developing a Cohesive Market View

How to combine fundamental information, a technical analysis, an assessment of market
volatility, and risk implications into a view of the market. Having a view of the market is
the primary task of any trader, and the remainder of the book will cover implementing
the view and managing the resulting position.

Evaluating Trading Strategies Chapters 8-12

Chapter 8 – Directional Trading Strategies

Directional trading strategies are the simplest, most immediate means of gaining
exposure to the market. The chapter explores how to evaluate a pure long/short
directional implementation of the trader’s view.

Chapter 9 – Spread Trading Strategies

Spread trading strategies involve offsetting long and short positions that are designed to
profit from the convergence or divergence of the initial price relationship. How to
evaluate various types of spread position implementations of the trading view.

Chapter 10 – Option Trading Strategies

Option trading strategies involve using instruments with complex, non-linear risk
characteristics that can be used to take leveraged directional views, create structures that
profit under specific, predetermined conditions, or take positions that profit from
changes in market volatility. Understanding the basics of this complex topic and
evaluating various types of option implementation.

Chapter 11 – Quantitative Trading Strategies

In some data-intensive markets it is possible⎯or necessary⎯to utilize a quantitative,
machine-based approach to understanding the market and implementing trading
strategies. Here is a look at how to evaluate different types of machine-based trading
strategies as potential means of implementing the market view.

Chapter 12 – Evaluating Trades & Creating A Trading Plan

How to take the candidate directional, spread, option, and quantitative trading strategies
and evaluate the best means of implementing the trader’s market view of the market.
Once the trader has decided on their preferred strategy, she will create a trading plan
that describes its implementation.
6 Trader Construction Kit

Managing Positions & Portfolios Chapters 13-14

Chapter 13 – Trading Mechanics

After arriving at the optimal strategy for the current conditions and drafting a trading
plan, the trader must accumulate the desired position. To efficiently operate in the
market the trader must develop and maintain solid trading mechanics.

Chapter 14 – Managing Positions & Portfolios

Securing a position is not the end. A trader must continue to assess both the market and
the viability of his thesis, and stand ready to take any necessary action to optimize the
profitability of the trade.

Being A Professional Trader Chapters 15-16

Chapter 15 – Pricing and Hedging Structured Transactions

Traders exposed to deal flow at financial institutions will frequently be called on to assist
with complex structured transactions, which can originate anywhere from the organic
hedging needs of a producer or consumer to a sophisticated player looking to
opportunistically shed or assume an esoteric exposure. The trader’s involvement can
range from performing routine price discovery and hedging, to risk decomposition,
extracting value from embedded optionality, and warehousing significant volumes of
non-standard products. The chapter concludes with a practical example of pricing and
hedging a common structured transaction.

Chapter 16 – Navigating the Corporate Culture

Trading firms are complicated organizations, with a host of written and unwritten rules.
A look at how things actually work, and how to avoid common pitfalls that derail
trading careers. Just as markets evolve, traders progress through an evolutionary
trajectory during their careers. How to avoid stagnation, diagnose technique flaws, and
continue making progress.

Prerequisites and Requirements for Usage

This book was designed for undergraduate, MBA, and Masters of Finance students
interested in a career in trading, recent graduates seeking to gain practical insight,
neophyte traders looking for an edge, and support staff seeking a greater understanding
of the industry or eyeing a jump to the commercial side of the desk. To successfully
navigate this text, the reader should have:

1. An undergraduate-level familiarity with math, statistics, and economics; more is

obviously better.
2. Access to the Internet and knowledge of how to search for information.
Introduction 7

3. Access to financial information, including stock, bond, and commodity prices

and the basic tools used to do fundamental research and create rudimentary
historical price charts.

Introducing Product X
My goal is to explain the common strategic building blocks that are applicable to all
markets. In the interests of being useful to the maximum number of readers I have
attempted to present the material in a product-neutral fashion. This would be
challenging (if not impossible) if I were to draw the preponderance of the examples from
my personal experiences in the energy market. Conversely, using a broad range of
examples from currencies, equities, and fixed income would ensure that I was frequently
pontificating on subjects of which I had no practical knowledge.

I have attempted to resolve this dilemma by creating a highly detailed case study
describing the market for a fictional commodity called Product X, complete with
underlying market fundamentals, historical prices, and a global balance of trade. The
Product X case runs through the entire book, and will be incrementally examined and
interpreted with the tools developed in each successive chapter. The reader will get to
see, start to finish, how to analyze a market, develop actionable information, evaluate
trading strategies, and select the optimal means of implementation.

Working through the process as a trader would when approaching a new market will
provide a depth of understanding of the material impossible to achieve with dozens of
individual stand-alone examples. There will be occasional real examples, most
commonly to illustrate historic market events that have a bearing on the topic at hand.
Many will be from the energy commodity space, as it is my area of greatest personal
experience.1

This book covers a lot of ground and must occasionally, out of necessity, presents
concentrated overviews of complicated subjects. Each chapter will conclude with
suggestions for further exploration of the topic(s) and continued self-education.

Trader Construction Kit contains a large number of graphics, the majority of which are
price charts. Unless otherwise specified, all price charts will be line graphs of end-of-day
close data for a standard 252 business day year.

1
I was an employee of an energy-trading firm during the majority of the time this book was in
development, and will not discuss any information that would be deemed proprietary to my
former firm and its core business. All energy-based examples are drawn from either publically
available information or presented as generic, hypothetical situations.
 1
Know Yourself

The TV Question
A person has a television (TV) to sell. The seller thinks for a while, pondering its value,
and decides that the TV is worth $20.00. He makes a sign that says "TV For Sale -
$20.00," tapes it to the television, and wheels it down to the curb to sell. As he does, he
sees a neighbor pushing the exact same television down to the driveway with a sign
taped to it that says "TV For Sale - $10.00."

What should he do?

Everyone wants to know what it takes to be a trader, what intangible characteristics

separate the winners from the losers. For the vast majority of successful traders, there is
no single thing that steers them down the path toward either the penthouse or the
outhouse. If there were a perfect trader, her approach might look like this:

Vitruvian Trader

• The ideal trader has a clear sense of what she is trying to achieve at all times.
• The trader expects a particular market response when a base set of fundamental
and technical conditions are disturbed by incremental change or the influence of
external stimuli. This informed perspective on the future of price is called a
view.
10 Trader Construction Kit

• The trader considers a variety of strategies to implement her view, selecting the
one with the closest response to the underlying driver with the best potential
reward, the lowest probable risk, and the best performance characteristics.
• The trader sets the position with a defined profit target and a stop-loss.
• The trader monitors the position for changes to the underlying thesis while
maintaining an alert, intellectually engaged but emotionally detached state.
• If action is required, the trader executes with the maximum possible efficiency.
• The trader evaluates the results and adjusts the operational parameters (trade
selection criteria, stops, targets, etc.) of the methodology as necessary.
• Repeat.

Being a professional trader is a two-part problem, how to evolve to be the best possible
risk-taker and how to develop, refine, and deploy the most efficient process.

For most people, success as a trader is less a matter of deus ex machina brilliance and
more a result of a steady progression, an ongoing evolutionary process wherein every
student starts with innate skills and attempts to out-learn and out-develop peers. This
chapter will explore the attributes common to successful traders and the common
mistakes that keep neophytes from reaching their potential. Not all traders approach the
job in the same way, and not all trading jobs are the same. Understanding the subtle
distinctions will shed light on the development necessary, in terms of both the steepness
and duration of the learning curve. All roads may lead to Rome, but not all paths end at
the job of one’s dreams. In this case, they all start with another question:

Do You Play Poker?

Poker is the only game in the casino that does not, by definition, have the player’s odds
mathematically fixed and permanently stacked against them. While random chance can
play a part in any particular hand, the long-run odds of a player prevailing depend
primarily on her proficiency relative to that of opponents. Poker is a game of strategy,
tactics, probability, and calculation and is a serviceable, albeit simplified, simulacrum of
trading. Playing No-Limit Texas Hold ‘Em2 for a meaningful amount of money involves
the same kind of decision calculus and personal involvement as managing a trading
position. It is by far the best and most accessible means of learning to take risk, short of
actually sitting on a trading desk.

2
Frequently called “The Cadillac of Poker,” No-Limit Texas Hold ‘Em is by far the most popular
variant of the game and is the preferred form of competition at every level, from major
tournaments to penny-ante home games. I was once wasting time playing with a friend in an
airport using M&Ms instead of chips when a disheveled guy came shambling in off the concourse
and said “Hey man, ummm, can I get in on the action?” I looked up at him and said, “That
depends. Got any M&Ms?”
Chapter 1 - Know Yourself 11

Poker As a Whetstone
Good poker players are extremely analytical, as success depends both on an advanced
understanding of the underlying probabilities of the game and a feeling for the nuances
of human nature. Professionals spend a great deal of time studying their opponents, and
characterizing their playing style based on two attributes: the degree to which they are
conservative or adventurous with their money, called being “tight” or “loose,” and their
general inclination toward passivity or aggression. Mapped on intersecting axes, they
yield the quadrants Loose/Passive, Loose/Aggressive, Tight/Passive, and
Tight/Aggressive:3

Figure 1.1 Characterization of various poker styles.

A Loose/Aggressive player, sometimes called a maniac, gambles wildly and without

control. This player is a thrill-seeker, who plays to feel the rush and takes huge swings up
and down, rarely having enough money to withstand the self-induced volatility and
usually going broke as a result.

3
This common model for categorizing player behavior may have originated from Alan N.
Schoonmaker’s grid-based system seen in The Psychology of Poker (Henderson: Two Plus Two
Publishing LLC, 2000), 71-79.
12 Trader Construction Kit

A Loose/Passive player gets involved indiscriminately but gives up easily, squandering

small amounts of money over and over as the game goes on. This person, derisively
labeled a calling station, wants to be involved but lacks commitment, making him an
easy mark for aggressive players.

A Tight/Passive player will sit at the table forever waiting for the perfect situation that
never, ever materializes. She is frequently referred to as a rock, is not inclined to get
involved, and doesn’t like to take any risk when she does.

A Tight/Aggressive player will wait patiently until the odds are decisively in his favor,
then act with maximum aggression to extract as much money as possible from
opponents at the table.

Tight/Aggressive For The Win!

Most top poker professionals believe that Tight/Aggressive is the only winning behavior
over the long run. More interestingly, elite players feel that a Tight/Aggressive approach
to the game is not a naturally occurring set of traits. Very few people are intuitively
disciplined enough to limit their participation to situations when they have a real
statistical advantage and also willing to exert maximum pressure on their opponents. It
is a learned behavior. A winning poker player has consciously, intentionally modified
her decision making and approach to the game to be both more calculating and more
aggressive in order to maximize the chances of success. This is exactly the right mindset
for a professional trader, and the behavioral model maps perfectly.

A Loose/Aggressive trader is a thrill-seeking adrenaline junkie, swinging around in the

market to satisfy a need for action, consequences be damned.

A Loose/Passive trader will always have some sort of a position, but never anything
significant, and will tend to give up at the first sign of a loss.

A Tight/Passive trader is waiting, always waiting, for the perfect opportunity that just
never quite seems to appear.

The Tight/Aggressive trader waits for the conditions to be favorable, and then commits
to a strategy with a meaningful position managed in a tactical, controlled fashion.

The first thing strong poker players do when sitting down at a table full of opponents is,
surprisingly, nothing at all. They will sit and watch the ebb and flow of the game for a
half hour, an hour, or as long as it takes to preliminarily classify their opponents and to
see how the game is playing at the moment. They will study the betting, the aggression
level of the participants, and the quality of cards being played. They will listen to the
players talk about how they played previous hands to gain insight into their thought
processes, style, and skill level. They will see how much money is in play, and by whom,
Chapter 1 - Know Yourself 13

as an indicator of how much profit there is to be made. Finally, they will make a
candid assessment of themselves relative to what they have learned about the game, its
participants, requirements, and profit potentials relative to the risks involved. As the
saying goes, “if you can’t spot a sucker at the poker table, then you are the sucker.” Smart
players know when to stand up and walk away from a game that is too tough or that
does not suit their style, even without playing a single hand. They also know when to
settle in for the long haul if they find a situation that seems profitable.

Here is the previous paragraph again, with replacements in italics.

The first thing strong traders do when entering a market full of counterparties is,
surprisingly, nothing at all. They sit and watch the ebb and flow of the market for a half
hour, an hour, or as long as it takes to preliminarily classify their counterparties and to
see how the market is trading at the moment. They will study the prices, the aggression
level of the traders, and the fundamental information. They will listen to the traders talk
about how they put on previous positions to gain insight into their thought processes,
style, and skill level. They will see how much money is in play, and by whom, as an
indicator of how much profit there is to be made. Finally, they will make a candid
assessment of themselves relative to what they have learned about the market, its
participants, requirements, and profit potential relative to the risks involved. As the
saying goes, if you can’t spot the sucker in the market, then you are the sucker. Smart
traders know when to stand up and walk away from a market that is too tough or that
does not suit their style, even without doing a single trade. They also know when to settle
in for the long haul if they find a situation that seems profitable.

How can novices develop a trading style analogous to the tight/aggressive poker style?
By understanding what attributes contribute to success and emphasizing them, and by
recognizing destructive tendencies and seeking to avoid them.

Traits of Successful Traders:

1. Disciplined.
2. Self-analytical.
3. Intellectually honest.
4. Rationally accepting of failure.
5. Have an ability to suffer.
6. Learn from their mistakes.
7. Hyper-competitive, driven.
8. Have a strong work ethic.
9. Positive.
10. Prepared.
11. Ethical.
14 Trader Construction Kit

Good Traders are Disciplined

It is easy to wonder what is right, somewhat more challenging to figure out what is right,
more difficult still to understand why something is right, but very hard indeed to do
what is right, particularly when the course of action may be unpopular, unpleasant, and
involve personal or professional costs. It is very easy for anyone to say what she is going
to do; it is much more rare to find someone who consistently does what she says. The
other ten traits are important; discipline is mandatory. Discipline enables all of the other
traits to be expressed, and allows a strong analytical process to be translated into
thorough trade selection, rock-solid execution, and effective position management. This
is one major reason why former athletes and ex-military are so highly prized by trading
firms, often above more highly intellectually pedigreed individuals. If an ex-Marine or
Navy SEAL says they’re buying here and selling there, you had better believe things are
getting bought here and sold there.

Good Traders are Self-Analytical

All machines break down from time to time, and every motor needs the occasional tune
up. Flaws can creep into any (or all) aspects of a trader’s methodology, and if left
undiscovered or unchecked will destroy even the most robust process. While honest,
objective feedback should always be welcomed, a trader cannot rely on others to
diagnose the flaws in his technique. A trader’s peers may be unwilling or unable to offer
productive critique, and even if they are, the trader may not be able to process and use
the information. A professional trader must be both willing and able to forensically
examine the decision-making process and all aspects of the methodology to determine if
there are flaws that need to be addressed. Debugging a trader’s methodology will be
discussed in greater detail in Chapter 16 – Navigating the Corporate Culture.

Good Traders are Intellectually Honest

Most people find it extremely easy to lie to themselves about the underlying motivation
for their actions. This prevents personal growth by denying them opportunity to learn
from their mistakes.

Taking a significant amount of risk is a very committing exercise, requiring a great deal
of forethought and no small amount of emotional stress. Once invested (in both senses
of the word), it can be difficult to hear counter-arguments or process incremental new
information, regardless of how critical, timely, or obvious. In extreme cases, traders will
go to elaborate lengths to convince themselves the market is acting “irrationally” or
“stupidly,” that the shift in fundamentals was “bad data,” and that devastating
information is “just noise.” It is difficult to believe how fully intelligent, perceptive
individuals can deceive themselves under stress.

Intellectual honesty allows traders to self-police their actions. Traders must be able to
step back and ask themselves “why am I doing this?” If they don’t have an answer, (or it
isn’t a good one) they need to check themselves before they wreck themselves.
Chapter 1 - Know Yourself 15

Good Traders are Rationally Accepting of Failure

Poker players sometimes say, “A real gambler doesn’t need anything.” It does not take
any self-actualizing philosophy to imagine that desires can, and do, influence the
decision-making process. Wanting to win too badly can muddy up what needs to be a
clinical assessment of the risks and rewards inherent in any proposition. Needing a
particular result makes it paradoxically more difficult to achieve.

This behavior is on display every weekend on television as highly compensated

professional athletes miss short putts, drop easy catches, and brick free-throws that they
could make with their eyes closed at practice or with nothing at stake. The sudden
pressure of having to do something completely ordinary (and the associated
consequences of failure) can transform any task from routine to impossible. Losing
traders who approach their maximum allowable loss for the year almost inevitably
explode violently shortly thereafter. The combined pressure of wanting desperately to
succeed but being unable to fail is too much, leading to poor decisions and, ultimately,
the exact circumstances the trader was seeking to avoid.

A trader must put himself in a space where, given what is at risk and what he hopes to
gain, he is completely comfortable with either outcome, that is, the potential profit is
worth the probable risks involved. A trader needs to learn to think that a particular trade
could work, given the probabilities, not that it should work or that it will work. It must
never need to work. Trading ideas that don’t work are an unpleasant yet inevitable
byproduct of the process. A trader must accept that losing is part of the game and move
on with the minimum of psychological damage, because there will be a lot of losing over
a career. Traders are not in the perfection business. The name of the game is batting for
average and controlling the risk, so that the trader can afford to play again tomorrow.
Traders need to learn to trust in themselves and trust in their process. Poker, with its
reduced probability set and defined outcomes, is a perfect laboratory for developing this
kind of self-confidence.

Poker also teaches the difficult-to-grasp concept of divorcing the short-run outcomes
from the quality of the decision-making process that created them. This may seem
counterintuitive, particularly when applied to a results-centric endeavor. “Isn’t the point
to win, to make money? Isn’t it a good decision if it makes money, and a bad decision if
it does not?” Sometimes good decisions lose, and poor decisions win. If offered a chance
to bet $1.00 to win $1.00 on the flip a coin that comes up heads 99% of the time and tails
1% of the time, any trader would be insane not to bet on heads. If, when flipped one
time, the coin comes up tails, it was not a bad bet, just a bad probabilistic outcome.
There will always be exogenous events and instances of random chance. Bad luck
happens.
16 Trader Construction Kit

For many high achievers, not succeeding immediately as a trader may be the first
significant failure in life. Athletes with experience losing have more likely developed
productive coping/compensation behaviors. When I studied karate as a boy the first
thing I was taught was how to fall so that I did not injure myself. Every trader must learn
how to fail so that he does not hurt himself.

Good Traders Have an Ability to Suffer, or to Displace Suffering

One key survival mechanism involves having or developing a larger than normal ability
to tolerate suffering or the intellectual capability to compartmentalize it. The trader
must find ways of dealing with the pressure and discomfort such that it does not degrade
the decision-making process. If the trader has structured and sized trades correctly and
adopted a good gambler’s mindset, it is possible to not care too much about any one
particular outcome, trusting that in the long run there will be more gains than losses.
Sooner or later, however, every trader will misjudge the market and find out what he is
made of under the worst possible circumstances.

Good Traders Learn From Their Mistakes

In any given day, month, or year, a trader’s approach to the market will be a success or a
failure. It is easier to learn from failure where it is possible to start from the logical
premise that the method may be flawed and forensically examine it for defects. Adapting
to a changing environment while still generating productive results is vastly more
difficult, and will require a visionary sense that the underlying conditions are either
eroding or are vulnerable to a seismic shift. Observant traders will look for clues like a
decreasing winning percentage, greater difficulty finding good trades, greater execution
slippage, and thinner margins. Profitable traders are like snakes, shedding their
methodologies like so much dead skin when they are no longer productive.

Making mistakes is part of the evolution of a trader, but there is no excuse for making
the same mistake twice (let alone multiple times). Whenever possible, it is far better to
learn from other people’s mistakes by studying other markets and trading styles and
observing what does (and more importantly) does not work.

Good Traders are Hypercompetitive, Driven

Traders must first be profitable (or they will not be traders for long), and then
distinguish themselves relative to their peers. Traders will be compared to their desks, to
traders in other products at the firm, and to standardized industry benchmarks. They
will be graded on total dollars earned relative to the cost of the resources utilized, and on
the amount of risk taken. At most firms, management will start to look askance at the
minimally productive trader, and will usually manufacture some reason to shuffle an
underperformer into a different role (or out the door) to make room for a shiny new up-
and-comer with potential.
Chapter 1 - Know Yourself 17

Good Traders Work Very Hard

Good traders work much harder than average traders, and do so throughout their
careers. A strong work ethic helps a trainee outlearn peers and get a shot at the desk.
Junior traders must claw their way up to competency as fast as possible to keep their
seats. Traders must continually out-work their peers in the market to remain profitable
and be compensated for their production. Senior traders must remain current while at
the same time always pushing to find the next product, market, or strategy that will
expand or extend their career.

Good Traders Prepare

Good traders do vast amounts of research to minimize the chances of being surprised by
a data item, research report, or economic indicator that they should have factored into
their decisions. Traders are in the anticipation and reaction business. The more time
spent pre-planning for contingencies, the faster and the more precise the reactions.
Doing the homework allows the trader to spend the critical time period after any market
event executing a plan, not pondering the possible ramifications as the market moves.

Good Traders are Positive

Good traders believe that they can accomplish what they set out to do, that through hard
work and skill that they can find profitable opportunities, design and execute a trading
plan, and make money for their firm and themselves over time. Part of this is having
rational expectations, but most of it is fairly straightforward psychology. A baseball
player who thinks he can’t hit the ball will never step up to the plate. There is no point
adding artificial barriers, there will be plenty of real ones there already.

Good Traders are Ethical

Most traders are ethical because they acknowledge and accept the carrot and stick
implicit in their job description. A good trader at an aggressive firm can make so much
money that there is no justifiable, logical reason for them to break the law or do
anything else that could jeopardize their extremely lucrative career. Being ethical is also
is good for their business. Once established, a trader’s reputation becomes well known
and difficult to shake. Behaving unethically eventually becomes extremely
counterproductive, and failure to honor a transaction or live up to the terms of a deal
will lead to an immediate cessation of business with the offending party. A trader cannot
expect to get better treatment in the market than she is willing to give, and in a fast-
paced environment the shoe will be on the other foot very quickly. Within the rules
rough play is allowed, however, and should be expected.

For those that, for some unknown reason, do not value the tremendous privilege their
position implies, there are substantial penalties for transgression, including severely
punitive fines and the very real threat of significant jail time.
18 Trader Construction Kit

Traits of Bad Traders

1. Not admitting that they are wrong.

2. Not taking responsibility for poor decisions.
3. Making the same mistakes again and again.
4. Trading too much.
5. Engaging in thrill-seeking behavior.
6. Making simple things complicated.
7. Ignoring their limitations.

Bad Traders Do Not Admit They Are Wrong

A trader holding a losing position faces a painful decision: suffer the losses in the short
term in the hopes that things get better and not worse, or exit the position and move on
to other opportunities. Some traders allow their ego to become part of the decision
making process, refusing to remove negative positions because they cannot accept
booking a loss. In other cases, particularly with an inexperienced trader, they may fear
that the losing position will be a referendum on their capabilities as a risk taker.
Regardless of the underlying reason, if the trader is unable to admit that a position is not
working and proactively rectify the situation, then he has stopped managing risk and has
become a passive spectator, riding the exposure wherever it may go.

Bad Traders Do Not Take Responsibility for Poor Decisions

This is a classic symptom of a weak, undisciplined trader. Every good trade is a product
of her unique and singular genius, planned with the calculating tactical brilliance of Sun
Tzu and executed with the effortless virtuosity of Paganini. Any losing trades are
obviously the fault of the stupid analyst, the stupider weatherman, the insipidly stupid
salesman, the buffoonishly stupid quant group, or the toxically stupid management, all
of whom are conspiring to bring down the One True Hero of the markets. This
distancing from any sort of negative outcome prevents productive self-critique and
impedes refinement of a trader’s technique and methodology.

Bad Traders Make the Same Mistakes Over And Over Again
Poker players refer to any persistent problem in their life or their game that causes them
to lose money as a leak. Visualize water leaking out of a hole in a bucket. Whenever a
trader says “I always lose money when I do this or that trade,” the obvious question is,
“Why do you keep doing it?” There are allowances for suboptimal performance when
learning a new market, instrument, affecting a stylistic change or implementing a new
methodology. Beyond some point, however, consistently unprofitable behavior cannot
be tolerated and the trader will have to revise his approach or cease activity. This can be
tremendously difficult, particularly for historically high achievers unaccustomed to
failure.
Chapter 1 - Know Yourself 19

Bad Traders Trade Too Much

It can be very frustrating for a trader to not be able to find any positions that seem worth
taking, particularly early in the year when all of her colleagues are off and running or late
in the year when they are desperately trying to meet a goal. If a trader cannot find
anything that meets the normally exacting criteria, the easiest remedy is to simply lower
the standards a bit and start re-considering previously discarded ideas. Eventually, with
a low enough hurdle to clear, something has to seem worth doing, even if it is a 50/50
coin flip or worse. “At least I’ve got a position! I’m in the game!”

Having tasted the sweet nectar of bad decision making, professional over-traders rarely
stop there. With newly lenient standards they become transactional dervishes, executing
every trade not patently awful, buying and selling and buying again with reckless
abandon.

Bad Traders Engage in Thrill-Seeking Trading

Overtrading is a good impulse warped by desperation and desire. Thrill-seeking trading
is a manifestation of boredom and an unhealthy, destructive attitude toward risk taking.
Thrill seekers trade to feel the rush, to be in the action, and are generally poor stewards
of the firm’s capital as a result.

Bad Traders Make Simple Things Complicated

A close cousin to both the desire to overtrade and a desire to not take responsibility for
losing positions is the tendency to take a bad position and, instead of cleanly exiting and
taking the pain, attempting to fix things by putting on some sort of semi-equivalent off-
setting trade to hedge the exposure. When the new trade inevitably exhibits some
unwelcome performance characteristics, the trader tacks on a third deal to correct that,
and a fourth to compensate for flaws in the third. The end result is a giant knot of
positions that wobbles inexplicably back and forth with every tremor in the market, but
that allows the trader to brag on any particular day that he has something that is
working.

Bad Traders Ignore Their Limitations

There is a saying: “a good trader can trade anything.” Given time to learn the structure
of a market, assimilate the applicable fundamentals, and discover the unique nuances,
any trader with a disciplined, rigorous methodology should have a better-than-even
chance of finding a way to be profitable. Many traders take the success they have worked
so hard to achieve in one market and simply assume that the underlying methodology is
universally applicable, without bothering to understand how the unique characteristics
of a different market will influence their approach. This is particularly common in
young traders who, caught up in the excitement of mastering a market assume that they
have mastered all markets. This can be a particularly expensive delusion.
20 Trader Construction Kit

There is a delicate balance. Traders must not unnecessarily limit themselves, but once a
limit or area of poor relative performance is identified, it must be respected.

The Middle Path

Every trader has strengths and weaknesses. Perversely, since it will take a while to work
through the manifold possible permutations of market events and trader responses, it is
possible to discover new and exciting inefficiencies well into one’s career. Technique
flaws break down into: easily correctable mistakes that can be remedied with critique
and advice (or more commonly, self-critique); persistent flaws that require analysis and
some re-programming; and deeply ingrained behavioral defects that will have to be
slowly massaged out in the long term (if that is even possible) and managed around in
the interim. Worse, new problems will crop up and old problems will re-emerge in
moments of weakness or inattention.

Every successful trader I have known has changed materially as he has progressed
through his career. Part of it is the obvious reactions to living a life under constant
pressure and the various tolls it takes, but part is the intentional and continual re-
programming that successful traders do to themselves in the name of surviving and
prospering. As soon as traders stop learning and evolving, they have started to decline
relative to their peers.

Traders can, and do, minutely dissect decision making and the personality factors that
influence it, which can be exceedingly creepy for the non-initiated. Weirder still are the
methods for “self-improvement.” When I became dissatisfied with what I felt was an
unacceptable latency in my decision-to-action timespan, I took up speed chess and spent
the next 18 months waging Internet death matches with fast-fingered teen-aged
prodigies until my reaction time to a cognitive input was whittled down to nil. Some
self-programming will involve a change of approach that, once validated, becomes
permanent. Other cases (like my speed chess example) are more akin to athletic training,
where the results will fade without continued practice. Becoming a better trader is both a
matter of heuristic and physical programming.

Stylistic Species of Traders

A trader’s personality will manifest itself as a variety of positive and negative traits, some
will need to be encouraged, and others repressed or eliminated. This balance of
behaviors will determine whether or not the individual will have any prolonged success
as a trader. Those same personality traits will also influence the methodology a trader
deploys and the style of trading she is naturally drawn to. There are some immutable
constants in any successful trading methodology: risk management, position control,
and stop-loss discipline. Around that rigid skeleton are areas where personality will
define the approach to the market and manifest as a natural preference for a
fundamental, technical, or quantitative style of market analysis.
Chapter 1 - Know Yourself 21

Adherence to a particular style is the initial differentiator between traders. An

individual’s style and choice of market view forms the foundation of the methodological
framework that shapes how he gathers data, distills it into actionable information via an
analytical process and evaluates and implements trading ideas.

Choosing a style is arguably the most critical part of any trader’s evolution. It cannot be
forced, because it has to suit the trader’s personality and strengths. There are three
principal styles of trading, fundamentally based, technically based, and quantitatively
based. Fundamental traders are facts people. Technical traders are sentiment people.
Quantitative traders are numbers people.

Fundamental traders examine the variables that affect supply and demand to attempt to
understand the market’s current price equilibrium, and then look for drivers that could
meaningfully alter that balance. Some markets require a heavily data-intensive approach,
which necessitates sophisticated collection, processing, and analytical functions. The
ability to render data into actionable information will be the limiting factor in a firm’s
ability to grow, as each new market will require an almost parallel build out of capacity.
Fundamental Analysis will be covered in detail in Chapter 3.

Technical traders believe that all fundamental information is instantly reflected in the
current price and attempt to analyze the short and long-term fluctuations as a window
into market psychology. Technical analysis is less about volume of data and unique
interpretation methodologies, and more about recognizing recurring patterns in the
market and making probabilistic trading judgments. One significant advantage of
technical analysis is the ability to survey many products at the same time, and translate
profitable methodologies from market to market. The principal weakness is a lack of
understanding of the underlying motivational factors. The trader sees what is
happening, but does not know why. Technical Analysis will be discussed in Chapter 4.

Quantitative traders build data-intensive models to derive an estimate of a product’s

“value” then seek to transact on any material divergences from that level, believing the
market will eventually arrive at the “correct” price. Systematic traders construct
elaborate computer models to derive transactional ideas from market data, in some cases
allowing the software agent to execute and manage positions in real time without human
involvement. Numerical methods of analyzing a market will be touched on in Chapter 3,
with quantitative trading methodologies explored in Chapter 11.

Hybrid Theory
There is a sort of person who prefers the intellectual purity of a methodology based
entirely on one style. This can be a valid, productive approach as long as the trader fully
understands the strengths and limitations inherent in the chosen methodology and has a
personality well matched to its requirements. I believe that there are tremendous
benefits to adopting a hybrid approach built around the simultaneous use of multiple
22 Trader Construction Kit

styles. Fusing disparate elements into an intellectually cohesive whole provides checks
and balances and adds reinforcing or clarifying analysis to ambiguous situations. The
challenge lies in weighing the informational inputs in a consistent fashion. It is all too
easy to overemphasize analysis that suits the trader’s current view or position while
ignoring dissenting warning signs.

Types of Trading Strategies

The trader may derive informational inputs from a fundamental, technical, or
quantitative source, or a combination thereof. The second major differentiator between
traders is the type(s) of strategies they choose to deploy, how they implement their view
in the market. There are a number of main thematic styles of trading, the most common
are directional trading, spread trading, option trading, and the utilization of quantitative
tools.

Directional Trading
Directional traders seek to profit by correctly forecasting the future price trajectory of an
instrument, then positioning themselves to capture the anticipated movement.
Directional trading is conceptually straightforward, but requires the greatest level of
discipline from the practitioner. Unlike other forms of risk taking, the directional trader
is tasked with controlling all of the operational parameters of the strategy. The main
advantage of a purely directional position is also its greatest drawback, the linear,
unmitigated exposure to the totality of market fluctuations and the myriad underlying
drivers. Sometimes called flat price or macro trading, directional trading is covered in
Chapter 8.

Spread Trading
Spread trading is a strategy that involves the purchase of one instrument and the sale of
another, a position designed to profit from either the convergence or divergence of the
initial price relationship over time. The trader is either betting on a correlation
breakdown, or the resumption of a traditional price relationship. Spread trades are very
popular as the long/short structure is, to an extent, self-hedging, protecting the trader
from overall directional market risk. Spread trading will be discussed in Chapter 9.

Option Strategies
Options are part of a larger family of products called derivatives because they derive
their price from another product, called the underlying security. As the price of the
underlying moves, the price of the derivative will change by a contractually specified
(but not necessarily equal) amount, and the rate of change can have either linear or non-
linear attributes. This subtlety adds significant complexity to the valuation of options
and other derivative securities, but also exponentially increases their utility as financial
engineering products. Strategies for pricing and trading options will be discussed in
Chapter 10.
Chapter 1 - Know Yourself 23

Quantitative Strategies
The requirements for productive participation in some extremely high-speed or
massively complex markets can exceed the capabilities of most, if not all, human traders,
leading them to develop machine-based tools and systems to compensate. There is a
tremendous range of applications, from simple data acquisition and manipulation tools
to sophisticated autonomous algorithmic agents designed to replace the human trader
entirely. Quantitative strategies will be explored in Chapter 11.

Structured Transactions
Structured transactions are the ne plus ultra of complexity in the trading business. They
are most commonly seen when an entity is trying to off-load a complex risk package in
one fell swoop, or when a financial intermediary is pitching a novel structure to a client.
Complex transactions are like risk onions, with many different layers that need to be
carefully peeled away, and if not handled properly will most surely lead to tears. Pricing
and hedging structured transactions will be covered in greater depth in Chapter 15.

Trading strategies are the wrenches, hammers, and screwdrivers in a trader’s

transactional toolkit. There is a right tool for each job, and there is a best strategy for the
trader’s position and market. The best traders are technically proficient with all of the
strategies, and will simultaneously evaluate flat price, spread, option, quantitative, and
structured solutions for every potential position they are considering.

Unfortunately, there is no pre-packaged personality test to determine what trading style

and approach to the market will best suit a neophyte trader. Inferences can, and should,
be made to try to narrow down the field of exploration, but at the end of the day the
student is going to have to expose herself to as many styles and types of trading as
possible in order to see what is interesting and what her rudimentary aptitudes are.

The TV Question Revisited

Recall the question at the start of the chapter:

A person has a television (TV) to sell. The seller thinks for a while, pondering its value,
and decides that the TV is worth $20.00. He makes a sign that says "TV For Sale -
$20.00," tapes it to the television, and wheels it down to the curb to sell. As he does, he
sees a neighbor pushing the exact same television down to the driveway with a sign
taped to it that says "TV For Sale - $10.00."

What should he do?

The Answer
He should buy the neighbor’s TV for $10.00, and then try to sell both for $20.00 each.
24 Trader Construction Kit

The Reason
The neighbor has underpriced her TV relative to its theoretical value, $20.00. To a
natural trader, this represents a potential $10.00 profit opportunity. Most people do not
intuitively differentiate the value proposition (the neighbor’s TV is too cheap, relative to
its value) from their goal of the moment (selling their own TV set). The most common
response is to remain fixated on the initial goal and either match the neighbor’s price or
attempt to undercut them.

I have asked The TV Question to a broad cross-section of my colleagues in the industry,

from fresh-faced trainees to the biggest swingers on the floor. The vast majority did not
get the answer. Without exception, however, all of the truly elite traders answered
correctly. Most responded instantly, reflexively, and with virtually no contemplation. It
was obvious to them. Many traders who got the question wrong were well-respected risk
takers in the midst of extremely productive careers, so it is not a predictor of absolute
success or failure. The TV Question seems to distinguish the naturals from the
(relatively) more pedestrian masses that are going to have to work harder to survive and
thrive.

Summary
Very few people naturally possess the combination of traits necessary to be a successful
trader. Evolving into a productive risk-taker is a process analogous to the cognitive re-
programming practiced by tight/aggressive poker players. A trader must be disciplined,
self-analytical, intellectually honest, rationally accept failure, have an ability to suffer and
to learn from mistakes, be driven, have a strong work ethic, and be positive, prepared
and ethical. Characteristics of weak traders and impediments to progress are an inability
to admit error and take responsibility for poor decisions, and a tendency to repeat the
same mistakes, over-trade, engage in thrill-seeking behavior, make simple things
complicated, and ignore limitations.

Traders must identify and play to their strengths, minimize their weaknesses, and
choose an analytical framework and trading strategies that complement them. A trader
may gravitate toward fundamental, technical, or quantitative methods or analyzing a
market, or choose to employ a combination of all three. They may elect to express their
view of the market with directional trades, spread positions, option structures, or
quantitative strategies.

Before they can begin to evaluate a market, traders must understand the entities that
make up the transactional ecosystem, which will be explored in Chapter 2.
Chapter 1 - Know Yourself 25

Resources

• Reminiscences of a Stock Operator by Edwin Lefèvre

• Every Hand Revealed by Gus Hansen
• Doyle Brunson’s Super System: A Course in Power Poker by Doyle Brunson and
Chip Reese
• The Biggest Game in Town by Al Alvarez
• The Psychology of Poker by Alan N. Schoonmaker
• The Theory of Poker: A Professional Poker Player Teaches You How To Think
Like One by David Sklansky