This is part of a series of future posts summarizing and analyzing key points made by traders interviewed in Market Wizards by Jack D. Schwager. Market Wizards is a collection of interviews with some of the world’s most successful traders and investors including Paul Tudor Jones, Michael Steinhardt, and Bruce Kovner. The book is widely recommended by traders and investment professionals and is included on the Sharpe Investing Recommended Reading List.

This first post focuses on a section about Larry Hite titled Respecting Risk. Managing risk is the key focus of Hite’s investment strategy. “We approach markets backwards. The first thing we ask is not what can we make, but how much can we lose. We play a defensive game.” His goal was to achieve the best returns within rigorous risk control limits. This could be analogous to having a volatility limit on a portfolio, where traders are forced to unwind positions if volatility exceeds a threshold for a given period.

Hite is considered one of the top 100 traders of the 20th century, and one of the fathers of systems trading. He established Mint Investment Management Company, and achieved an annual return of over 30% before fees for 13 years. Hite retired from active management in 1994 and currently is a managing director at Hite Capital Management LLC.

In Market Wizards, Hite, like many great traders, compares trading to poker. Profitable long term investing is really based on betting the odds, and if you can estimate the odds of a specific trade or investment, then you can know if the price is high or low. Similar to poker, favorable odds do not guarantee a favorable outcome in the short run, but in the long run trading based on favorable odds can be profitable.

Hite stresses three central trading rules. First, he advocates never risking more than one percent of total capital on one trade. This is an important element of risk control, and many talented traders stress not risking a larger percentage of capital on single trades.

His second rule is to always follow trends and never deviate from your methods or systems. This links back to the relationship between trading and poker. Losing money in the short run on a trade that will be profitable in the long run is still a good trade. You need to have the conviction though to trust your system or theory amidst short term losses.

Hite’s last rule is to diversify. He traded in multiple markets across the globe, diversifying his portfolio and reducing risk. Investing in multiple assets that are not correlated helps to reduce risk.

The star trader also provided insight about analyzing the effects of news on stocks. He suggested that if a stock responds to positive news with only a small increase in value, that may indicate the stock is nearing a top. In addition, when stocks reach new highs, investors should realize that there is a reason for this break out and follow the trend.

“There are two basic rules about winning in trading and life. One, if you don’t bet you can’t win. Two, if you lose all of your chips you can’t bet.”

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