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Live the Dream by Profitably Day Trading Stock Futures

S o how did you first become interested in trading?

In 1961, when I was 14 years old, I read How I Made Two Million Dollars in the Stock Market by Nicholas Darvas, and from the moment I finished that book, I said: "This is what I want to do. I want to trade." Actually, I had an entrepreneurial spirit even before I had read it.

How so?

By the time I was 12, I was buying and selling coins, because the coin market really took off back around 1959 and 1960. Those days you could still go to your local bank and go through rolls of nickels and pennies and find things that were valuable and then take them to a coin dealer and get paid more than face value.

So you understood the concept of buying low and selling high at a tender age?

Right. I think I was unfortunately swayed by the "easy money" appearance of trading coins. Then, when I read Darvas's book, I figured that looked like a better way to make a living than working your whole life. So during my high school years I followed the stock market and I continued wheeling and dealing in coins. I entered college and I bought my first stock.

What was it?

Chrysler. I took some of my profits from my coin collecting to do that. I continued to trade stocks while I was in school. That's basically how I got started.

So what did you do after college?

I was lined up to go to work at the investment trust division of a bank, but I was in the reserves - this was during the Vietnam War - and I was waiting to be called up. The bank didn't want to hire me until I had completed my reserves obligation. I waited a year to be called up, and then a recession hit around 1969 or 1970, so the bank didn't want me after I completed my reserves requirement.

What did you end up doing?

I ended up working for Sears. Even when I was in the reserves, though, I was trading stocks.

Were you making decisions based on fundamental analysis, or were you looking at technicals?

I was primarily momentum based. I would just find whatever was the hottest thing and go with that. I can't say I was extremely successful, even though I held my own. I was too much of a trader, because I didn't have the patience to ride anything. I would cut my profits, which was exactly what Darvas preached against. Another problem I had, which all traders seem to have, was that I was always undercapitalized. I was trying to get that one defining trade, and I never could.

You were trading individual equities then. Did you ultimately move on to the commodity markets?

Yes, I did. I started trading commodities in 1971, and I was attracted by the leverage. I was trading hogs and porkbellies. I really didn't trade with any defined trading plan. It was nothing quantifiable.

You were still pursuing the dream of trading for a living?

Yes. My whole life was geared toward making it in the market someday, and that hurt me in any other career aspirations because I just couldn't focus on anything but the markets. I did work in the early 1970s as a broker at Clayton, which was one of the largest brokerage firms at the time.

How long did you work for Clayton?

I left them around 1974 because the price of gold and silver started to explode, and I started going around buying silver coins. I did pretty well at that, but that was only for a four- or five-month period.

But you kept trading markets?

Yes, I started trading options. They didn't have the index options like on the OEX, but I was trading equity options on the CBOE. There would be times when I was extremely successful, but more likely than not I would end up back at breakeven. The entire 1970s ended up just being a period when I was always trying to build up my money. I would build it up, but then I would always go back to breakeven.

Is that before or after commissions?

I always managed to break even after paying commissions. Then, around 1978, I went to work as a part-time insurance investigator and transferred in 1980 to Reno, NV. For the first time, I had a significant job that paid well and I used the money from that job to fund my trading activities. But it was the same old story when it came to my trading; I never seemed to get anywhere until the spring of 1985. That's when everything changed for me.

What happened?

A lot of things happened. For one, I had losing years trading futures for 1983 and 1984. Then as 1985 began, I lost on 22 trades over a 25-trade period, which was just horrendous.

That must have been rough!

I hit bottom psychologically. For the first time I asked myself whether this was what I wanted to do. About the same time, I learned that I was going to be laid off from my job. That brought everything to a head, because I was using part of that income for trading futures. I realized I wasn't going to be doing that any more, so I knew something had to be done.

What did you do?

In late February and early March 1985, I spent about 100 hours analyzing all my trades over the previous two- to three-year period. I was trying to find out if there was some pattern that I was falling into that was causing me to lose. I was looking for psychological pitfalls as well as technical or fundamental pitfalls.

What did you discover?

I found out a number of things. I found out I was always trying to pick tops and bottoms. My stops were always

'way too close to the market. I was being unduly influenced by what I would read in The Wall Street Journal commodity section. I got too carried away by the excitement of the moment. I was too much of a crowd follower. So I started trying to correct all of those mistakes.

What did you do?

I didn't want to continue following the crowd. I started subscribing to the Market Vane newsletter, which tracks bullish and bearish sentiment for commodity markets. That helped me a little, but the big thing, and we wouldn't even be on the phone right now otherwise, is that in mid-March I made a trade in the cocoa market and the day I put on the trade, the Journal had a negative article about cocoa. Normally, when I'd see a negative article, I'd go short cocoa, but on that particular day cocoa had been building a base and was starting an uptrend, so that article caused cocoa to drop and I went long. I never could have done a thing like that before.

H ow did it turn out?

In that trade I made close to $1,500 in a matter of days. That was the defining trade for me. There have been many times I made more money, but that particular trade was very important. From that trade I said, "Okay, this is the beginning!" During the next two months, I made another $5,500. So I basically made $7,000 in two months and this was in an account that had had $2,200 in it before I made the cocoa trade. That was the best I had ever done trading

futures up to that point.

So it was onward and upward?

No, not quite. All of a sudden, disaster struck again and I lost on 33 out of 38 trades. Which is pretty bad, but my actual losses weren't more than $1,000, because the few winning trades I made were in the Standard & Poor's 500. That was a result of the other significant thing that happened to me in the spring of 1985.

And that was?

I had a four-minute phone conversation with an S&P pit trader after trading hours. He told me in essence that all they did in the pit was key off the intraday highs and lows. With that in mind, for the first time in my life, I started trying to develop my own methodology. From the advice he had given me, I did pretty well trading just the S&P and the New York composite futures. Now I've made money 11 straight years doing that.

What are some of the things that you look for?

Throughout the late 1980s, up until October 1990, I was successful but I never could really quantify why. I was basically looking at patterns, and the one pattern I was keying off of was when the S&P futures would make a low and then bounce off that low by X amount of points, I would go in and buy. I would want to see that the Dow Jones Industrial Average (DJIA) was up. I would call my broker maybe 10 times a day, and every hour I would get updates on what the DJIA was doing. So I was doing this without watching anything, just using the phone. I was looking for bounces off the lows coupled with a strong DJIA and preferably a strong transportation index. That sustained me through the late 1980s.

Anything else?

I was keying off of the OEX put-call ratio, which the CBOE updates every 30 minutes. I'd call them using an 800 number they had. I would always try to trade off of extreme divergence - like if everyone was buying puts, I would fade? that and go long and vice versa.

And you just traded one lot?

I decided in the spring of 1985 not to try to get rich overnight. That had been a problem with me throughout my trading career. I came into futures thinking that leverage was a great way to really get rich. I spent 14 years working with futures and then more than that with stocks and I hadn't really done anything significant, so I decided I would just try to grind out a profit month after month, regardless of whether it was $100, $1,000 or $2,000. I would only look to trade on the strong trending days. I would try to stay out on the choppy days.

So you waited for the good trades to come to you?

Yes, and I still do. I would only trade two to three times a week back in those days.

Let's talk more about the actual patterns.

What intrigued me about stock index futures, besides the fact that I seemed to have a knack for it, was that it was the only market that made sense to me. The pattern that I picked up on was when the market would make a low during the day and bounce off that low by a certain amount of ticks, then that was an indication that the low was set, meaning the market would not come back and make another low.

Did it work the same way in reverse?

Yes. If the market had made an intraday high and then sold off that high by a certain number of points, then that high was in and the market would not come back and make another high. Just knowing that gave me my edge. I could understand the market. It wasn't one of these things where it was always bouncing back and forth and not making any sense.

Did you quantify this pattern?

I did, because in August and September 1990, I had two losing months in a row and that hadn't happened in four or five years. That shook me up. Plus that year, before I had those two losing months in a row, I hadn't had that great of a year. I was making money, but not like I normally was. I realized I needed to quantify more of what I was doing.

Were you worried that the markets had changed and you hadn't, or were you worried that you had changed?

I was worried that I had changed. Throughout that year I had noticed a pattern that I'd never done much with, and the pattern was very simple. I noticed that after a certain time of the day, if you saw that the pattern was 180 points off of its intraday low, then it was time to buy. So in October 1990, I decided, for the first time in my life, to blindly follow a mechanical system.

H ow did that turn out?

In October, November and December, just trading one NYFE contract, I averaged $2,500 a month. Whenever the market was 180 points off its intraday low, after a certain time of the day, I would buy. That pattern worked pretty well for me through the end of 1990 and throughout 1991. I had some friends with computers test the pattern on a historical basis, and it turned out that you could really get hurt in a sideways or choppy market. But I took that pattern, and that led to my discovery that any time you saw the market making new highs during a specific period in the morning, that was a powerful pattern that would indicate that the rest of the day would be up. So I started keying off of that pattern (Figure 1). That's my basic pattern, but there are a lot of variations to it.

FIGURE 1: S&P 500 10-MINUTE BARS, MARCH 4, 1996.Smith wants to see the S&P making

new highs in the morning and the other market indices such as the DJIA making positive gains as well.

You mentioned that you had some friends do some testing with their computers. Is that because

you don't use computers?

I don't believe in them at all. I'm totally against using computers to trade.

Why?

When I was a broker in the early 1970s, literally nobody made money trading futures. I saw a lot of people make a lot of money in short periods, but they always gave it back. Back in those days, everybody was using charts. Because of that I became real cynical about using charts. Today, computers have taken the place of charts. Everybody's using computers to assist them in trading, and I think people rely on computers as a crutch. They don't want to do any thinking themselves.

S o what would you recommend?

I'm a tape reader. I've always been impressed with the floor traders in the pit. They don't use computers, and all they have in front of them is the last price and the high and low, and then above them they have a ticker tape where they have things like the DJIA and the tick index. So I try to pattern my trading after them.

Another well-known tape reader was Jesse Livermore. Have you read [the novel based on his life,] Reminiscences of a Stock Operator?

You know, I've read that book eight or nine times, but it seemed like the eight or nine times I read it were always during the periods I wasn't making money. Once I started making money, I vowed I'd never read that book again. I'm amazed how he's held in such high esteem even by the market wizards, because he basically manipulated the markets, and after the Securities Exchange Commission (SEC) was established in the early 1930s, he never was a success again.

The reason I asked is because some of your trading, buying into strength and selling into weakness, reminds me of some of his practices.

I try only to trade on the big trending days, and the big trending days usually start early. I've evolved into a tape reader, where I have a mechanical system at the base of what I do.

Can you give me an example?

Sure. For example, today my mechanical system lost $500 because in the morning it had everyone going long, but when my system kicked in, the DJIA was down 32 points, the tick index was -519, and there was no way in the world that I was going to go long under that scenario (Figure 2).

FIGURE 2: S&P 500 10-MINUTE BARS, FEBRUARY 20, 1996.In this example, the S&P was

making a new high in the morning, but both the S&P and the DJIA were still in negative territory.

What happened?

Pretty much what I thought. The market fell apart.

So the very weak opening was the beginning, not the end of the weakness?

The market opened down with a wide gap, and after it opened - I think limit down? - it dropped another 500 points.

A lot of traders operate under the assumption that the open is either near the high or the low of the day. By the mere fact that the market opened and then dropped 500 points, you knew that the open couldn't be the low of the day, so all that was left was for it to be the high of the day. So when my system kicked in, when the market traded above the open, I didn't think it would go up much further.

You've indicated that regardless of what your basic system tells you, there are other indicators that govern your trade. Can you tell me about those?

What distinguishes me from the average futures trader is that I don't look at the oscillators that futures traders usually look at, like the RSI?, stochastics? and the MACD?. I don't believe oscillators can help you. Instead, I look at the traditional indicators that the old tape readers who used to trade the stock market looked at.

Such as?

I look at the DJIA, the NASDAQ, the tick index, the intraday Arms index. I look at the transports and I look at the utilities. I look at divergences between the DJIA and the S&P futures. In The Outer Game of Trading, an S&P floor trader named Donald Sliter is interviewed. This guy trades 2,000-3,000 contracts a day. Koppel and Abell, the authors, asked this guy, "What would you say is your strategy when you are trading in the pit?" He said: "Understanding strength and weakness. It's very basic. I stick with it, and it works." So they asked him, "How do you understand strength and weakness?" He said: "I scalp to the short side if the futures are trading weak to the Dow. I scalp to the long side if the futures are trading strong to the Dow." So here's this guy who trades thousands

of contracts, and basically he's looking at the futures and the DJIA. With some variations and to some extent, that's what I do.

Let's look at these individually. Why is the tick index important to you?

If I'm going to be buying or selling, I want to see that strength or weakness confirmed with the tick index, which is the net difference between stocks that traded up on the last trade versus those that traded down on the last trade.

So it represents the waves of buying or waves of selling that are going on?

Yes. I just use that as a gauge of the overall strength or weakness of the market.

How positive a reading is typical of a strong market?

Well, that's where experience counts. I just want to see a plus sign. I don't ever want to see it below -250. Today it was -519 (Figure 3). I've never gone long when the tick index has been that negative.

FIGURE 3: S&P 500 10-MINUTE BARS, FEBRUARY 20, 1996, THE TICK INDEX.Another

of Smith's favorite indicators is the tick index. When the S&P made a new high in the morning, the tick index was

still in negative territory.

Y ou mentioned you look at the Arms index also?

The TRIN (trading index), or the intraday Arms index, measures the volume that's going into advancing stocks versus declining stocks. Today wasn't a good example, because when everything else looked terrible, it actually looked positive because IBM and a lot of technology stocks were strong today. That skewed the index.

If you don't use a computer, how do you get your information?

I use CNBC. On the bottom of the screen every 60 seconds are real-time quotes for the DJIA, the transports, the tick index, the TRIN, the NASDAQ, advances, declines and other indices. In addition, they give you the S&P cash and after that they give you the premium. You just add the premium to the cash and that's your nearby futures price, which is what I trade off of.

We've covered some of your patterns and your intraday work, but how about longer term?

My favorite indicator over all the years has been the public versus specialist short sales ratio. Every week in

Barron's, unfortunately with a two-week lag, the shorting activities of the public, the members and the specialists are listed. Starting in August 1994 and continuing up to right now, the public has been shorting at levels above the specialist. In my lifetime, and I'm sure if you go back historically as well, you'll never ever find that level of public shorting, where they short more than the specialist week after week.

Because normally, the specialists are shorting simply because their role as a market maker requires them to be short at times?

Right. There was even a couple of times this year where the public shorts were over the total member shorts, and that includes specialists plus the members. And that's happened something like three times in the last year and a quarter, and I don't think I've ever seen the public short above the members. If ever there was an explanation for what happened to this market in 1995, that was one of the key ones right there. In November 1995, I said there were some internal things in the market that were starting to break down, like the new highs and new lows, and we're going to put this indicator to the test because it's still calling for higher prices over the next several months. The market's gone up 800 points since the end of October and early November 1995.

What else do you like?

Also included in Barron's, under the NYSE member activity report, is my second favorite indicator, the member

off-floor balance index. It's a measure of the trading activity by all members of the NYSE, and there's always a net buy or sell figure. There's usually a historical bias toward net selling. Well, from September through December, the NYSE members went on one of their biggest buying sprees in the last 20 years, going back to 1975. As we saw in January and early February 1996, the market just skyrocketed. A lot of people don't pay attention to those two indicators because they think their effectiveness has been diminished because of all the options trading and derivatives trading, but it's something I still watch and it still has value if you know how to interpret it.

Have you always used the same indicators?

A problem that people have as traders or investors is that they're always looking for the perfect indicator. At any given time, there's an indicator that's always right on, but then that indicator will change to another one and that's where people get tripped up if they're not flexible enough to see what indicator is working.

How about an example?

Several months ago, the Commitments of Traders report gave its first major sell signal in several years when the commercials went net short. Several traders that I know swear by this indicator and went short. But they were blown out of the water because the market never blinked as the DJIA went up some 800 points. My point here is that these traders should not have overlooked the ultra-bullish public/specialist short sales ratio, the heavy net member buying volume, and also the heavy OEX put buying by the public during that time.

Traders and investors are always looking for the perfect indicator. At any given

time, there's an indicator that's always right on, but then that indicator will

change to another one and people get tripped up if they're not flexible enough to

see what indicator is working.

Hasn't the Commitments of Traders just given another sell signal?

Yes. When the CFTC reported the latest numbers last Friday, it showed that as of last Tuesday, the commercials were once again net short. Since Tuesday, the market has had four down days in a row. Coupling the negative commitments report with the recent extreme optimism by the advisory services, a lot of bears think they might finally get their long-awaited correction.

Of course, that goes counter to the public-specialist ratio.

Correct, because that indicator is as bullish as ever. So although I'm cautious right now, I can't get outright bearish because I have to respect the indicator that's been working the best the past year, and that's the public/specialist shorts ratio.

Your day trading has tended to be from the long side. What about shorting the market?

My mechanical system is basically a long system. I've spent a lot of time trying to quantify something on the short side. For a short, and I can count how many times I went short in 1995, probably about four or five times, I'm looking for a market that's making new lows around 9:20 to 9:45 am. I'm looking for a market that's 180 to 200 points off its intraday high. I have to have a negative tick and I have to have a TRIN that's 0.95 or higher. Those four patterns combined will get me short, but they've been few and far between in this bull market.

Especially in 1995, I'm sure.

Well, what was frustrating was that I finally figured out how to short the market in November and December 1995, and I had a lot of good short trades in November and December 1994. Once I figured that out, we had this great bull market and I didn't have much opportunity to refine it or anything.

Besides trading futures, you also look at mutual funds.

Yes. I never have and never will be able to trade more than one contract in the futures market. I've had professionals who bought my manuals ask me, "You've made money for 11 straight years, why haven't you increased your exposure to trading futures?"

Well, why haven't you?

I know my limitations. I'm very risk adverse. If I had a drawdown the day I increased my exposure to the futures market, I'd be scared so much psychologically I would never trade again.

So what have you done?

For 11 years, I've methodically withdrawn my futures trading profits and invested them into mutual funds and, especially, junk bond funds. As we speak, just 21/2% of my money is in the futures market and the rest of it is in junk bond funds and mutual funds. I like junk bonds because that's the only market I can actually put Nicholas Darvas's strategy to work.

What is his strategy?

His strategy is you go along with an upward trend, use a trailing stop and as the trend continues, you buy more, and when the trend reverses, you run like a thief. It's always been my dream to trade that way, but I'd never found anything conducive to that until I found junk bonds. Investing in junk bond funds I earned 30+% in 1991, 18% in 1992 and 21% in 1993. The upward trend in junk bond funds was halted in 1994 and I was taken out.

What takes you out of the trade?

As soon as there is a 3% drop in my junk bond funds, I get out. That occurred in February and March 1994 and the rest of the year was straight down. Then I got back into them in a big way in January 1995. Depending on the fund I was in, I made between 17% and 19%.

So you use futures trading to fund your investment plan?

I have used, and continue to use, futures as a tool to build up my wealth, because I am convinced that the only way to get wealthy is to do it long term in either stocks or junk bonds. A person can make a lot more money with patience than they can with brilliance.

So trading for living has worked for you, but-

I always dreamed of trading for a living and I finally have achieved that, but never in the way I had imagined. I always envisioned myself as one of these Jesse Livermore-tape reader types, but it's been very different. Here, I'm slowly building my capital by trading junk bond funds, which on an average day might only move up or down a penny. But achieving my goal of trading for a living would not have occurred if it hadn't been for this turning out the profits each month trading the stock index futures.

What about your mutual fund strategy?

I have several techniques for investing in mutual funds. My favorite technique is to review in early December the 20 no-load funds that have had the top year-to-date percentage gains. From that list, I look to buy a fund that's at the top of the performance rankings using a 12-week, four-week, and one-week review. I am looking for strong recent momentum with the hope that the momentum will continue during mid- and late December - that's normally a strong seasonal period - and into the first quarter of the next year, when new money comes into the market.

How has that strategy worked in 1996?

I went into Investco's Health Science Fund and made 4% in December 1995 and then another 6% through

mid-February. I'll remain in this fund as long as its upward momentum remains intact.

Clearly, your trading is based on you discovering who you are. What about someone just

getting started? What would you say to them?

I don't think I'm anyone special, but the problem is that most people just aren't cut out to be traders. It's something that has to be in you very early on. I know there are exceptions, but I don't think most people can come into trading, or even investing, in their 30s and 40s and promptly expect to be a success. That's just an opinion, but that's one thing I've observed.

Why do you think that is?

Where people really trip up is that trading is no different from being an athlete or a musician or an artist. There's a certain skill that you either have or don't have. No matter how much money you spend trying to learn how to trade or how much knowledge you try to gain, it's just not going to do you any good unless it's something you have inside you. So many people call me up and say they want to be full-time traders. And I say, "Why don't you just try to become a major league ballplayer instead?" It's the same type of thing. But people just don't want to hear that. What about people who buy mechanical systems?

I'm a very outspoken critic of mechanical trading systems. I think that a person needs to take a market, turn it inside out, learn all the psychological, technical and fundamental aspects of the market and go from there. I don't think you can just come into the S&P and start day trading it successfully unless you understand the stock market.

But your mechanical methods have tested out well.

It's ironic that all of a sudden a mechanical system from my book is one of the top-ranked mechanical systems as followed by Futures Truth. I've always thought that you don't just give your money to a broker and say, "Okay, trade this mechanical system." Life isn't that easy. But for the last year and two months, people have been trading my system, strictly mechanically, people who know nothing about trading. I'm sitting here watching these guys make money, and I'm watching them make trades I don't often take because I don't like the tape, and the trades turn out to be winning trades. So I'm having a crisis of confidence in some of my beliefs about mechanical trading systems.

What else don't you like about mechanical systems?

I have two major reasons I don't like mechanical trading systems. One is that psychologically, I can't live through drawdown, and every mechanical system has drawdowns.

You need some reason to go ahead and stop trading, even though the mechanical system rules say you're supposed to live through the drawdown.

Yes, and I can't do that. I've watched my own system perform so well, and there are times I start saying to myself, "Well, maybe I should just blindly start following this," and that way I don't have to spend all this time and effort trying to synthesize all these indicators.

What's the other major reason?

You shouldn't buy a method from anyone who doesn't provide you with their brokerage statements to document that they've used the system in real-time trading conditions.

Which you've provided.

That's right. I believe that if a vendor does the talk that he better darn well be able to do the walk by providing documented real-money statements for multi-year periods.

I don't think you can just come in and start day trading unless you understand the market.

Food for thought! Thanks for your time, Gary.