Trader Vic Joins TradingMarkets 2008!

Victor "Trader Vic" Sperandeo will be one of the featured speakers at TradingMarkets 2008, a three-day conference with 21 of the best, most successful traders in the world. Author of Methods of a Wall Street Master and Principles of Professional Speculation, Sperandeo is a true "trader's trader" having been on the ground floor as the options market in the United States was born and being a pioneer in the trading of S&P 500 index futures. Some of Trader Vic's professional trading set-ups - such as his 2B indicator and 1-2-3 trend reversal - remain among the most popular and widely imitated set-ups among traders all over the world.

Sperandeo's TradingMarkets 2008 presentation, "The Secret to Trading Like a Professional," will include a number of Sperandeo's top trading set-ups, all geared toward helping traders accomplish that most difficult but most essential of tasks: to be a buyer in a world of sellers and a seller in a world of buyers. Professional traders have traded this way successfully for decades. At TradingMarkets 2008, Trader Vic will show you how professionals do it - even in markets as volatile as those we have seen over the past year.

Trader Vic's most recent book is Trader Vic: On Commodities and in this extended interview, first published this spring, the trader brings us up to speed on the work he has done in commodities analysis in recent years, particularly the Diversified Trend Indicator (DTI) which he developed and licensed to Standard and Poor's. In light of the tremendous run that commodities have had over the past few months - and as we approach the eve of TradingMarkets 2008 - we thought this might be an excellent time to reintroduce readers to one of the most widely followed traders of our time: Trader Vic Sperandeo.

Penn: Trader Vic, welcome to the Big Saturday Interview. Tell me what is different about the trader I am speaking with now and the trader thousands of aspiring speculators came to know through your books, "Methods of a Wall Street Master" and "Principles of Professional Speculation"?

Sperandeo: In the days of the methods books, in the 1970s and the 1980s, traders like me were purely skills based. We used to come in and take our positions, and you're either right or wrong.

There is no core return from that kind of style. You have to create the, if you will, returns, from pure skill.

Penn: And now?

Sperandeo: The difference in what I'm doing now is that it is more of a concept or strategy that is more portfolio-directed. It uses a core, let's say a portfolio concept of deriving returns. And then, in some cases, I enhance those returns with trading.

"The portfolio concept is what I really do today. I created a concept that flows off of a core rate of return."

Penn: What do you mean by a portfolio concept?

Sperandeo: Let's say you had a traditional mix of stocks and bonds, 60/40 maybe, or even, let's say 60/35 and 5% T-bills. You wouldn't have to do anything to that, and you would still make a return.

You would get a return on the stocks depending on the environment at the time. And the bonds would give you the coupon. And you have a core return. If you choose to pick some stocks that are better than others, then you get alpha (i.e., above market returns). And the S&P 500 would be your benchmark.

The portfolio concept is what I really do today because I'm not as young as I used to be. So I, basically, created a concept that flows off of a core rate of return. And then, in the case of my money management, I try to enhance the core returns.

So a big part of my returns are given to me instead of me having to earn every single dime of them. And that's really the difference. I won't call myself an old man yet, but it's an older man's strategy.

Penn: How does this work with commodities? You talk about the role of cyclicality in your book. Is commodities cyclicality where you derive your core returns from now?

Sperandeo: If you look at any charts, basically, what you'll see, predominantly speaking, is an up and down cycle. It's fundamentally built into what they are, commodities, by nature. Regardless of what may occur for certain periods, they will always go up and they will always go down.

I'll just make one example. Corn, which traded in 1930 at 80 a bushel, today is 5.60 a bushel, depending on which contract. And the return on corn over the period is 2-3-plus percent compounded.

Now if you started to look at corn in 1950, you would--1960, 1970 I should say, just to take the last 38 years, you'd find that corn now, basically, has a high of $5 and a low of $1.5. And basically it traded at $2.50 a bushel about 85% of the time each year. So within a year, it's going to trade at $2.50 a bushel. It has for the last 38 years, go back 40 if you like. What does that say? Corn goes up and corn goes down.

Penn: And this is true across the board? And what you base your trading on?

Sperandeo: All of the commodities have that scenario. You can't get away from the cyclicality. That's why it is a long/short strategy, which is the trading methodology, and the S&P DTI to take advantage of the nature of those commodities and the interest rates. In the DTI there are no stocks because stocks tend to be secular, and commodities are cyclical.

Penn: Could you talk a little more about what the S&P DTI is actually measuring then?

Sperandeo: It doesn't measure price--it measures trends. That's an interesting twist on things. Most indices measure prices. If the prices are up the index is higher. If prices are down, it's lower. This does not do that. This measures the extent and duration of trends. The greater the trend, up or down, the longer it goes up or down and the more returns are shown from the indicator.

If it doesn't go up or down, if it goes across the page, i.e. is stable, it doesn't have returns. It may lose in those environments. The point is that this measures trends.

"The S&P DTI is a very balanced combination of commodities and financial futures. Remember: anything that goes up and down goes in there."

Penn: What does the S&P DTI consist of? You said no stocks...

Sperandeo: It's a very balanced combination of commodities and financial futures--except stocks. It has currencies in it, which are a function of short-term interest rates, and other things, but primarily short-term interest rates. It has bonds in it, which basically are a function of interest rates that go up and down. Remember: anything that goes up and down goes in there. And anything that does not go up and down, generally speaking, is not in there.

So that's why no stocks. The combination of the two different asset classes, if you will, financial futures and commodities are mixed 50/50. And the reason they are mixed 50/50 is to give a certain stability to, let's call it the portfolio, for the moment. They are not correlated. One part of the portfolio is making money, the other one is not necessarily losing money. It could be making money but, generally, it makes less than it did the year before.

The S&P DTI is designed to be consistent, not to make large returns. It may make large returns, but it isn't designed that way. It's designed for consistency within 12 months.

Penn: Can you elaborate?

Sperandeo: Let's make believe oil was the whole DTI for this example, and oil went from $110 a barrel to $20 a barrel. Well, the DTI would double, right? So if oil did that in a straight line, if oil increased by 100% the DTI would reflect that. It would be up 100%. So the more oil goes up, the greater the returns are reflected in the S&P DTI.

If oil went up only 50 cents from $10, or 5 percent, well the DTI might actually break even, or lose. And if it went down it might get, in this example, it would get flat. And since there's no movement, it can't get long and it can't get short. Energy does not go short in the DTI, so that's a bad example, but you get the point.

Penn: So to the DTI as a whole, movement is key, regardless of direction.

Sperandeo: The point is, if something is not moving, if things are not volatile, if things are not going up and down, well, then the DTI is going to reflect that. There are no trends. And if something has a trend, and goes in a straight line up or down, and the DTI reflects that, then there is more money. So it measures the aggregate of trends, but not prices.

Let's take wheat. Let's say wheat goes from $10 a bushel--it's a little more than that, but just for this example - and it goes back to $2 in a pretty straight line. When I say "straight line", I mean a pretty steady, solid movement. Well, wheat declined 80% and the DTI, if wheat was all of DTI, the DTI would make 80%.

The Goldman Sachs Commodity Index would say if you held only wheat, it would lose 80%. So it doesn't have anything to do with prices because we go long and short. So going down a lot is a good thing, okay? Or going up a lot is a good thing for anybody that's a holder of the DTI.

Penn: How are the commodities within the S&P DTI weighted?

Sperandeo: The weightings of the commodities are based on production. And again, since it's all 50% of the pie, it's basically based on half of what the estimate of production is.

Let me dwell on this to make it clear. There are two major industries that did this work far more extensively than we can do it. And that is the Goldman Sachs Commodity Index and the Dow Jones AIG Commodity Index.

They measured the production of commodities to which ones have more weights than others. What we did when we constructed this is we said, look these two major firms know what they're doing. We'll go kind of in the middle of the two. This is not scientific. It's a back of the envelope concept. And we went in the middle of the two major long-holding commodity industries.

On the other side of the pie, the currency side of the pie, what we did was we took GDP of each of those countries, for example, the US represented the greatest GDP so it got the greatest at 15 percent. Now, again, these are not scientifically derived. They are designed logically to give more weight to the dollars and to this bigger GDP than the euro, which was second with the yen third. And then, the British pound, and so on.

Penn: You talked earlier of the DTI not being designed to make a lot of money. Instead, you have used the term "alpha consistency" as a superior goal. What is alpha consistency and why is its pursuit worthwhile for traders?

Sperandeo: Most commodity-oriented methods are trying to make a lot of money. And, like I say, the DTI is not built that way. It can make a decent amount of money--whatever you want to define that as. But it is not structured to make a lot of money. It is not leveraged, for example. It does things that most commodity programs don't do. For example, it rebalances monthly, and it takes away from the winners and gives to the losers.

"Commodities that go down are not going to go bankrupt. Corn can't go bankrupt, so if it goes down, it's going to come back up and vice versa."

Penn: How does that work?

Sperandeo: It takes away from the fact that if something is very, very strong and in an uptrend, we capture the profits of that monthly. And, therefore, what are we doing? We are going after consistency. You know that you can make the statement that at some point whatever goes up is going to come down. It's not going to be taken over. Commodities that go down are not going to go bankrupt. Corn can't go bankrupt, so if it goes down, it's going to come back up and vice versa.

That's what we try to capture, taking incremental profits away from the winners and giving it to the rest of the pie. And in doing that we roll our volatility, okay? That's another principle. That's actually one of the main principles, to keep the volatility low, is to not allow it to go up. The Goldman Sachs Commodity Index, for example, has approximately a 20 volatility. The DTI has a 6 volatility.

Penn: A third?

Sperandeo: One-third, right. Now the reason that it does is because it balances the sector weightings and has the financial sector in there, and because it takes away from the profits of the winners and gives it to the things that are down that are ready to come up. And it rebalances that pie, keeps the weightings the same and, therefore, you get this very low volatility, relatively speaking. It's a low volatility instrument that is gearing itself to make consistent returns.

*

Penn: Let's move back to the trading end of thingsFor somebody who is interested in that "pure skill" trading you talked about earlier, someone looking to trade individual futures, who was just starting out - where would you direct this person? How does someone start trading futures?

Sperandeo: Well, I mean the first thing we do is get some books that will help educate you. And if you,re saying how do you start, meaning getting some money to go ahead and do it, there's not a great deal required to trade futures and you can certainly start with a small amount of money, relatively speaking. Various firms have various minimums...

But if you were a young person and you really wanted to gain the best experience, you,d go down to the Loop in Chicago and you,d go to the floor of the Exchange and you,d apply for a job! You,d get a job on the floor and basically learn from that.

The greatest experience is definitely working on the floor. But, yes, you can open up a small account, read some books, and you can try the paper trading first. And then if you're successful on paper, then you could try real trading, which is a little bit of a different dimension.

"Systems have value because the problem, when it comes to money, whether it be in stocks or it be in commodities or anything, is that people are emotional."

Penn: Should new futures traders rely on systems or try discretionary methods and set-ups?

Sperandeo: Let me tell you why systems have a value. They have a value because the problem, when it comes to money, whether it be in stocks or it be in commodities or anything, is that people are emotional. And this is also the case when it comes to food. That's why people have such a hard time losing weight. And for the most part, it also has to do with sex. We just do the wrong thing sometimes.

Generally, when you're dealing with human beings, you have emotion that runs counter to logic. And one of the good things with systems is that they keep you grounded to discipline.

You know, intelligent people are losers (as traders) because they tend to be seldom wrong. So they tend to overstay their welcome if something is going against them because they,ve been right so many times in the past.

And like everybody else, they ride with the wind. If they,re making money, they,re happy, they sound like "oh, it,s good that it went up!" And if it goes down, it's bad. Well, that is the most novice mentality you can have in any kind of money management business.

Making money and losing money is really the same thing in this game. The key is that when you win, you should win more than when you lose. Losing is not bad. Losing big is bad.

Penn: And this is where having a system comes in?

Sperandeo: If it's designed properly, it's what keeps you out of losing lots of money. That's what hurts you in this business, losing peak money. You know the firms that blow up. There,s really only one major reason: that's leverage. That's the primary reason. But in order to lose with leverage, you've got to be wrong. So they should never lose a lot. If you,re using leverage, then you,ve got to take smaller losses, right?

But in general, systems are good because they can perform to execute disciplines. And that's kind of the bottom line of why systems work well in the commodity business, because people are tempted to take profits. You know the markets are up. I mean you hear this all over the place. Gold is high. Well, maybe it's high. It could be halfway to its goal.

By the way, there's a high correlation between gold and oil. Just for the record, if anybody wants to run the correlations, its about 85 to 90, which is almost like T-notes and T-bonds. A bit higher, but it's a very high correlation. So in order for gold to be like oil, gold would have to trade at about $1,600.

Penn: Good grief!

Sperandeo: So in some respects, it's not high at all. It's still got 50 percent to go. But most people will look at it and say, "gee, it's turning at 990, or 980, and it used to be $250 in the 1990s and now it's up here, so it's high." So now, what does the system do? It tells you, well, if the trend is up you're still long, depending on the trend-following process.

The S&P DTI has been a goal for quite some time. And it tells you not to worry about the price. You know, not making a decision of taking a profit because you think the price is high. So you see, that's where a methodology that is systematized is very helpful to most human beings because they get their emotions involved.

They want to take a profit. You know, it's kind of like: let me out! I made some money, now give it to me! So they let their emotions act subjectively within the context of the financial world.

"You need volatility because the more volatility, the more ability you have to capture middles."

Penn: How does a futures trader decide which instruments to trade?

Sperandeo: You basically need two things. We're talking trading. Not talking long-term investing. You need volatility because the more volatility, the more ability you have to capture middles. And then you need liquidity.

You,ve got to get in and out at a reasonable price when you want to buy and when you want to sell. So those are two things you start out with. You start out with liquidity and volatility. One or the other comes first. It doesn't matter, but you need both.

For example, palladium is volatile, but it has no liquidity. That's a bad thing to trade because it has very little liquidity.

Now gold is a very good thing to trade because it has a very respectable liquidity, and it has a degree of volatility. Silver is even better because silver is extremely volatile and it has the liquidity. Platinum is worse than gold. It's a little better than palladium because, again, is has a lot of volatility but very little liquidity. So that's how you determine the things to trade.

Penn: Once upon a time you spent many hours day-trading the S&P futures. Are the techniques you used then still valid now, in your opinion?

Sperandeo: Sure. Virtually everything is the same. It,s actually easer to trade today than it was in the mid-1980s because programs became a dominant feature of trading in the mid-1980s and that made day trading very hard. It changed the world.

In the 1980s and 1990s, day trading became difficult because the programs would dominate and you never knew where one was coming from. And you could be bullish for the right reasons and, all of a sudden, somebody would do a sell program and you would lose money. You could still do that today. It's just less prevalent than it was.

Penn: What were some of the techniques or strategies that you used when trading the S&P futures?

Sperandeo: Well, that would be a long drawn-out answer perhaps. I,d have to give some thought to that... I believe in my second book, in one of the last chapters, I really outline all the things I used to do, and I would only refer to that because there are so many different things that one has to see and do.

Penn: Maybe from a broader perspective?

Sperandeo: The most important is news of the day, because news affects short term price action a great deal. So these numbers that come out, any economic number that comes out affects the markets in the short run. Most of it is all noise and doesn't have any meaning to the intermediate trends or the long-term trends.

But the short-term trends are important. So someone would have to know what,s going on in the news, and know what the expectations are. For example, if the CPI (Consumer Price Index) core rate is expected to come out at .02 of a percent, and it comes out as .04, somebody has to realize that that,s a bad number, and it might indicate higher interest rates under normal conditions. And, therefore, tightening by the Fed, therefore the market sells off. And so, to be a short-term trader, you have to act very quickly and sell either short or your longs, as you will lose money.

"Texas Hold 'Em teaches you to fold a great deal of the time, and lose quickly, and lose small. And that's why it's a great teacher because, really, trading futures is like that as well."

Penn: You talk a lot about losing. The importance of losing and the ability to understand the implications of losing as a trader. You,ve compared it in the past to the lessons people can learn from playing games like Texas Hold 'Em...

Sperandeo: Well, the lives of the "trader"--as opposed to an investor--involve making many, many decisions. And naturally, the more decisions you make, you're going to be wrong a great deal of the time. That's because they're rather quick decisions and not analyzed as ably as, let's say, more important decisions you might make on bigger investments. So most people just don't like losing. And so it's hard for them to take a loss.

And in poker, Texas Hold 'Em in this example, teaches you to fold a great deal of the time, and lose quickly, and lose small. And that's why it's a great teacher because, really, trading futures is like that as well. You have to lose quickly, and small, many times.

If you are trading objects unto themselves, like the S&P futures, or you want to trade gold, or silver, or grains, you're focused on that group, if you will, or that object. And you know you,re going to be right and you're going to be wrong. And the quicker you realize, to get out of a bad position, the more professional you are and, also, the longer you'll be in business.

Penn: Certainly. And that's the game, on balance, that you have left behind in your pursuit and development of the S&P Diversified Trend Indicator.

Sperandeo: With the DTI, it,s just the nature that the base of the concept is very valid. It makes very conservative returns over time, and it completely throws out of the water the idea that commodities are a no-win game, a zero sum game, a volatile game, a game you can lose all your money in. I mean it completely throws that out because it's just a different way of using futures, if you will, and commodities, and getting in sort of an investment portfolio, rather than an aggressive trading picture.

Penn: Undoubtedly. Mr. Sperandeo, thank you very much for giving us some of your time this afternoon. It has been a pleasure speaking with you and learning about what you have been up to with the DTI and commodities over the years.

Sperandeo: Thank you. I appreciate your time as well.