MARTIN SCHWARTZ | PIT BULL | Lessons from Wall Streets Champion Trader.
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In this review we look at the book Pit Bull from champion trader Martin Schwartz.
Schwartz, a former marine corps captain, is a Wall street stock trader who made a fortune during his career. He also gained popularity when he won the US investing Championship in 1984, more than ten years prior to the likes of Mark Minervini.
We uncover the key lessons provided from a professional trader who is famously known for turning a $40,000 account into over $20 Million, without realising a drawdown of more than 3% in any given month, super performance to say the least…
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Schwartz refers to Newtons law in which an object in motion will stay in motion.
He says a stock that is going up in direction is likely to continue going up, and each new high is therefore often the best place to enter a long position. Amateurs on the other hand try to call tops and bottoms counter to the ongoing trend, often leading to disappointment.
A clear advocate of trend following, but Schwartz warns of over confidence when benefiting from a seemingly never-ending trend, and says;
“My biggest losses have always followed my largest profits.”
But Schwartz’s views leave us with the question of how do we know when to enter and exit a trend? And how do we know if we are being overconfident whilst increasing the likelihood of a large loss occurring.
The first rule I found is what Schwartz referred to as the Red Light Green Light indicator. He says it is his favourite indicator to determine a trend.
The theory is based on a 10 period EMA, which stands for Exponential Moving Average. The EMA tracks price over a set period and gives more weighting to the most recent price movements, unlike the SMA, or Simple Moving Average which gives an equal weighting to all price points.
Schwartz looks for bullish opportunities to buy or go long a position when price is above the 10 period EMA, or sell, even going short a position when price is below the 10 period EMA, indicating a bearish environment or red light.
Schwartz says; “My moving averages are the key to being on the right side of the trade”.
Schwartz by his own admission is a short-term trader and a trade lasting as much as a week would be considered long term. In fact, he says he is often in and out of a trade in five minutes and never usually in a trade for more than a couple of hours.
The methodology used by Schwartz requires markets with plenty of liquidity accompanied by considerable volatility. The footprints left by this price volatility can leave clues for high probability entries. For example, Schwartz would draw support and resistance lines like the ones shown here, these often also confirm the overall trend of the timeframe in question.
His philosophy is to buy strong stocks showing temporary weakness, much like a rubber band having to snap back, sometimes the price is slack and sometimes it is over stretched.
Buying at a time when price is slack, at a support level, above the 10-day EMA, and in a general upward trend, puts the odds of success in Schwartz’s favour. When all his criteria were met, he would load up with huge amounts of capital, sometimes only looking for a one or two point move.
Schwartz refers to his method as a high probability low risk concept. The low risk aspect comes from using tight stop losses, which if triggered would indicate a break in support and a lower probability of success. In such a situation he would want to be out of the trade at the earliest opportunity, with any loss of capital limited to the stop loss.
Stop losses are paramount to Schwartz’s method and he is repetitive throughout as to their importance, and says:-
“Being able to honour your stops is what separates the top dogs from the mongrels on Wall Street”.
Another tactic Schwartz uses is gap trading, and he presents an example in his book which we can see here.
This example is called a continuation gap, a continuation gap is determined by the increasing trend prior to the gap occurring, it is a bullish signal, but Schwartz warns that a trade should only be considered if the price remains above the gap for three consecutive days.
The other gaps Schwartz refers to are the breakaway gap and the exhaustion gap.
The breakaway gap is considered the most bullish and occurs from a base.
The exhaustion gap shows up at the end of a move and is a signal that prices are likely to reverse thereafter.
Schwartz says any of these gaps can be a very good source of trading ideas.
Another interesting tool Schwartz uses when making a trading decision is the historical performance of a given calendar period. He regularly refers to the ‘Traders Almanac’, which provides data on the distribution of returns.
As an example, here we can see the average performance for each month over the past 20 years.
We can see September has historically given the worst average performance of minus 0.8%, whereas April has provided the best average return of 1.7%, and so on.
Although Schwartz’s trade decision is not based on this data, it does impact on his appetite for risk in a specific period.
Schwartz also digs deeper by looking at returns for specific days of the year, again these stats are included in the Trader’s Almanac, it is a useful tool and I’ll try to add a link below for those interested.
Another interesting concept Schwartz refers to is the Magic T theory, which he said was key to his methodology.
Named the T due to its shape and the equal distance on the left and right side.
Created by Terrence Laundry, the theory suggests that if the market has for example spent 6 months underperforming then it is likely the market will spend the next 6 months outperforming.
The theory can be used against any timeframe.
Here we can see an example of a longer-term T theory based on the Dow Jones index between 1910 and 1990.
Using the most recent T we can see a 16-year period of subnormal returns followed by a near 16-year period of superior performance.
It’s certainly an interesting concept worth further research, and if a trader of Schwartz’s calibre puts the concept at the core of his methodology, it’s worth considering.
He went on to say :-
“With the Magic T, there was order in the universe, a high and low tide every twelve hours. The Magic T and I became as one”.
A clear character trait is evident through the thoughts of Schwartz, he is detached from any ego, from any need to be right, and is far more focused on not losing money than anything else. Many traders have this in reverse, they have a desire to be right at all costs.
Schwartz says ;-
“Most people think that they are playing against the market, but the market doesn’t care. You’re really playing against yourself. You have to stop trying to will things to happen in order to prove that you’re right”.
Ultimately, Schwartz combines the right mentality with specific criteria to put the odds of success in his favour.
Remember, you are not a victim, you have the keys to control the many variables available to make a specific trading decision. You are accountable, the only aspect you cannot control is the outcome of the trade.
Embracing the mindset of accepting full responsibility has been the platform of Schwartz ultimate success.
If you are looking for a specific strategy to apply to the markets, the book may not be for you, but if you are looking for inspiration, ideas, or sound philosophies to make your own, this is a great read.
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