only condition was that in the Interstate account everything was a 50 -50 split-profits, losses, expenses-as it was with all the trading accounts I managed for others. The performance numbers in Table P 1 from 1978 to 1986 represent my gross trading income before expenses on the Interstate account alone. I also had my own account, which was relatively small, plus one other, which was nearly as large as the Interstate account; so actually my production was almost double what is presented in Table P1.

The environment at Interstate could not have been better. I had the benefits of trading large siz e, but I didnt have to put up my own money unless I lost. The organization had an excellent information network, which was available at a cost minimized through the economies of scale. I was free to come and go as I pleased. I was able to save and secure my profits, while living the life-style that pleased me. I had found my freedom.

I was privileged to work among some of the best traders on Wall Street, including Frankie Joe, Howard Shapiro, and others. We all had different styles, and all but a few made considerable amounts of money. In observing many different traders, however, I began to see a different aspect of the business: the personal cost paid by those who worked at odds with their emotions. I saw some men at the top of their field who were fundamentally unhappy, and I wanted to know why. I wanted to understand what it took to attain success in the broadest sense of the term. The results of what I have leamed are contained in Part II.

The golden days at Interstate came to an end when the company w ent public and dissolved the trading department in September 1986. The reasoning was that trading profits were erratic on a quarterly basis, and Interstate was afraid that its stock would react negatively to erratic changes in eamings. I think it was a mistake. To my knowledge, the trading department made money every year. In one single year that I remember, just 10 of us grossed over $30 million, meaning that Interstate netted somewhere in the neighborhood of $15 million off 10 traders! Nevertheless, the decision was made, and it was time to move on.

I set up my own offices in October 1986 and traded actively until January 1988, when I decided to start a money management firm: Rand Management Corp., for which I am now trading again.

The Alligator Principle: Proof of the Need to Think in Essentials

When men abandon principles ... two of the major results are Individually, the inability to project the future; socially the impossibility of communication.

-Ayn Rand

BEING EATEN ALIVE

I have a trading rule I call the "Alligator Principle." Its based on the %Ma \ an alligator eats: the more the v ictim tries to ,tru(-,(-,Ie. the more the alliptor Let.. Imagine an alligator has you by the leg: it clamps sour leg in its mouth and %%ail, while you struggle. If you put one of fur arms in the x icinity of its mouth w hile fighting to get your leg free, it lunges and then has %our arm and lei= in [IN clutche*. The more you struggle, the more the alligator takes you in.

So if an alligator ever gets you b \ the leg. remember that \our ()set% chance is to sacrifice the leg and drag \ourself away Translated to market term., the principle is when You knot You tire wrong, close dour position Dont rationalize, hope. pray, or anything else, just get out.. . dont change your position, hedge it. or anything else; just take the loss and g et out!

Like a lot of things I knot, I leamed this principle the hard way. In the mid 1970s, I had a small options position in INA Insurance. I bought 2() December S25 calls for 1 1/4 (5125 per call). Shortly after buy ing them, the stock started to) down, and the options dropped first 4,s 1512.50 per call), then L.4 (S-25 per call i. M\ mle for options at the time tea, that if you lose a quarter, close out. But instead of taking my 5500 loss. I attempted to cover my loss b \ selling fit) of the December

$30 calls for 3/8. Of course, then the stock started to go back up on merger mmors. The December $30 calls I sold at 3% went to 1%, and the December $25 calls were at 2V2. So then what did I do? Why naturally, I sold 25 puts at 11/8 on the merger mmors! Then the merger mmors were denied and the puts went from 1 Ys to 08! Every step I took made the matter worse. That alligator had a full meal-I tumed a $500 dollar loss into a $6000 loss, all because I didnt maintain the discipline to apply prin ciples I knew to be correct.

You see, at the time INA was a lackluster stock; it wasnt traded heavily and didnt move much. When the price did move, it was pretty predictable. I felt that admitting that I had made a mistake on INA was like saying I didnt know the alphabet. I violated mle after mle and principle after principle, all out of "false pride"2 and vanity. Thinking back on it now, my behavior was nuts, but it nevertheless taught me a hard-eamed lesson: always think in essentials.

THINKING IN ESSENTIALS

Let me provide a little motivation by showing what thinking in essentials can do for you. On the moming of Friday, October 13,1989,1 awoke to a market that was ripe for correction. Before the market opened, I began calling my clients and the people I advise, telling them, in essence, the following:

Im looking for the market to go down in a major secondary correction. Since M arch 23. the market has been in a sustained primary upswing. Only 299c of primary swings in all bull markets in history have lasted longer. Moreover, the Transports have appreciated 52%c in the same period. By comparison, in the 92-year history of the Industrials average, of 174 upward movements in both bull and bear markets, only eight have appreciated more than 52%c before failing. The junk bond market is falling apartthere are no buyers. Further, the averages are down four days in a row from the new highs established in the Industrials on October 9, which were not confirmed by the Transports or by breadth-a definite bearish indication.

The continual upward movement in the averages and the general bullish atmosphere have been fueled by takeover and glamour stocks, while a large percentage of individual stocks have topped and are in an intermediate downtrend. The Japanese and Germans have raised interest rates; U.S. inflation is running at an annual rate of about 5.5% and the Fed has reduced Free Reserves ov er the last two reporting periods relative to the previous periods. I dont see any signs of the Fed easing in this atmosphere.

Consequently, Im building a short position in the market by buying index puts; relatively small now, but if the market sells off on high volume (around 170 million shares), breaking the 2752 level on the Dow (the August high), then it is time to go short aggressively.

In the early afternoon, the market was on the way down, but on moderate volume. I was buying puts at a moderate rate to build up my short position, expecting the market to continue to sell off into a correction the following week. I was keeping a close eye on volume. The news broke that financing for the United Air. had fallen through, and at about 2:45 PM., volume swelled, the S&P 500 Index futures started to plunge, and I began to buy puts as fast as I could. By a little after 3:00 P.m., I couldnt get any more orders executed-all hell had broken loose. The Industrials average closed down 191 points.

Monday morning I expected the market to open down about 50 points or so, and I had prepared a list of stocks and options to go long if this occurred. I put in orders to sell back my puts on the opening, and waited. The market opened down and sold off over 60 points in th e first two hours. I cashed in my short position and went long stocks and options. The short position cost approximately $73,605, and produced income of about $831,212, for a net profit of $757,607.1 remained long for several weeks, and cashed in another nice profit.

I had no way of knowing that the market would close down 191 points (Figure 2.1) -the second largest drop in history-on Friday the Thirteenth or that the catalyst would be the collapse of financing for the takeover of United Airlines. I was fortunate that the move was so large, but I wouldnt say that I was lucky to catch it. Every single analytical criterion that I use, including several that I havent mentioned, pointed to being postured for a correction; all the odds were in my favor.

I will explain, as the book goes on, each component of making this kind of market call. But if I had to reduce all the components of my methods to a single phrase, it would be thinking in essentials.

Its not necessarily how much you know, but the truth and qua lity of what you know that counts. Every week in Barrons there are dozens of pages of fine print summarizing the weeks activities in stocks, bonds, commodities, options, and so forth. There is so much information that to process all of it, and make sense out of it, is a task beyond any geniuss mental capacity.

One way to narrow down the data is to specialize in one or two areas. Another way is to use computers to do a lot of the sorting out for you. But no matter how you reduce the data, the key to processing information is the ability to abstract the essential information from the bounty of data produced each day.

To do this, you have to relate the information to principles-to fundamental concepts that define the nature of the financial markets. A principle is a broad generalization that describes an unlimited number of specific events and correlates vast amounts of data. It is with principles that you can take complex market data and make it relatively simple and manageable.

Take, for example, the simple statement "Savings is required for growth." Is this true? Is it a principle? On a common sense level, it seems self-evident that it is a principle. To buy a house, you need the money for the down payment; and to get the money for the down payment, you ha ve to save for it. On the other hand, Keynesian economists have been telling us for years that we can deficit-finance ourselves into prosperity; that saving actually discourages growth, and spending is the key to continued prosperity. Who is right? What is the principle involved?