Paul Tudor Jones - Billionaire Stock Trader
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In this review we look at another stock trading legend, Paul Tudor Jones.
Jones made the Forbes 400 rich list in 2020, increasing his wealth from 5 billion to 5.8 billion over the previous year. Also ranking at number 13 amongst the richest hedge fund managers in the world.
The Wall Street Journal also called him the most watched, most talked about man on Wall Street.
Known for being a contrarian type trader, we look at Jones’s philosophy of going against the crowd, and his path to becoming one of the richest men alive.
Jones was born in 1954 in Memphis, and later graduated from Virginia University in 1976 with a degree in economics.
Initially employed as a clerk on trading floors where he stayed for 4 years, Jones was later employed by the commodity broker Eli Tullis where he was mentored in the trading operations of the New York stock exchange.
In early 1980 Jones decided to start his own investment company called Tudor Investment Corporation. In the year 2017 the firm was estimated to be managing 17.7 billion worth of investments.
Throughout the years Jones has acquired a specific philosophy when it comes to trading stocks. Often referred to as a contrarian approach, he looks for the market to be at a turning point, whether that is a top turn or a bottom turn.
Paul Says;-
“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle, but I have made a lot of money at tops and bottoms”.
One of the key criteria Jones uses to ensure he’s on the right side of any turn, is the 200-day moving average. In fact he says:-
“My metric for everything I look at is the 200-day moving average of closing prices”.
In theory Jones is not looking for the highest or lowest point of a trend, he is really looking for a confirmed turning point. His confirmation of a turning point is the crossing of the 200-day moving average therefore avoiding the catch of what is often referred to as a falling knife.
It is important to distinguish between picking the high or low as apposed to a true market turn.
Many of you will rightly relate Jones’s trading philosophy to that of a swing trader, a similar concept we covered in a previous video.
Jones gained popularity when he predicted the stock market crash of 1987, also known as Black Monday.
The crash caused huge panic across the world markets, with indices falling more than 20% in a day.
Jones, however, knew that the 200-day moving average was a key indicator, and price crossing the line would signal a falling market. He not only sold his positions but shorted the market. In the process his fund grew by almost 200% that year whilst others lost fortunes.
From a technical standpoint, we could have seen this crash earlier than using the 200-day moving average alone. For example, in April we seen the same double top as September.
We also seen the same bounce 2 weeks later.
This followed another bounce causing a double bottom over both periods.
Both periods then seen another bounce, followed by a decline.
At this point both technical patterns looked almost identical. Although in May we had a confirmed 3rd bottom, followed by a considerable recovery.
In October however the price attempted to bounce, but failed, falling below the support line. The rest is history.
The ideal time to short the market would have been at this break, with a stop loss placed above the failed bounce.
The eventual risk reward on such a set up would have been considerable.
Risk reward is another highly regarded rule which Jones not only applies but teaches to students at the University of Virginia.
Jones looks for a minimum risk to reward ratio of 5 to 1.
Therefore, he is willing to risk 1 dollar to make 5 dollars.
Applying this concept means you can be wrong 80% of the time without losing any capital.
Let’s put this concept into a diagram to better understand the theory.
Here we have price, and here time. It is important to note that the concept applies to any timeframe.
We decide to buy a stock at $10, and we are willing to accept a 10% loss per unit. This provides the $1 dollar risk per unit.
As time progresses the stock price could either rise, or fall.
Remember the adage of cut your losers short and let your winners run? This concept forces that highly important discipline.
Jones says;
“If I have positions going against me, I get right out, if they are going for me, I keep them. Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in”.
Applying Jones’s risk reward concept and combining it with the 200-day moving average rule is fundamental to his method.
Let’s apply this method to the market crash we seen starting in February this year.
Here we have the 200-day moving average line.
At the end of February, price crossed and closed below the line, and in theory Jones would have sold his positions.
The following few days seen a failed bounce above the line, and its possible Jones would have seen the close of price on the 5th day, as an opportunity to short the market.
Like the previous chart, a stop loss could have been placed here just above the tail of the previous candles. Again, creating a great risk reward opportunity whilst others seen their buy and hold accounts plummet.
Here we can see 10 of the previous major market crashes, from 1969 to 2009, ranging from drawdowns of over 20% to a huge 72%. But how would the 200-day moving average rule that Jones applies, impact these drawdowns? Let’s take a look.
I managed to find a snippet supplied by Bloomberg covering 6 of the previous market drawdowns.
The red bars show the total drawdown for each given period, and the orange bars show the drawdowns prior to price dropping below the 200-day moving average line.
The average maximum drawdown for each of these crashes equates to just over 35%.
By applying the 200-day moving average rule, the average drawdown for the same period equates to just over 6%.
Clearly (although only part of the equation) the 200 day rule is very effective in regard to risk control, another aspect Jones holds in high regard, and he says:-
“I'm always thinking about losing money as opposed to making money. Don't focus on making money, focus on protecting what you have”.
Jones is an exceptional risk manager and points to a simple indicator to judge if you’re risking too much, he says he never wants to be in a position where he is scared to open his account and find huge losses, if you have this feeling, you need to tighten your risk management.
Again, entering a trade with a risk reward approach, and combining with the 200-day moving average rule, is fundamental to Jones’s method, and should, by default support with managing risk.
It was interesting to read that Jones first took an interest in trading when he read an article from Richard Dennis. Dennis is widely known for the Turtle ‘Trend following’ Strategy which we covered in a previous video. There are certainly elements of Jones’s strategy which align to that of the Turtles, and trend following is clearly one of them. In fact, Jones said to his students; -
“You don’t need to go to business school; you’ve only got to remember two things. The first is, you always want to be with whatever the predominant trend is”.
His second piece of advice was again the risk reward approach.
Jones’s use of the phrase ‘predominant trend’ is also important. We know he refers to himself as a contrarian trader who looks for a turn in the market, but the turn must be in line with the overall trend. We can interpret this to be what is commonly called a pull back.
At this stage we can put all the pieces of Jones’s philosophy together.
We have the overall ‘predominant trend’.
A pull back within the trend.
Price above the 200-day moving average. This could be price crossing above or remaining above the moving average line.
And again, his risk reward approach. To which Jones says: -
“I look for opportunities with tremendously skewed reward-risk opportunities. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship in your favour”.
All in all, a rather simple philosophy of cutting losses and staying with the trend.
A young Jones was asked a profound question by his tutor Eli Tullis, which influenced his trading to this day, he said; -
“The markets will be there in 30 years, but the question is will you be?”
The message reinforced Jones’s capital preservation stance and resulted in him taking advantage of the many market trends over the years.
A great book from a true stock trading legend.
Thanks for listening.
Financial Wisdom
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