Trading the Tape- Another Example

I posted about this a number of weeks ago but want to resurrect it here:

Full story written by Imogen Rose-Smith and discovered on Timmay's site, it covers the story of Merritt Graves, a young hedge fund manager. I have pulled out some details pertinent to this topic...

"...The 23-year-old, who tracks nearly 100 trading positions on his phone’s Web browser, was monitoring the stock market, which by that time had been open for more than three hours.

This college student has an unlikely full-time job: He runs a $4.7 million long-short equity hedge fund.

In themselves, the numbers put up by Caelum Capital, as Graves’s five-person firm is known, are impressive. For a fund piloted by a kid who has no professional investment training and who only recently moved out of the dorms, they are uncanny. Last year, when the average equity hedge fund manager was down 26.4 percent, according to Chicago-based Hedge Fund Research, Graves was up 40.6 percent. In 2007 he returned 174.1 percent, after more than tripling his money the previous year — and nearly doubling it the year before that.

Graves called the subprime mortgage crisis and its impact as early as 2005. He also predicted the severe stresses that hit the banking sector in 2008.

As Caelum’s sole investment professional, Graves has achieved this remarkable record not by shooting for the moon but by maintaining tight risk controls. In addition to holding a diversified portfolio of 80 to 100 stocks, he limits each position to 0.5 to 8 percent of the total and won’t borrow more than 2-to-1 overnight. His fund’s net market exposure — his longs minus his shorts — has typically ranged from –30 percent to 30 percent of the portfolio’s total market value. As a result he has delivered far less volatility on the downside than either the Standard & Poor’s 500 index or the Nasdaq composite index, and his fund’s returns are relatively independent of both benchmarks.

“It has been a long road of constantly getting more disciplined,” says Graves, sounding more like a grizzled money manager than an undergrad who still eats in a college cafeteria.

Monitoring the markets while attending class is something that Graves has been doing since junior high school, when he learned formative lessons about risk. At age 14 he convinced his parents to help him open an account at discount brokerage Ameritrade — and twice lost all his savings from odd jobs as the technology bubble collapsed. In 2002, at age 17, he borrowed $7,000 from a local day trader he had befriended and lost it all again.
“It hurt so much worse losing someone else’s money,” recalls Graves.

After taking a year off from trading to study the markets, the then-teen summoned the courage to borrow another $7,000 from the same individual, who agreed to give him a shot at making up the prior loss in exchange for half of any additional trading profits.

It proved to be a smart bet. Within a year Graves had turned the $7,000 into $340,000, netting a personal profit of $100,000 after taxes. His winning streak continued as he began studies at the University of Iowa, spent a year abroad at Australian National University and took 12 months off to live in Berkeley, California, to focus on his trading before continuing his education at Pomona. During that three-and-a-half-year period, he turned the $100,000 into $2.8 million, which he used to seed Caelum Capital in October 2007.

Arguably Graves’s greatest strength, developed through trial and error, is his ability to interpret buy and sell signals from security-price movements — in short, to “read the tape,” a skill that is tough to teach and that he shares with hedge fund stars who are more than twice his age, like SAC Capital founder Steven Cohen and Paul Tudor Jones II of Tudor Investment Corp.

“Intuitively, I started to feel what the market was doing,” says Graves, reflecting on his evolution as a trader. “Things started to become more visceral.”
...Merritt Graves has always been entrepreneurial. In the fourth grade he baked cookies that he sold in the teacher’s lounge until the school district shut him down (he even had his own business cards printed up). Later he ran lawn-mowing and snow-shoveling businesses and earned money cutting down Christmas trees.

In eighth grade, while watching business network CNBC, he decided to invest his savings in the stock market, convincing his parents to open the Ameritrade account...

...“I thought investing looked cool,” he says.

It was the summer of 2000, and the dot-com boom was going bust. Graves had invested his entire $500 in savings in a handful of high-flying technology companies that ended up going bankrupt. He lost everything.

Undeterred, Graves raised a new $1,000 stake by flipping burgers and running a pressure-washing business. He bought more tech stocks. He lost everything again.

By then, Graves was attending Iowa City High School, where he was a popular and engaging student with wide-ranging interests. Daphne Foreman, his ninth-grade English teacher, says Graves especially enjoyed Fahrenheit 451 , Ray Bradbury’s portrayal of a dystopia where censorship rules, identifying with the free-thinking and insatiably curious Clarisse McClellan, one of the main characters.

“Merritt was obviously concerned about things most kids weren’t,” says Foreman. “He had a presence about him.”

During his sophomore year Graves raised $7,000 from Jeff Larson, a local day trader and entrepreneur he befriended who must have sensed something special in the teen (Larson did not return phone calls seeking comment). Graves used that money, along with $2,000 of his cash, to get back into the market, this time trading small- and microcap stocks.

The third time wasn’t the charm. That spring, Foreman says, Graves began looking more and more tired, missing school entirely some days. He lost everything again. “I advised him several times to back away,” says his father.

Instead, in his quiet, determined way, the younger Graves began to monitor the market rather than trade it, teaching himself to sense where stocks were moving by watching the tape. He read about investing and behavioral finance, and identified a major weakness in his trading: a tendency to double down on declining positions in an attempt to make his money back quickly and end the pain of losses.
By July 2003 Graves was ready to try again. With the second $7,000 stake from Larson, he focused his attention on stocks with larger market capitalizations."