Our next guest was a philosophy major and a magician before he ever considered trading in the stock market. In Part 1 of our talk, he describes how philosophy and psychology determine his firm’s decisions and the story of how he started trading in a small town in Pennsylvania.

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In This Episode, You’ll Learn:

• On the 20th Anniversary of Scott’s firm, he looks back on how it all started.
• Scott’s life as a magician and how the principals of magic influences his perspective on trading and the market.
• How he became a philosophy major and how he applies philosophy to trading and everything his firm does.
• How he started trading in the market, getting a group of his college friends to take out cash advances on their credit cards and investing it.
• The Austrian perspective on economics that his college was well known for.
• How he educated himself in futures trading and invested long before he ever met another trader.
• Scott’s initial lessons learned from trading in the stock market; how he lost almost all of his capital in one day and had the first sleepless night of his life.
• How he made the mistake of investing in coffee and cocoa in the late 1980s and what he learned from that experience.
• How he started his first firm in 1989.
• How Scott traded while living in rural Western Pennsylvania.
• How a philosophy major with no connections to the financial world used his network to find a mentor.
• The story of Scott becoming a principal at one of the biggest short-term CTAs in the world.
• The story of Dominion Capital Management, which he started in 1994 by moving to Chicago.
• Why he is based in Traverse City, Michigan.
• How his firm is a bit different and why they don’t have any mathematicians or scientists on their team.

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Resources & Links Mentioned in this Episode:

• Learn about the Square of Opposition that Scott explains in the episode.
• In Scott’s first job at a firm, the company hired people belonging to Mensa.
• Learn about how trading was conducted and firms operated before the use of personal computers and the Internet. Scott’s firm had a VAX computer.

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

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Niels

Welcome to another episode of Top Traders Unplugged. Thanks so much for tuning in today. I know how valuable your time is, so I appreciate you spending some of it here with me. On today's show I'm talking to Scott Foster, Founder and President of Dominion Capital Management. Scott is the first person that I've come across who managed to combine elements from philosophy, psychology, and magic into a disciplined trading strategy which focuses on find the universal truth in human behavior and apply then successfully in the financial markets. This is truly and educational journey which keeps surprising right to the end. For those of you who are new to the show, I just want to let you know that you can find all of the show notes including a full transcript of today's episode on the TOPTRADERSUNPLUGGED. COM website. Now let's get started with part 1 of my conversation. I hope you will enjoy it.

Scott, thank you so much for being with us today. It's great to have you here.

Scott

It's good to talk with you Niels.

Niels

Fantastic. Now the first thing I noticed in preparing for our conversation today is, in fact, that you're celebrating your 20th anniversary as a firm. Let me start by congratulating you on a very big milestone in a business where only a few firms can say that they have successfully been navigating the financial markets for 2 decades.

Scott

Thank you. I didn't think we'd make it at times.

Niels

No, exactly (laugh). Now I know that behavioral finance has become a bit of a buzz word these days and that it draws on philosophical and psychological elements. My understanding is that these things probably did not come to you as theory, but more as a natural element in your upbringing as a child, since your father, if I'm not mistaking, taught philosophy. I assume that this is where you got your initial inspiration or curiosity in life to pursue something that, in a sense has become a very important part of your journey and the way you approach trading and life in general. So, I'd love to hear much more about this as it's not a common background, I think, of a successful trader and fund manager. If we didn't just throw the fact that you are also a magician into the mix, I think we have the ingredients of a fascinating conversation and I guess it goes to show that many different paths and approaches can be used when it comes to navigating the financial markets. Before we get into all of the details about the company today, I would love for you to take us all the way back and really telling us your story, and what led you to take this path. Feel free to go back as far as you want, as it's really about getting to know what led you down this road in the first place.

Scott

Alright, well, probably the best place to start is when I was entering college and my interests were in computers at the time, and I entered college as a computer major; actually double major - computer and prelaw. My mother wanted me to be a lawyer. I was fascinated by computers. Around the clock, I would be on my Radio Shack computer on bulletin boards, doing some hacking, programming, that kind of stuff. I kind of fell in love with programming because I had been taught symbolic logic at a young age from my father who was a professor of not only philosophy but logic. After I got into college, I ran into a few problems. I found that college administrators don't really take too kindly to hacking, so I decided it might be better if I switched my major and having the familiarity that I did with philosophy, I felt very comfortable with that, and I ended up jumping in and studying philosophy and also a lot of psychology.

It never would have ever occurred to me that I would end up managing money. It was not in the cards, or at least I didn't think it was. I was planning to become a professor, like my father, and teach, write books and read books and all that kind of fun stuff. Along the way, I got involved with (someone) who now is my wife, and she was a few years behind me. So I had to figure out how we were going to coordinate getting married and moving on when there was a spread there, so I decided that I would not go on to graduate school. I would stay at the college where we were and work there for 2 years until she finished her undergraduate degree, and then we would move on. During that timeperiod that would give me a little bit of time also to make a little bit of money to pay for graduate school. My father, being an academic his whole life, he also was quite an entrepreneur and an investor, and he did much better as an investor both in real estate and in equities, and as an entrepreneur running a delicatessen and some other things. He made most of his money outside of the academic world. It occurred to me that maybe I could do the same thing. I could make some money to help pay for graduate school and get myself started with the new family and that type of thing, so I had investments. I had been interested in investments.

Niels

So you do learn something in school I guess (laugh).

Scott

I'd recently finished school, and I didn't have any money.I just had some of the money that was left over from my investments, so I took that money and then I went to my friends and said, you guys saw what happened with these other guys on campus and they made a lot of money, how about we pull some of our money together and I'll trade it for us. They said, we're all paying for our college, we don't have any money either. I said, well you have credit cards, right? Everybody got credit cards while they were in school. Take a cash advance off of your credit card. Well, at 29.9% six or seven of us all took the maximum amounts we could off all of the credit cards that we had accumulated while in college and we were able to pool together about $20,000, which seemed like a staggering sum. Now knowing what I know about how compound interest can work against you at 29.9% on money that you are speculating with it's probably not necessarily the best way to go. But it didn't stop us.

We opened an account, and I started trading and applying a wide variety of strategies - stuff that I read. Everything that I read I would try. I was day trading. I was trading some spreads relative to...some crazy different spreads and currencies and the 1st week I made $10,000, and thought WOW, this is great. The 2nd week I made another $10,000. The 3rd week I made another $10,000. The 4th week I made about $15,000, and I'm already thinking I'm about 6 months away from retirement here. This is awesome. Everything was just going well. I remember I got a meeting with the guys and we all got together and I said look here, we're going to start upping the leverage once we get to about $200,000 and already targeting when we're going to get to the million dollar level. Everybody's eyes are wide and you just can't even imagine how pumped up we were. Then over the next few days I got involved in the coffee market. I learned later there's a very good trading maxim that says, you should never trade anything that you can eat for breakfast. That means you probably ought to avoid coffee, cocoa, pork bellies, eggs (I guess pork bellies and eggs aren't around anymore). These markets are very, very difficult and erratic, and they're very closed and very specific. They can be traded, but they often surprise novice traders on how they trade.

So the market was rallying, and I'm reading any new stories that I can get and I'm trying to figure out...I've been tracking a lot of commodities for almost a year trying to understand their nature and their historic price ranges. Coffee had a spike up, and I thought the coffee fundamentals that I'd been reading for the last 6 months were bearish and the spike was on a rumor that there was going to be a Brazilian dock workers strike. Everything that I could tell, from what I read was that it was illegal for them to strike. The government actually has to give them permission to strike, or something along those lines and they had said that they would not do that. So I decided to go short the coffee market. I can't remember how many contracts I went, but I know it was the most that I could do with the margin that I had available, which was another money management lesson I was to learn. It was not good. I think I also did some cocoa too that rallied in sympathy, but mostly it was coffee.

It's so difficult to get information back then in trying to call up the brokerage and order the news stories and see what's going on and so forth. I was finally able to dig up a few news stories later in the day that were talking about what had happened. What had happened is apparently the government gave the Brazilian dock workers a right to strike and so they were projecting that coffee was going to go so much higher in London. I did the conversion and I tried to figure out where that price was that they were projecting and I turned like six shades of green, because it's not only going to cost me more money, it's going to wipe out the entire rest of the trading account and go deficit. So literally, in a span of 48 hours I'm on top of the world thinking I'm the next Paul Tudor Jones, I am the answer to trading; and then I practically can't breathe, and I'm thinking my friends are going to kill me. I'm going to have to go to family members to bail me out. Why didn't we pay some of the money back to the credit card company after we doubled the profits? I was questioning everything.

Up to that day I don't think I'd ever had a sleepless night in my life. When I was in college, I never pulled all-nighters to study. I wasn't that engaged to do that. Being a philosophy major, when you grow up in that world you know the material, so you don't have to worry too much about that. I had a sleepless night. I literally stared at the ceiling and listened to my heart just race and thinking what am I going to do? I have just destroyed my entire life. I'm never going to recover from this. Well, the next day I get ready for the coffee open. Fortunately, it doesn't open in the US as high as it had opened in London. It had already opened and sold off a bit in London, but it was still a nasty gap higher, and it ended up wiping out everything in the account except for about $10,000. I had run the account to $60,000, $65,000, something like that. It wiped out everything except for $10,000.

So I had to then get on the phone and call the other guys who had so graciously advance money off their credit cards to me in waiting for the checks to come in the mail. I thought they were going to kill me. These were good friends of mine; they were OK about it. They said you still have $10,000 in the account. You took $20,000, and you ran it up. Just take that money and run it up. I thought, yeah. I can do that. I just won't trade coffee anymore. So I did. After a couple of days to get my head together, I went back to the drawing board and began to look at the trades I'd been analyzing and a lot of the trades I was doing at the time aside from outrights. I was doing a lot of spread relationships. They made sense to me. I could understand more relative value than I could absolute. That seemed to be a lot more predictable. Whether you are trading hogs against cattle, or feed against the cattle, or cotton against soybeans, where back in the day they actually competed for their planting, which they really don't anymore, and currencies against each other, and a lot of that type of stuff - crack spreads - so I found a spread that was at an historical extreme in wheat - it was a May-December wheat spread. So I worked my way into that position, and I ended up being correct, and I tripled the account size and I knew from that point on I was never going to make it to graduate school. I was hooked. This was the greatest thing since sliced bread.

Unfortunately, I could pick some decent trades, but I knew nothing about money management. Obviously you could tell from the coffee trade. So I managed to put myself in multiple difficult situations. I think the next month after that. After I recovered and then built the account up some more I found another spread that I thought...I wasn't just doing spreads; I was trading around stuff, buying a few currencies here and there, day trading in and out, and doing a lot of things. I'd build these big positions on spreads when I really got a conviction, because I really felt that they were going to revert back. I got involved in a copper spread - a May-December copper spread - that was at a huge extreme. The front month was trading around $.14, $.15 cents over the December, which at that point was out there. The all-time historical extreme at that point was $.17 or $.18 or something like that. I was trying to build a position expecting it to go to contango and have this thing go all the way back to where the December would have been premium to the May. I was building a position, and it went $.06, or $.07 in my direction, and I thought, oh this is great. I'm going to pyramid this.

So I put some more on and then it started to go against me, which then I was losing money at double the speed because of my brilliance of increasing the position size. It started to go against me, and it just kept going against me, day after day. It was unbelievably...I got that same feeling back - the coffee feeling, even though it wasn't coffee. I was sick to my stomach. Every day was pain. It would go against me another 25 or 30 points, and I'm thinking this can't go any further. Then it stabilized for a few days, and then I made another brilliant move. I decided to increase the position because then it would take me less to get back to just break even. I added a few more on to it. Then literally the next day the spread had an outrageous 200 point move against me. I think ultimately the spread peaked at about $.20 premium in the May of the December, which was, I think, an all-time extreme. I don't know since then, but at that point I think it was an all-time extreme. I couldn't take the pain.

Literally I dumped half of the position which was quite large at the time. I dumped half the position and then the very next day it started moving in my direction. After 3 or 4 days, I got back half of all of the money that I as down, which was quite a bit. I just couldn't take the pain anymore. I bailed out of the position. Then I sat and watched it go in my direction the next 17 days in a row. It literally went to contango; the December went premium; I don't know if it was full, but it went premium to the May, and I would have made just a staggering amount of money, but instead I was completely ruined and devastated emotionally. I hadn't lost as much money as the coffee trade. It was a setback, but I never realized how badly you could feel by combining not only taking the loss, but then watching it go in the direction and knowing if you hadn't...later realizing that when you do the post mortem that your main problem is leverage. You don't understand what you are dealing with, which I didn't at the time. I didn't realize.

So I kept trading spreads and sure enough, maybe 2 or 3 months later I find a really great soybean meal spread. It's an historical extreme, what I didn't realize there was a reason that it was at an historical extreme because some shenanigans were going on in the soybean market. The soybean market was being cornered by an Italian firm. I got into the position and it got knocked way out of whack due to the squeeze, and then I got blown up out of the position and the board of trade forced them to liquidate their position and again I would have made a fortune, but I couldn't stay with the position. That was kind of really the turning point for me why am I living my life this way? I'm in agony and pain half the time, and the other half the time I'm absolutely in euphoria. After that trade, I realized that there's got to be a better way to do this. I can't do this anymore. I have to find a way that I can manage...that I can sleep at night.

Niels

Was there anyone at the time, Scott, that pointed you in the right direction or was this all self-taught? It is one thing to come to the realization saying, this is not a great way of doing it, but the other thing is to actually say, well, this is the way I have to pursue it. Sometimes it often helps if someone with experience comes along and points you in the right direction. Was there anyone around you at the time? Was it really just your own curiosity that lead you to take the next step?

Scott

There was...it would have been nice, I guess, if there had been somebody around, but I guess there were benefits to both ways. I don't think I actually met another trader, or spoke to one, or met one until maybe three years later. There was very little written about money management, and very little written about just survival. You learned as you went along. So I sat down, I consider myself a smart guy, I can figure this out, I can figure out that you should not over leverage. It's the beginning stages where you're realizing how you're internally battling the fear of greed issue. You just want to make that money and then you don't realize, as I'm sure we'll get into later, when we talk about prospect theory, you don't realize the pain side of it and how much more you're going to feel that pain than the euphoria. So I morphed into...when I had that happen, that trade. I finally realized I needed to broaden my understanding of money management, and also my trading strategies. I had been slowly getting away from any kind of diversification, particularly strategic like. I kept going more to these bigger kind of macro spread extreme trades because of the payoffs; I'd had a lot of success with them and even the ones that I blew up on I could justify to myself I was right. I picked the right direction and it was an epic move, and it was just that I needed to better money management. After the soybean meal situation I thought to myself, I have got to figure out some...I have to be a little more diversified. I have to get the money management. At that point, it became obvious to me that I needed more capital.

Niels

I guess also at this stage, Scott, you were completely discretionary, right? There were no rules as such?

Scott

Exactly completely. I, at the same time, it's alright that you bring that up because I had such a fascination with computers and knew how to program a variety of languages from years and years and years prior to that. I saw a few advertisements at that time for mechanical trading systems. So I picked up one of those that had different optimizable things and started to tinker around with that. At the same time I was trying to broaden my horizons of looking at different ways of trading and trying to understand money management better, and also at the same time realize that to do all of this I was going to need more capital. So I talked to the guys who were still on the hook for the money.

Niels

The credit cards?

Scott

Exactly. I said we need some more capital. This isn't enough, and it's dangerous because if I try to diversify strategically and in markets and so forth, it may ultimately lower the risk but we don't have enough capital to diversify correctly, as I saw it at the time. I said, how about this, how about we form a company and that way we can have some shares to issue of this, and each of us can do the friends, family, and high networks that we know type thing, and we can try to get some more capital together. So we formed this company called the Dominion Financial Group Ltd.

Niels

At which year are we in now, Scott?

Scott

In that mix, I kind of got lost in the whole situation because I was enjoying myself so immensely doing this that it didn't quite occur to me that my personal life was moving on. I had gotten married. My wife was furnished and we're having a child, and I'm thinking, you know what, we're only trading a few hundred grand, and the profits that we are making are just enough to cover quote machines and fax machines and all the stuff that we're accumulating, and the office space that I had rented. It's very difficult to run a business on such. Even that was still woefully inadequate capital base to run a trading operation, but I didn't know that at the time. I began to know it once I started to think about. I can't hire people on this and I can't pay myself more on this, and I can't afford buying a house on this because we still have debt to pay back because I wasn't smart enough to pay that off when I should have, so we kept expanding. Looking for capital is always a tricky thing.

I'm 22, 23 years old philosophy, psychology, studied theology, nothing that has anything to do with anything, and I know none of the mainstream firms, nobody is going to set me up or help me out or do anything, so I started asking people that I knew, do you know anybody that is involved in finance or business? I was living in western Pennsylvania, in Grove City where the small private LaBarts College was, and it's about 60 miles north of Pittsburgh. I thought; I'm going to have to go down to Pittsburgh. Pittsburgh's got to have some wealthy businessmen, some entrepreneur, somebody who can maybe help me, because I have no idea how to get to the next level. So through a friend of a friend - one of those weird connections where somebody knew somebody who happened to have a brother or a friend that went to the same school that I did, and I didn't even know what to ask for. I was somebody that was a trader, somebody that...so eventually somebody happened to know a fella who was in municipal finance in Pittsburgh who knew a guy who worked at a brokerage firm who happened to have been one of the few people who had handled some futures trading for traders at Pittsburgh National Bank. So through a series of calls I was given a name of a guy who used to trade bond futures for Pittsburgh National Bank, but now he was living in a little small Amish community about 15 miles west of where I was in western Pennsylvania.

So I called this guy. I have no idea who he is, and I said I was given your name by this person and I'm a trader and I'm just starting to dabble in this kind of thing and I'm looking for some direction on how to get some more capital and so forth. He says, why don't you just come over to my place and we'll talk. So he gave me his address, and I got in the car and I'm driving. Grove City is in a very rural area to begin with. But you go 10 miles west of that you are in Amish country, and there's just nothing - horses and buggies and farms. I'm thinking I must have the address wrong here. This can't be right. I'm weaving through and finally...there's no GPS back then and I've got the maps out in the car and I'm lost and I finally get to where the address is and it's like a farm house and beside it there's this big barn and I'm thinking this has got to be wrong. I'm standing out there, and suddenly a gentleman appears out the front door and he says, you must be Scott, and I said yeah, so I guess I'm in the right place. He said yes, come on, let's go talk, I'll show you my operation. I'm thinking, operation, what you're combine and ... So he walks me over to the side of his house where this big barn is, and it's really old and kind of beaten down, and he slides open the door and I walk in there and my jaw just dropped to the floor.

There were computer screens everywhere. There were five traders in there. Lights are going off. People are on the phone screaming, and I was, this is unbelievable. This is existing in the middle of nowhere on a farm? After we got to talk a little bit further, I didn't know a lot of names or people, but he was trading at Pittsburg National Bank, and he was good friends with Stanley Druckenmiller, who was there at the same time, in the early 80s. He had made quite a bit of money being an early Fed watcher and understanding the whole Volker thing and the interest rates situation. He just walked away and decided he was going to trade his own money, and then some of the other trader friends that he had who were native to that area of western Pennsylvania, he said hey, you want to trade? You can trade out of my barn with me, and we'll just help to defer our costs. We can get the news services and the quotes and stuff, and everybody is just on their own, but there will be some comradery and we'll trade.

So I sat down with him, and I said here's what I am doing and here's what I'm trying to do and here's my track record, and here's my story. He looked at me, and he said, what are you trying to accomplish? I said I want to get more money so that I can do some different strategies and so forth, and I want to do what you're doing. I have my own little setup, and I'm in the middle of nowhere, though not as much as you're in the middle of nowhere. He looked at me, and he said, you'd be more than welcome to come here and trade out of my place and maybe you could get some money at least, and you know what you really need. You need to go out in the world and see how other people do things and really get an education about trading and the different markets and so forth. You've got it all in your head from reading a handful of books, but you'll learn a lot from getting some experience. He said there are companies that trade futures for other people. He couldn't think of the name of it. He was referring to CTAs, and he said that there was a recent article in the Wall Street Journal about a company in Pittsburg, and he said I actually am good friends with one of the principles of the company, why don't I give him a call and maybe you could do some stuff with them. Maybe there's something there, some kind of relationship.

I asked him a few questions about what they did and so forth. Then the fellow who introduced me to Carl said, are you guys looking to hire, or are you looking to team up or partner, or do you want to do any sub-allocations, or just trying to open any possible door for anything to help me out, and Carl said no, we're really not but we've been growing so fast that there is always a chance that maybe we might want to hire somebody somewhere down the line. Why don't you just...Scott send a resume down here, and we'll take a look at it. I hung up the phone, and I said I'm really not interested in working for anybody. I have my own thing, and I really like what I am doing. He said well maybe you can do both, or you can find a way to still do your own trading and so forth. Next day I sent a resume down to A. L. Management and they got it the next day in the mail. Miraculously, the mail never goes the next day. They gave me a call and said can you come down and see us. I said yeah, when would you like me to come down? They said come down right away.

So I drove down to Pittsburgh and chatted with them, and spent some time with Al, who was a very interesting guy. What I didn't know at the time was that Al was a member of Mensa, and he had this theory about the way to build a company was to make sure that everybody in the company was a member of Mensa. He was only starting to kind of get over that because Carl wasn't in Mensa, but the secretary, all the traders, the receptionist, everybody that was there were Mensa people. So it was a very interesting environment. I wasn't in Mensa, but we hit it off. So we had a long conversation, and Al said, hey you know, I like what you are doing. This is all very fascinating, and maybe we can work something out and you can do some research for us and you can still run Dominion Financial Group Ltd. So I thought hey, that's a perfect world. I'm going to get paid here, and I'm going to get introduced...this is like an amazing miracle that I have some options here. So he said we'll discuss things and why don't you come back down to Pittsburgh tomorrow. This whole thing is a whirlwind, like 4 days.

They called me back down, and we spent the entire day talking and they made me an offer on the spot which was very generous for the day, and they said you can keep doing what you are doing. So I thought, WOW this is great, this will take a lot of pressure off the small capital base that we have, and now I might get insurance for my child and this is wonderful. So I did that. I packed up everything and moved to...all the other guys that were still involved in the Dominion Financial Group. They had graduated and they had all been taking jobs all over the place, so I was really the only person, I had a little bit of help from a few other guys, but the larger group of people were diverse. When I told them the Pittsburgh thing, I thought that was good because then we wouldn't have to cover the cost of the office and all the other expenses. I packed up the family truckster, and we headed down to Pittsburgh.

After a month or two, Al came into my office one day, and he said you've really got me thinking about a lot of stuff. Because within the first few months they were doing like a single system and I said you really ought to do three systems and do different timeframes. I was introducing a lot of different ideas that just hadn't occurred to him and he was really the only guy doing the research, and after so many years he wasn't thinking really of new things. Research was a very difficult thing. They had a VAX computer. There's a mainframe. He bought a used VAX computer for $66,000. Everybody had terminals while I was there, over the next few years, people started to get PCs, but it was difficult to do the research. He said I want you to play a greater part in the company. I want you to be a principle of the firm, and I want to give you some more cash, and make it more interesting for you and I want you to stay around. I said well, if I'm a principle does that mean I have to stop the Dominion Financial Group. He said I'm afraid it does because you can't have that conflict of interest.

So I went back to the guys, and I told them that and they said you've just gotta go for this. This is your opportunity, and so I did. I became a principle of the firm, and I think my titles was Senior Trader, and in a very short time there was Al and then Carl, who was buying into a partnership with Al, and then I was the number 3 guy on the totem pole. So it was a whirlwind. I went from studying philosophy and literally 36 months later I'm the number 3 person in one of the 10 largest CTAs in the world. I don't know if that stuff happens anymore, but it was miraculous, and it was really a great time period. Then as you learn very quickly in the trading world, everything changes and I think the very next year Al's mother died, Al's brother died, and now he's going through I can't remember if it was number 2 or 3 divorce. He just said I'm done. I can't do this anymore. I've been doing this for 20 something years. He had stockpiled enough dough, so he made a deal with his partner Carl to sell Carl the rest of the business and the understanding was that then I would get the same deal when Carl had to buy into AL and become a 50% partner. Well Carl, having taught out at the University of Colorado, or one of the schools he had an office out there, and he would live out there and do a lot of marketing. He wasn't really hands on around the office. He was just flying around the world playing golf and raising money and writing articles. I think he had a Ph.D. in decision sciences from MIT, or something. He had the credibility.

Niels

Yeah, we'll definitely go into that. It's a fascinating story. I really appreciate you sharing all those details. I think there's so much to be learned from that, and I think it's so inspirational for many people who listen to it to hear your story. I want to...you are absolutely right we are definitely going to talk about Sapphire and all of that, but before we jump into the next part, I want to ask the question which is a little bit off topic, but I'm sure you're up for this, and that is the relationship between magic and financial markets where you could say that reality and perception is reflected in two different worlds or perhaps not so different. I know you've spent some time thinking about these things but probably not many people do, can you share some of those thoughts that you have about these two, on the surface, very different worlds?

Scott

Certainly. I got involved in magic at a very young age. Most of it was sleight of hand. Most of it was what we call close-up magic. When I was in college I was a bar tender, and I would do table hopping, I would go table to table and do magic for tips and so forth. When you learn how to do magic well you are forced to become, to a certain sense a student of psychology. At the same time I had been studying psychology in college and it helped flesh out a lot of the concepts of why people are fooled and what it is about people think that the hand is quicker than the eye. It really has nothing to do with speed it has everything to do with perception and how people perceive things and the biases they have in their perception. Many of the same concepts you could talk about and you could go through the different aspects of prospect theory or behavioral finance, and you could tie them out to magic if we had enough time.

The most important one, which is the way that our brain processes information, the heuristic behind that we put together pieces of things when we don't have all the piece so that our mind can function well. So you see things, when you look at a door in a room from an odd angle it shouldn't look perfectly square, but your mind makes all these corrections because it knows what ought to be the way that it is and so forth. Your mind fills in. It's kind of like now in science we have these incredible high resolution television screens, and they fill in the pixels even if there's some damage to the CD or whatever, and our brain works in that same way. So the way that you fool... the way I was able to fool people is that you use the way that they interpret data against them so that they think something is happening, or something is going down this path when it's really going down another path. It's for lack of a better term you could call it Gestalt psychology, which is where you have this heuristic...and that helps you to process things.

What hit me early on in my trading, and that really helped me with all the pain and suffering you begin to see the importance of psychology when you are trying to understand how your emotions are at times working for you and at times working against you. But I realized that so much about how my emotions were functioning was a function of my perception. What you think, how you view the world, how you see things. I was able to make a connection with me doing magic. When I'm doing magic, and somebody is in front of me they see what I want them to see and I lead them down a thought process that hopefully will bury the real secret of what I am trying to do. It's difficult to explain. We use these psychological principles to cancel out people's explanations by doing variations of the same effect. You do it different ways so that each time then you keep confirming the fact that you never touched something even though you touched it and whatever they would all take a lie detector test and pass it if you learn how to set the table correctly.

What kind of popped out to me was that I was, being involved in the market. It's as if I was a spectator, as if I was the person on the other side of the table, or on the other side of the stage, and my perception was just being like a cork on the ocean, I was letting all these things affect me and I wasn't really a player, I was a spectator in what I was doing. So as a magician you begin to realize what you do as a magician is you control the narrative. You control what you want the reality to be seen, and later as I got more into trading and began to debate and understand what is more important in the markets? Is it perception or reality? Is it that people perceive that something is going to happen or perceive that interest rates are too high or low, or they perceive that XYZ, or if it actually is or isn't. At the end of the day,it's a very blurry line between perception and reality. You can even argue in the markets that reality doesn't matter because eventually when reality catches up it will change perception.

Niels

Sure, sure. It's quite interesting because obviously I guess now a days a lot of people are at least debating whether the Fed of the central banks are creating some kind of illusion for the world right now with all of that magic money or whatever they are, they're printing and that creates obviously some interesting situations. I just find it fascinating the way it's impacted you and how you've used it, which we may learn a little bit more about as we dive into it. So I want to bring it up to date and just talk a little bit about how you set yourself up today and the infrastructure that you run, what you found efficient for operating in the short term space, but of course I have to touch also on the fact that you've certainly not chosen one of the financial hubs to locate your business. Traverse City doesn't strike me as being the biggest financial center, so how does that impact your business life?

Scott

To this day we don't have a single client in the state of Michigan, but Traverse City, for people who are not from anywhere in the Midwest, they wouldn't realize it, it's a vacation destination. A place where people in Cincinnati, Chicago, Detroit, a lot of the Midwest cities all have their summer homes for the last 150 years. It was like on the east coast going to upstate New York or something, back before there was air conditioning. There's 27 wineries up here, and there are 4 microbreweries, and there are downhill skiing and the sailing and boating is great and the snowmobiling is nice, and believe it or not there are these beautiful big sand dunes and sand beaches, which I would have never dreamt of coming from the east coast. I just ended up staying, and I'm here because I want to be here. I have at times talked about going back into the city. I worked in Pittsburg; I worked in Denver. I worked in Chicago. When we first moved up here, and up until the crisis it wasn't very difficult to get traffic through here. It wasn't like it was in Chicago. We just got a lot of people that were incidental. I happened to be there with an hour to kill. I need to do another meeting, I'll see you, and that was nice. I never made it home for dinner because of that, but it was nice for the business.

The first couple of years up here we had people from just about every country that we've ever done business with from Japan, from Australia, all over Europe, Canada, you name it and then that started to slow down a little bit. Then post crisis it's been a lot more difficult to get traffic up here. Why? Part of it is because the business is... overall managed futures is just not doing well, so there's not a lot of product development and not a lot of stuff happening and when that's not happening nobody wants to make that extra leg. Our clients come up here, obviously, and people who do due diligence, but we just don't get the incidental traffic. To a small extent, yes I think recently. It makes it a little bit more difficult.

Niels

Now that you've described the beauty of it you might actually see some more people coming.

Scott

I hope so. It would be nice.

Niels

How are you structured in the business side, with all the technology we have today compared to where we were 10 years ago, as you explained? What does it take now a days to run a short term trading operation?

Scott

Well, what we do, our needs are a bit different from your average CTA, and maybe explaining that a little bit will help understand the nature of our business. Generally speaking, businesses are built around whatever our core product is and as a CTA your product is your trading and your profits. So everything is built around that, and everything supports that and so forth. So most CTAs and particularly short-term CTAs tend to build their business around their research, which is highly quantitative. The staffing and the math guys and the rocket scientists and all that is a huge part of what they do. It's not a huge part of what we do.

At times it's difficult to explain this to people because they just expect if you are a short-term trader you've got a staff of Russian scientists, and mathematicians crunching numbers around the clock and you're laying fiber optic cable to the exchange for latency reasons and all this kind of stuff and they look at our firm and we've never, other than a friend of mine that I hired for a few years as a programmer, we've never had anybody who's had any kind of science, math, or computer degree all the way through. Even our staffing now we have more people that have degrees in psychology, philosophy, religion, communications, things that you would not normally associate with trading in general, but more specifically short term systematic trading. The reason for that if I can digress for just a minute, it's always a source of contention when people look at it and say you obviously don't have the research necessary to complete in the world. We have been in business for 20 years; we've at least been able to stay in business, which I guess is a good thing, and we've have our moments and ups and downs but the real issue is why do we do things the way we do them? Why is it that we don't go down this road, or we don't tackle these problems the same way everybody else does? The short and sweet answer to that is because of my background.

I approach the whole trading situation from a real blend of philosophy and psychology. We've talked a little bit about the psychology stuff, not a lot, but the philosophy really to me was a bigger element, a bigger issue in terms of pushing me in a certain direction in how my trading is going to look and what I needed to do to support a particular style of trading. That goes back to it's a gradual process that's happening in those earlier years that I was talking about trading for myself and trading for this small trading group that I put together and then my experiences - my three years as a Senior Trader at A.L. Management. You go through this whole process and as the whole time I'm looking at what is my strategy? How do I want to approach the markets? What is my strength? What do I want to do? I kept having a problem reconciling all the different strategies that I was reading about.

There was a certain philosophical hiccup in my brain that I could not get my arms around. What it was, was the fact that my background in philosophy is more geared toward ancient philosophy. My father got me turned on the Aristotle and Plato and the Socratics at an early age and he was my professor for a lot of my classes in college. I was either well educated or brainwashed; I'm not sure which perspective I want to take, but I had a real passion for the classics and Aristotelian logic in particular. So the markets that I'm looking at I'm thinking OK, how do I want to trade? I'm thinking do I want to be...it seemed to me it didn't matter what I picked. I

If I was going to trade the markets on a fundamental basis, I am basically saying that I am looking back in the past and I'm looking at certain fundamentals that would make something cheap or expensive or that's what everybody says, that this stocks to use ratio the price ought to be X, or when this happens, or whatever, if you are in the stock market, the PE ratio. You are looking at all these different events in the past and you are saying this will tell me in the future what value is and what it ought to be. If I am a technical trader I am going to look at the past and say here's a head and shoulders pattern and most of the time if that happens in the past... I've counted 75 times that it's happened out of X it seems to point in the future that this is going to happen. Pick a strategy, any strategy, at the end of the day I ran into a real difficulty with trying to understand just because it's happened in the past why does that mean it's going to happen in the future? For my field of study, which is epistemology, which is the theory of knowledge - how do you know you know? How can you validate or verify anything that you know and what give you any confidence in what you believe is true?

Niels

So universal truth I guess.

Scott

Exactly and that's what Aristotle basically said. He basically invented logic as what everybody accepted for 2,000 years. Everybody has been debating over the last 100 years or so whether it was right or not. He said in classical logic and syllogistic logic that when we put these propositions together: all men are mortal, Socrates is a man therefore Socrates is mortal, we can evaluate their truth by looking at what he called the square of opposition, which is if you drew a square on a piece of paper in the upper left hand corner, that stood for the universal affirmative.

For example, I could say all toll bridges are expensive, so in the upper right-hand corner is the universal negative: all toll bridges are not expensive. Down in your lower left hand corner is the particular affirmative at least one toll bridge is expensive and in the lower right-hand corner is the particular negative: at least one toll bridge is not expensive. Aristotle went on to try and argue we have inferences that are true always by looking at the relationships between these four propositions. For example, the top two the universal affirmative and the universal negative, they're called contraries. They both can be false, but the both can't be true. The relationship between the particular affirmative and the particular negative is sub contrary, and it's the exact opposite, both can be true, but both cannot be false. The relationship between the universal affirmative and the particular negative is called a contradictory, and they both cannot be true and they both cannot be false - one has to be one, one has to be the other.

The relationship that had the most important bearing on my understanding of trading was the sub alternative relationship, which is the relationship between the universal affirmative and the universal negative. If all toll bridges are expensive, then the particular affirmative, at least one toll bridge is expensive has to be true, but the reverse is not true. If you say, at least one toll bridge is expensive there's no way that implies that all toll bridges are expensive. However, the opposite is true - the reversal of that. If you say at least one toll bridge is not true, you have proven false the universal affirmative that all toll bridges are true which falls into a different line of thinking called falsification, and Popper gets into that. I was more intrigued by the universal because Aristotle was very consumed by universals. The things that were always true. Getting into natural law and so forth.

So I thought to myself, if I'm looking at a toll bridge, toll bridge, toll bridge, toll bridge, therefore, all toll bridges. How is that any different than looking at head and shoulders, head and shoulders, head and shoulders and drawing some conclusion that really didn't seem to logically come about. It's like saying white swan, white swan, white swan, therefore, all swans are white. Logically and basically the subaltern arrangement here, this understanding of Aristotelian logic is really at the basis of so many financial implosions that conclusions and ideas that are treated as universals because of witnessing the particulars whether than the other way around. I thought to myself I'm looking at particulars when I should be looking at universals, so what are the universals that I can trade from?

What is something that will be true tomorrow, true the next day, true the next day, true until forever and if it's true forever than it can't be empirically validated. So it has to be accepted as true and so like a natural law, it's understood. It's like 1 + 1 = 2. Well, I can do 1 + 1 a million times and get 2 but the only way I can say that it's universal is to say that I accept it that it will always be that way because it is. It can never be empirically validated. I find myself as an Aristotelian approaching the markets from what I would call a deductive point of view rather than inductive. We start with universals, and we reason everything that we do we basically believe you could do it if you were locked in a closet most of your life because it's necessarily true. It is not something based upon data.

This is, not to get off topic, but we talk about Dominion being a firm that looks at the world through Austrian economic eyes not because we make economic pronouncements, but the methodology of Austrian economists, the process is, that's their epistemology, it's very deductive, it's not empirical, it's not because we found 47 people that have benefited from minimum wage therefore it must work. It's not about working it's the principle, or the universal is true and must be true even if you don't see it to be true. I kept thinking to myself what can I focus on here that will help me. There are a couple of things that I discovered, but as it pertains to what we do in Dominion from day 1 to now is the psychology. The psychology of the markets is my universal affirmative. In other words, how people make decisions isn't going to change tomorrow, the next day, the next day, and it's not because of the studies that Tversky and Kahneman did and how they basically created portfolio theory as a science. This existed well before. it was something that was discovered, not something that anybody created.

This is the way people process information and they will always process it that way, and if that is true, which I believe it very much to be true, and we could get a lot deeper into philosophy and religion and all that to debate that issue, but if you'll grant me that, that's our starting point. So when we build a trading model, we build everything from that top down. We don't look at data a say what works and what can we do and how do we create a short term trading system? We look at it and say how do people make decisions? How are they trapped in these bad decisions? How can we capture that? It's very, very specifically in the market place.

So right now, as we're speaking, there are no computers running simulations in our office. It's not that we don't run simulations; it's just that we do zero data mining. We just keep trying variations of things. We have very, very specific things that we are looking to capture in the market place and most of the great ideas, once you picture them in your head, once they become obvious to you, you don't even have to back-test them. We certainly do; we need to do a ton of work but it's that type of approach. To make a long story short, we simply don't really have need of 100 PhDs or even 5 that are going to just start sifting through data. Our research is based upon a feedback loop of once you understand the ideas, seeing how the market feeds back that information of that decision making and so our traders are involved in our research process and a few other people are involved in it, but no quants. We can always farm out the quantitative stuff if it's something that I can't handle. I'm a pretty proficient programmer, and I managed to get through calculus in college. We're really looking for things that we can tie out. So that kind of is a long way of answering the question of how we staff our company and why do we do things the way that we do.

Niels

Scott

Absolutely. I often express my... I won't say unhappiness, but I think trend followers could do a much better job of explaining what they're doing. Everybody seems to want to be a scientist...

Ending

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