The Trend Following Bible

by Andrew Abraham

  THE TREND FOLLOWING BIBLE

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  THE TREND

  FOLLOWING

  BIBLE

  How Professional Traders Compound

  Wealth and Manage Risk

  Andrew Abraham

  Cover image: Andrew Liefer

  Cover design: © Danin Tulic/iStockphoto

  Copyright © 2013 by Andrew Abraham, Inc. All rights reserved.

  Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

  Published simultaneously in Canada.

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  Library of Congress Cataloging-in-Publication Data

  Abraham, Andrew.

  The trend following bible : how professional traders compound wealth and manage risk / Andrew Abraham.

  pages cm. — (Wiley trading series)

  Includes index.

  ISBN 978-1-118-40774-5 (cloth); ISBN 978-1-118-42186-4 (ebk),

  ISBN 978-1-118-43439-0 (ebk), ISBN 978-1-118-41763-8 (ebk)

  1. Investment analysis. 2. Portfolio management. 3. Investments. 4. Risk management. I. Title.

  HG4529.A27 2013

  332.64′5—dc230

  2012043888

  To my Family, Ruthie, Gabrielle, Ariel, Micael, my mother, and all those who supported me along my journey of trend following, thank you.

  CONTENTS

  Foreword

  Preface

  Introduction

  A Great Learning Lesson

  Have a Plan and Follow it

  A Lesson in Compounding: The Dentist

  Chapter 1: Get a Savvy Start

  Trading as a Profession

  Trend Following Is a Journey

  Make Sure You Are Properly Funded before You Start

  Establish Your Trading Goals

  Trading Pitfalls

  It's Your Choice

  Chapter 2: Getting the Most Out of This Method

  There Are No Secrets!

  Do You Want to Be Right or Make Money?

  Basic Tenets of Trend Following

  Compounding Your Way to Wealth

  Requirements for Successful Trend Following

  Chapter 3: Why Trend Following?

  Why Not Fundamental or Even Technical Analysis?

  My Answer: Trend Following

  You've Got to Love That Saying!

  Ed Seykota and Market Wizards

  Chapter 4: How Successful Trend Followers Trade

  The Trend Followers

  Gurus, Geniuses, and Legends Are Not the Way to Make Money!

  We Have Our Legends As Well

  The Biggest Mistake Traders Make

  Chapter 5: Managing the Risks when Trend Following

  Risk of Ruin

  The Exact Elements of Risk Management

  Choose Markets to Reduce Risk

  We Are Dealing with Uncertainty!

  Note

  Chapter 6: Your Complete Robust Trading Plan

  Trend Breakout and Trend Retracement

  If the Trade Starts Working

  The Calculation of Average True Range

  Trend Retracement Rules

  Just Do It

  Chapter 7: Trend Breakouts

  ArthroCare Corporation

  Baidu

  The 30-Year U.S. Government Bond

  The Canadian Dollar

  Feeder Cattle

  International Flavors and Fragrances

  Royal Bank of Canada

  TJX Companies

  Cotton Trade

  Eurodollar Chart

  Sugar

  Silver

  Chapter 8: Trend Retracements

  Don Steinitz's Approach

  Alexander Elder's Approach

  Step 1: Identify the Trend on the Higher Time Frame

  Step 2: Identify the Retracement/Pullback

  Step 3: Putting the Trade On

  Summary

  Protect Yourself

  Note

  Chapter 9: The Trend Follower Mindset

  Make It Second Nature

  Trend Following and Trading Is Not Retirement in a Box!

  What Makes a Successful Trend Follower?

  Sweet Simplicity

  Think Probabilities

  Traders Lose Because of Fear

  It Is All Perception

  Just Take the Trade Mode

  This Will Not Be You

  Chapter 10: My Trading Journal

  Conclusion

  Disclosure

  Index

  FOREWORD

  I've been trading for investors for over 30 years. My first fund, Tactical Commodity Fund, started in mid-1981. Tactical's current program began in 1993 as an offshoot of that first fund but with lower leverage and some evolutionary changes. I've learned a lot over the years. I've seen a lot of markets, a lot of bull moves, a lot of bear moves. And I can tell you I wish I had read this book 30 years ago. I would have made more money, especially near the beginning. Do yourself a favor. Read it. Now.
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br />   My trading-for-investors career began not long after gold peaked around 870 and a bit over a year before the S&P bottomed near 100. I subsequently watched gold drop more than 70 percent over 19 years and then rally over 700 percent in the next 12. I watched the stock market rally for over 17 years with just one big, brief pullback along the way only to witness two retracements greater than 50 percent in the next 10 years.

  I've seen almost too numerous to remember booms and busts in the commodity, currency, and interest rate markets. I've seen things happen that everyone said never would and watched as things didn't happen that everyone said were inevitable. I've traded and held positions in these markets nearly every single day since mid-1981.

  Tactical was one of the first systematic, computerized fund managers. We started out on a Radio Shack TRS 80, before the first Apple. Historical data that costs pennies now took months to type in by hand. We ran Fourier transforms and proved there were in fact no repeatable hidden cycles in the markets while everyone else was still talking about them. We tested all the market lore to see what was true and what wasn't. We tested the early mechanical systems that were touted and found most of them didn't hold up. Indicators that people still use today we learned years ago don't really give you a statistical advantage.

  I wrote my own back-testing software and tested everything I could think of. When personal computers advanced we bought the latest. For a number of years we had two Sun workstations running 24/7 doing systems testing when those were state of the art. Of course, now you can do the same things much faster on a laptop. But that was then and this is now. We kept testing. We kept learning.

  I read every book I could get my hands on about trading. I listened to the old traders. When I worked during summer breaks in college at a brokerage firm at the Chicago Board of Trade I kept my ears open as the old-timers related their adventures, their successes, their failures. I tried to understand the psychology of the winners and how it differed from that of the losers. I got the idea that the psychology of the trader was as important if not more important than anything in success or failure.

  I spent a lot of time learning things the hard way, a lot of trial and error, a lot of hard knocks. Trading is still a lot of hard knocks. Drawdowns can go on seemingly forever. You can have days, weeks, even months on end without much in the way of profits. It can feel as if you are a punching bag or a movie double who takes all the hits. But that's the nature of the game, of the business.

  Even after you've learned how to do it, you still take your hits. To succeed, you just need to stand up every time you get knocked down. You need to have the confidence that standing up is the right thing to do. You need to know when to stand back up and how. And just by standing up again and again and staying standing as long as you can before you get hit again, well, you can actually make more money than you lose over the long run in trend trading. It's quite an amazing process.

  Very few people succeed in this process. The learning curve is too steep and the correct psychology is too hard to implement. If you have any attachment to making money, and who doesn't, it is very tough to trade correctly.

  This brings me to the book you hold in your hands. To reiterate: I surely wish I had had it 30 years ago. It would have saved me a lot of work. And I would have made more money, especially in the early years. More specifically, I would have lost less money and that would have put me farther ahead today. Andy Abraham has written a gem. His writing style is enjoyable, clear and entertaining. He covers all the main ingredients needed for successful trend trading. He tells the truth.

  What impresses me most about Andy's writing is his honesty. He doesn't sugarcoat things. He doesn't tell you it's easy to make money. He tells you that you need patience and discipline. (By the way, “Patience and Discipline” has been Tactical's slogan since its inception.) Andy tells you drawdowns and losses are part of the business. He presents a track record of one of his own programs that he started just a few years ago that has not made new highs in 17 months. That's exactly how it works sometimes. What is so refreshing is Andy's honesty about it. The man has integrity.

  A characteristic of those traders who have been successful over many years is honesty with respect to their trading. You need to understand your own psychology, where you are mentally strong and weak, how you deal with baser emotions, particularly fear and greed. If you lack honesty with yourself, you will almost certainly fail. Andy's honesty, more than anything, tells me he understands trading psychology and gives me confidence he is qualified to teach others what he knows. I have yet to run across a trading book that emphasizes the psychological aspect of trading better than this one.

  This book is not a cookbook. It does not outline a mechanical system. It explains the psychology needed to succeed in trend trading, gives some examples of traders who have applied it, and sets out the underlying principles that should be followed for success—trade the best markets, trade with the trend, bet small, use stop-losses, cut losses, ride winners, don't overtrade, be patient, be disciplined.

  As a bonus, Andy gives you the scaffolding for a particular methodology that works for him as an example of everything he sets out in the basic rules. Just as you would never think of moving into a new house that has been framed but before the roof, walls, and interior are finished, you cannot and should not attempt to trade Andy's “system” without doing all the finishing carpentry. You need to do your own back-testing—doable these days with off-the-shelf software he describes—to fill in the parameter values and to learn how his trade-the-best market portfolio ranker shuffles which market signals you take. For those who don't have a clue where to begin, Andy gives you his exact pattern to follow. Your own back-testing fills in the parameter blanks.

  Andy advises everyone that they must trade a style that fits their personality. I believe very strongly that he is absolutely correct. You will not follow a system that does not suit you. In his wisdom Andy thus does not give you all the parameter values for the formulas in his personal trading scaffold. He wants you to do your own back-testing, to find a methodology that you are comfortable with yourself and have confidence in. When all is said and done, your approach may be identical to his with your own parameter values. It may be significantly different. Regardless, you cannot develop the confidence to pull the trigger after multiple losses in a row without having done the work yourself. Guaranteed.

  It's a fair bet to say that any trend following methodology likely to succeed over time will employ the general psychological and fundamental trading rules Andy outlines. The specifics of everyone's approach will vary, but the broad principles outlined here will be present in one form or another in virtually all robustly successful trend following approaches. People say that markets have changed and new rules are needed for the new game. I've heard that for over 30 years. The markets do change but the underlying fundamental rules for success don't seem to. They are all outlined here. How great.

  You are lucky to have picked up this book. If you are a seasoned trader, reviewing the basic elements of winning psychology makes this book worth perusing cover to cover. We can all use reminders, yours truly always. If you are new to trading, this book can save you years of trial and error and monetary losses. This book is now on my short list of recommended reading material for traders. I sincerely thank Andy for having written it. Have fun reading it. I wish you all the best in your trading.

  DAVE DRUZ

  Tactical Investment Management

  CTA / CPO since 1981

  Haleiwa, Hawaii

  November 2012

  PREFACE

  I wanted to write a book that I wished I could have read when I first began to trade. This book is unique and I hope it will give you all the tools needed to help you become a successful trader over time. I have had help along the way of my journey of trend following. Writing a book that encompasses all aspects of trading is my way of giving back and helping new and aspiring traders. By teaching and enlightening others I know I will make
a difference in many aspiring traders.

  Hopefully you will learn from my mistakes and avoid the 18-year learning curve I have been on so far. The lessons I have presented in this book will help you achieve the goals that you are seeking.

  I wanted to share my insight—from the perspective of a professional who trades for a living—what one goes through on a daily basis and what a trader needs to know and internalize to become a consistent and successful trader over time. The majority of books I have read over the years seemed to try to boost my confidence by demonstrating how easy trading success can be. Trading for a living is not easy by a long shot.

  My goal is to illustrate the major issues and challenges that traders face. I would assume there are those readers who would prefer to seek the “easy.” It really does not exist! My purpose and goal was to dispute all the snake oil, hope, hype, unrealistic get rich quick falsehoods. There is no easy money in the markets. You will have to work hard to achieve success. You will make plenty of mistakes; however, look out the front window and learn from your mistakes.

  I would assume that many of you have picked up this book because you are hoping to improve your trading. My goal is to give specific methods instead of vague generalities that can be used in your everyday trading and improve it. My goal is that you instill in yourself that ultimately you are the only one responsible for your success or failure. It is never the market, never the broker, or me, with my advice. I want you to realize that the markets can be cooperative at times and giving, as well as also ruthless and unforgiving. No matter what stage of trading you go through, there will be times of severe aggravation (if you let it). How you react to the realities of trading will determine if you will be part of the 90 percent who lose money or the small group of 10 percent who are consistent winning traders over time. My goal is to have you be part of the 10 percent club of winners; however, it is up to you to truly internalize what I am trying to instill in you.

  Introspectively there were other reasons why I wrote this book. Writing about trading actually helps me overcome the inherent difficulties of trading. No one is immune to the difficulties of trading. Even money managers who have assets in the hundreds of millions of dollars must face the mental challenges. I have had a blog, TrendFollowingmentor.com, in which I speak and try to educate about trading. Nothing is sugarcoated. I have been told by many colleagues that I focus almost too much on telling readers how trading is difficult. The reality is that trading is hard. I learned this fact the hard way. This is probably the complete opposite of what you would have thought when you purchased this book. You probably thought you could buy this book and be immediately on your way to making money. Trend following, however, is like a marathon, and I hope it becomes a lifetime strategy for you.