The Trend Following Bible

by Andrew Abraham

  On October 31, 2011, MF Global went bankrupt and shocked the futures markets. It is not just the fact that MF Global went bankrupt but that over $1.6 bbillion of client segregated funds supposedly “vaporized.” I was a client of MF Global and their predecessor EDF Mann since 1994. Along with many others, I was in shock about what was allowed to transpire. This had never happened in the futures markets. Another firm, Refco, blew up due to fraud and the next day clients were made 100 percent whole. Not so in the case of MF Global. What helps me overcome this frustration was to write. Over the Christmas holidays in 2011 I decided to write a book on trend following and trading for a living that would be different from all of the existing books on the market.

  It was partly due to a catharsis and in conjunction with the request by my oldest daughter who has been trading with me since she was 13. She had asked me to teach some of her friends how to trade. I had time on my hands and started to write.

  My bookshelves are full of trading books. I have read books regarding Warren Buffett, Value Investing, and all the books you can ever imagine on technical trading, but none of them got me to the point that 18 years of struggle did. I thought the more books, the more successful my trading would be. This is why I really believe my book will stand out among the many other trading books. I continued on this holy grail search with trading systems and formulas. I was so overwhelmed with courses and gurus. I could not figure out why everyone wasn't rich. I could not understand why more than 90 percent of traders fail. Many of these 90 percenters are engineers, pilots, and successful people in all types of fields. I read the various success stories of traders in Market Wizards by Jack Schwager whom I called the 10 percenters and was encouraged. There are other great books in recent years that focus on successful traders such as Michael Covel's books Trend Commandments: Trading for Exceptional Returns, Trend Following: How Great Traders Make Millions in Up or Down Markets, and The Little Book of Trading. There is a great deal of fantastic information to be gleaned from these books and I strongly recommend them.

  A driving force for me was to succeed in trading. I did not assume the lure of so-called “easy money''; I did not assume it would be easy. I read about Larry Williams who in a trading contest took $10,000 to approximately $1 million.I read in Market Wizards about Michael Marcus who started with $30,000 and took that sum to $80 million. Richard Dennis was also featured; he started with $400 and ran it up to over $200 million. These numbers were amazing but also dangerous to novice traders like myself at the time. Everyone who trades wants to achieve these results. Just because someone else succeeded, this might really help you. You do not hear of all those who failed and how long it took the ones to survive to become successful.

  Most traders have no concept of what is needed in order to achieve these lofty goals. I assume that all too many traders think this is easy and instead of focusing on what needs to be learned, they focus their time and energy on all the ways they could spend their new-found riches. Then there are those who invest all their time in search of holy grail indicators and systems that aren't.

  In every business venture before one starts the norm is to make a business plan. To the contrary, too many new traders are more focused and anxious to get rich rather than to make a business plan. They think they do not have time for the plan. The lure of easy money is a Pandora's box of problems. The dangers of unrealistic expectations are more than prevalent. Instead of focusing on all the dangers of trading, too many are focusing optimistically on their new-found easy wealth. I can humbly say I made countless mistakes and I paid for these mistakes, but introspectively I was of the camp seeking holy grail systems and indicators, which was a waste of time. These mistakes were required learning lessons for me in order to become a consistent trader even though I had people trying to help me. It is not just me. Behind all the glory of the Market Wizards was the reality. Richard Dennis, the teacher of the Turtles, lost 50 percent of his and his investors' accounts and has stopped trading. Michael Marcus borrowed money from his mother and lost it before he internalized his mistakes! Larry Williams, whose claim to fame was in a trading contest and book, How I Made One Million Dollars Last Year Trading Commodities, lost a million dollars the following year.

  There are countless stories of unknown traders who have blown up. They focused too much attention on the easy profits they thought they would make. They had no concept of risk management. They had no concept of hard work. Too many believed they could buy a trading system or trading robot and find their proverbial retirement in a box.

  The reality of successful trading comes down to several basic tenets and the realization that you have to work hard:

  1. Robust trading plan applicable to all time frames and markets.

  2. Complete risk and money management.

  3. The patience and discipline to follow the trading plan and follow the risk and money management guidelines.

  On my business card I have written on the back the tenets of successful trend following:

  1. Trade with the trend.

  2. Cut your losses.

  3. Let your profits run.

  4. Don't let the big profits get away.

  One who follows these simple rules is light years ahead of so many traders. These four rules are similar to the Ten Commandments. If one follows them, one will be “blessed” over time with the trading results. When combining these tenants one puts one's self in the position to potentially create extreme wealth.

  A vast majority of traders spend all of their time and energy trying to predict or guess what will occur in the markets. The right activity for traders is look at what is happening right now. Be in the moment and just follow the plan (hopefully they have a plan). The question needs to be asked, has the market taken out the X period high? Has the market retraced and is offering me a low-risk retracement trade? Bloomberg and CNBC are based on predictions. Everyone wants to be smart and show they know the future. Successful trend followers have internalized that it is nothing about being right or predicting. The point that these successful trend followers have internalized is to identify where they are located currently in relation to the trend and just take the trade if they have one.

  As I believe any trade is 50/50, you never know which trade will work. Too many traders are looking for certainty. Certainty does not exist in the markets. Traders want to know when trends start and stop. The reality is you never know. The flipside of the 50/50 is that you do not know how bad a trade can go against you. The concept of cutting losses is a paramount issue if one wants to stay in this business. If losses get out of control, one can easily be overwhelmed financially and emotionally.

  Letting profits run is very hard for some traders. They have that urge to ring the cash register. They do this primarily out of fear. In trend following one needs these rare big winners to offset all of the inherent small losses. Your trading plan must have the contingent for following trades that are working. This is the key to making money in the long run and building your positively sloping equity curve. With a trading plan there is no “Should I”, “Could I”, “Would I”, “Shoot, why didn't I take that trade,” or worse, “Why did I let this happen to me?” When we trade, we should trade for the primary reason to make money and build a positive equity curve. This primary reason is so powerful we are all trying (should be) to better our trading. This is why we try to perfect our trading. This leads us at times to second guess ourselves. We second guess because we don't have a plan and do not have discipline. If you are in this state I believe my book will truly help you develop “the plan” based on risk management, a robust trading methodology, and the proper mindset in which you do not second guess yourself.

  One must plan in trading. The extent of planning determines success or failure in trading. The more developed and stringent a trading plan with all potential outcomes preplanned, the greater the potential for success over time. There will be times you will think to violate your trading plan. You know that you should not; however, rationali
zation is a powerful tonic. You try to justify your decision to violate your plan. No one is standing over you and asking you why are you breaking your own rules? You just do it, wrongly though. Ironically, Mr. Market might even reward you for breaking your own rules. This is even worse for your psyche! Breaking your own rules becomes a slippery slope. It becomes easier and easier, and by the way you made some money last time.

  The big issue is you just bought yourself a one-way ticket to the 90 percent club of failed traders who lose money. The only way you can even hope to join the 10 percent club of consistently successful traders over time is being consistent in your trading plan. Consistent means seeing the same type of trade, recognizing it, and taking action. This is repetitive in nature. Actually I was recently told that this was boring. My answer was, I am not trading for excitement. I like boring.

  Without a trading plan how would you know where you are going?

  Clearly you would not!

  Even with your trading plan there will always be problems and surprises. Thousands of traders were caught in the MF Global debacle. A situation in which client segregated accounts were violated was an industry first. On Halloween 2011 MF Global went bankrupt. Client accounts were frozen. Not just cash was frozen; positions could not be offset for days. Frantic traders were calling 24 hours for days trying to exit their positions. I know traders that flew to Chicago to try to exit their positions. Another colleague of mine had three people on speed dialer trying to get through to the trade desk, to no avail. This was a nightmare for traders as well as the futures industry. The fortunate traders who had multiple accounts were able to offset their positions. Other traders who fortunately had the majority of their funds at Treasury Direct (the U.S. Federal Reserve bank) or at a cash management firm such as Horizon survived. Planning saved traders. Those that did not plan are not in business. Thank God I planned for the unthinkable and had a vast percentage of assets at Treasury Direct (the U.S. Fed). Luckily due to my paranoia and the advice of a colleague I transferred out some funds from MF Global before they collapsed. I still got burned, however, but not destroyed. The MF Global issue was extreme; anything can and anything will happen in trading. The only certainty is uncertainty. Who would have thought the Nasdaq would still be down 10 years from the highs? Who would have really believed the Japanese stock market would be down from 39,000 to approximately 9,000? What is shocking is that for 22 years Japan has been in a bear market. If someone told you this could happen in the U.S. stock markets you would think they were crazy. Who would have ever thought gold could go from a couple hundred dollars to almost $2,000 over approximately 10 years? Once you truly internalize that anything can happen, you realize the absolute need for a complete plan. The markets will always throw you a curveball. Investing your time and energy in your trading plan will reward you more than the futile search for predictions, indicators, and mechanical systems. In my book I am giving you my trading plan. What a great bargain.

  A solid trading plan is the holy grail if there really is one!

  ANDREW ABRAHAM

  INTRODUCTION

  My Journey as a Trend Follower

  Things that happen many times are not a coincidence. Probably today and even more so in 1994 very few people had ever heard of the phrases “trend follower” or “trend following.” I stumbled on the phrase “trend following” by sheer luck. I sold a business that I started in college in 1994. I had saved the majority of the money over the years and even acquired more money upon the sale of the business. I had no idea how to invest it. I was not comfortable with the stock market after witnessing the 1987 stock market crash as well as the stock volatility in the early 1990s. As I have always done, I tried to surround myself with the smartest people I could. I asked my accountant what he suggested. He told me that he had a client who owned a commodity brokerage firm who was very successful and suggested I meet him. My accountant was in his mid-60s with a rather large practice, therefore he had seen a very large pool of clients, and I trusted his unbiased opinion.

  I wanted to learn how my money could work for me and compound over time. I was overwhelmed with all the books and courses that offered so-called magical success and millionaire traders who really weren't.

  I started my journey of learning. Market Wizards by Jack Schwager mesmerized me and has encouraged me. My journey of trend following began. This journey was more like a marathon and still is.

  I probably made every mistake possible. Working past mistakes and a bad memory is very tough due to the emotional baggage we carry. I personally overtraded; I did not follow my trading plan, or better said, hardly had one; I did not follow my money management plan, as well as did not follow a correlation plan. After the many losses I encountered I felt frustrated, angry, and just plain lousy. Besides these emotional issues, there were the financial issues. I felt beaten up and poorer. I knew there had to be a better way. I wanted to dig myself out of this negative sand trap and join the rare group of 10 percent consistently successful traders that I read about in Market Wizards by Jack Schwager.

  Even though I had those who guided me, the fact is that you can be told exactly what to do but unless you internalize it, it is worthless! It was only from mistakes and losses that I learned. I had the extreme desire to learn and grow!

  I believe most traders really make mistakes due to fear, greed, or ego. There is this illusion or lure of supposed easiness or easy money out there. Why waste any time planning or working? I have heard, “I can buy a Forex robot and grind out the profits.” I chuckle to myself and think: How can it be so easy? Why isn't everyone rich if all they needed to do was to buy a Forex robot? The fact is everyone wants success and wealth, but are we really ready to work so hard for it? Not many!

  My journey has been two-pronged with the goal to compound money over time. I started my own trend following in 1994 as well as invested with hedge fund managers and commodity trading advisors who were trend followers. Investing with other commodity trading advisors has offered me diversity and helped me build my equity curve over the years. I allocate between 2–5 percent of my family's net worth in any one particular money manager. I have a group of managers. Year in and year out they have different returns. In some years I have outperformed them, in others not, but my goal was to diversify. It helped me very much during the MF Global debacle that I was diversified. Two of my commodity trading managers had some exposure to MF Global. The rest had no exposure whatsoever. In trading, as Salem Abraham from Abraham Trading Group has so aptly stated, you never know what can kill you. This underscores the need for a well-thought-out plan. My way of staying in the marathon is to spread it out. I look for managers as aware of risk as myself. My wife tells me I am compulsive obsessive paranoid. Before the MF Global debacle I would thank her and took it as a compliment. We sold our private home at the top of the housing bubble in January 2006. I did not feel comfortable with how prices were skyrocketing, and we were contemplating moving overseas. Fate occurred and we luckily sold at the top. This is probably the only time in my career I can claim such luck. After the MF Global debacle I wish I had been more paranoid. However, as in my trading, it was a good learning lesson, and I am not focusing on the past but on the future. I have opened up with numerous futures commodity merchants, and at the slightest smell of smoke I will wire the cash out of the futures commodity merchant and offset my positions.

  When I allocate to other commodity trading advisors, I have positive advantages. I have a diversification to clearinghouses, trading styles, and markets in addition to how I trade. That is the good news. The bad news is that to some degree this diversification costs me and eats into my compounding of my money over time. Most commodity trading advisors and hedge fund managers charge a 2 percent management fee and 20 percent incentive fee. I even have one manager who charges a 25 percent incentive fee. He gets 25 percent of my profits. However, he has done very well for me over the years, albeit there are periods in which he goes through severe drawdowns. I am willing to pay the
fees as I have been able to compound money over the years in this process, and this should be your goal as it is mine.

  My personal trend following has been a work in progress. The commodity broker I started with in 1994 learned under Ed Seykota, Van Tharp, and was an avid student of Mark Douglas. He taught me to focus on how to think as a trend follower. He taught me to think in terms of probabilities and to accept the risks when trading. I learned the only certainty in trading is uncertainty. No one provided the holy grail of a magical indicator or system, rather how to think, how to be disciplined and patient.

  ■ A Great Learning Lesson

  Discipline and patience are the foundations of the holy grail.

  Discipline means knowing exactly what you need to do at every moment and actually doing it. The easiest thing to do is to put off taking a trade that causes emotional distress. However, this is exactly what you need to do with discipline. A lack of discipline can be expressed as failing to do what you should be doing in every given event. A lack of discipline will destroy even professional money managers. In this book I have highlighted numerous examples. Simply telling someone to build his discipline is a lot easier said than done and trite. No one is perfect and discipline is not like a light switch you can just turn on. Every trader including myself has failed in some degree of discipline. However, I learned and internalized the absolute need for complete discipline. The discipline became enhanced over time, and when I completely internalized my trading plan, I became rigid in my plan, which built my discipline, and at the same time I became more accepting of my returns and the expectations of my trading returns. I was willing to learn from all of my mistakes. I strived to get to the point at which I did not make the same mistakes again. I learned to follow my plan and not be deluded by the fact I made a mistake when I did not follow my plan and even profited. Breaking my own plan or rules and profiting is what makes discipline so hard. Been there and done it. However, I learned this would not get me to my goals of compounding money and I was negatively rewarded.