The Trend Following Bible

by Andrew Abraham

  In one of the further sections I detail some examples of some of these trend followers. Do not think their returns are representative of those of all trend followers or that you can easily generate these numbers. The reality is probably that you can't, and the databases are full of trend followers who blow up or do not achieve these returns.

  As I stated in one of the earlier sections, I do my own trend following and I am sharing with you my exact methodology. I also invest with groups of other trend followers who I feel understand risk as I do. However, anything can and will happen when we are trading.

  Successful trading requires knowledge, skill, and experience.

  Trend following can be simple, but don't make the mistake of thinking it is easy! There are countless websites and late-night infomercials that try to tell you differently. They make you think that you just have to read a few pages or attend an online class, and then, magically, you'll become a successful trader.

  ■ Trading as a Profession

  If you have a regular job or run your own business, the probability is that you're working at least 40 hours per week.

  Comparing trend following to any business is an eye opener. Consider the following differences:

  ■ No employees to hire.

  ■ No set, exact hours to keep.

  ■ No inventory.

  ■ No rent.

  ■ No overhead.

  ■ No customers who complain.

  ■ No accounts receivable.

  ■ Very little equipment needed.

  ■ No bank loans needed.

  You are truly dependent on yourself! In order to start you need to take the following seven steps:

  1. Determine how much you want to start trading and risking.

  2. Open a brokerage account.

  3. Decide on which trading platform you want to use.

  4. Decide on which group of markets you want to trade. Do you want to trade stocks, forex, or futures?

  5. Have a well-thought-out plan and trading methodology with exact rules for entries, exits with a loss, exits with a profit, what markets to trade, and have built-in risk controls such as stop-loss orders to “try” to minimize or mitigate your drawdowns.

  6. Back-test and truly believe in the viability of your strategy.

  7. Be mentally prepared for the inevitable drawdowns.

  Simply, trend following is not like any other business venture. The only three fixed costs you have are:

  1. A computer or laptop.

  2. An Internet connection for your data.

  3. A trading platform.

  Trading is like every other profession: You learn the basics, you apply them, you gain experience, and then you take the attributes and make them part of your personality.

  ■ Trend Following Is a Journey

  I am glad you realize this is a journey or rather a marathon. It is full of ups and downs. Actually more times there are drawdowns and nothing happening than up and profitable periods. Drawdowns are the bane of trading. When you are profitable, you do not think of these inevitable losses. When the losses mount, however, the doubts increase. This is why I am presenting the reality to diminish your disappointment when reality sets in and there are the eventual drawdowns. There are times the drawdowns extend for periods of times that it actually becomes painful. Doubts about returning to prior equity peaks are brought up. In my personal experience, at the darkest moments were the upcoming light and the end of the drawdown. Drawdowns are not easy to digest. However, when you experience a drawdown and have been conditioned ahead of time what to expect, it becomes less painful. If you never anticipated that you would go through a 20 percent-plus drawdown and you are in the thick of it, it is much harder than if you had been educated that drawdowns can even be worse than this and that your worst drawdown is ahead of you. If you really never accepted the fact that you will encounter a drawdown like so many other traders, it will be very difficult to maintain your trading posture and confidence. This leads me to enlighten you on what you can realistically expect from your trading, both the good and bad, in terms of potential profitability and potential losses.

  I'm glad you're different from the masses that want a stock tip or insider information.

  You decided on my book of trend following because you're serious about becoming a successful and consistent trader over time. My goal is to help you in your quest to achieve this. However, please be aware and be realistic. Just reading this book will not automatically make you an instant millionaire. There is nothing instant with trend following. You will hear the word marathon quite often.

  Lifetime Strategy

  Trend following is a lifetime strategy for me, full of challenges and obstacles.

  You'll learn the basic ideas and concepts about trend following, but in order to make the most out of this book and become the trader you want to be, you'll have to internalize and believe in them. I will present you with example after example and most importantly help you in order to achieve the proper trend following mindset. You don't have to go to college for years to learn trend following. Unlike most other professions, years of experience are not necessary either. You have to have the desire and passion. I firmly believe that everybody can learn how to become a successful trader. (Later in this book you will learn about the turtles who did exactly this.)

  I am resolute that this manual will save you both money and time when it comes to your trading goals. I'm convinced that it will help you become the trader you want to be. You made the right choice. You could have done as I did for almost a decade, looking to pick up ideas and concepts regarding trading, but now you have me as your mentor. You will learn from all of my costly mistakes throughout the years. The irony I want to point out is that I had people who had helped me along the way, and I can even call them mentors, however, only when I truly internalized what they were trying to teach me did I succeed.

  Yes, You Need a Broker

  You may wonder if you really need a broker. The answer is yes. If you intend to trend follow, then you must have a broker. And it doesn't matter whether you are trading stocks, futures, forex, or options: Unless you are a member of the exchange, you won't be able to place your orders without a broker. Stock, futures, and options brokers are required to pass different tests in order to obtain their licenses. These tests ensure that the broker knows his or her business and will be able to support you if needed. I personally go directly to a futures commodity merchant (FCM). Trading in this fashion, I get the best price for my trades and I trade through the commodity trading advisor desk.

  What you will not need is a full-service broker. After you finish the book you will be able to make your own decisions based on the trend following methodology. If you want, I will share with you the name of one of the brokers I use personally. Just shoot me an email.

  Don't Be Misled!

  There are no shortcuts in trend following. My own experience has been a journey of almost a decade of learning and finally internalizing what was needed in order to succeed over time when trend following.

  As in all professions, you need a solid education before you get started. Many go to college for years in order to learn and earn a degree. Even with going to college there is no guarantee of success, especially these days. My goal of trend following has been to compound money over time and achieve financial freedom. My goal was never to work by the hour, but to create a lifestyle that many think is unachievable.

  What is shocking is that many aspiring traders think they don't have to learn a single thing. Some believe that they can buy a “magic system” or “trading robot” that will be retirement in a box. Some beginning traders think that they can learn everything they need to know from a “free” e-book that they downloaded from the Internet. Then there are those who read the Wall Street Journal, Barron's, Smart Money, and countless other magazines looking for tips in which to invest. If it were only that easy, we would all be rich!

  ■ Make Sure You Are Properly Funded before You Startr />
  If you don't have sufficient funds to trade, then you need to start doing something about it now. Either save more money or do not even begin. Trading without being amply funded will only lead to disaster. With a small account one can trade stocks or mini commodity contracts.

  The question is asked, “How much do I really need to start trading?”

  That is a personal question. It depends on your time frame and the markets you want to trade. The lower the time frame, the less funds are needed. If you decided to trend follow stocks, you need less than if you trend follow futures. If one were to day trade via trend following, one would not need much money due to margin requirements. This is regardless of stocks, forex, or futures.

  I personally prefer a daily time frame as it gives me greater freedom and no pressure. If looking at dailies, I suggest for stocks a minimum could be $10,000. For futures traded on a daily time frame the minimum is at least $50,000 and quite possibly more, up to $100,000. Regardless of these estimations, it is a personal decision, and you do not want to risk more than 1 percent of your account on any one trade. This would be the best formula for you to decide how much you should start trading with. Start slowly and build confidence over time. Rome was not built overnight nor will your trading career. Focus on learning before trying to make money.

  Many beginning traders think they should trade all of their savings. This is financially reckless and increases trading pressure. To determine how much money you should trade, you must first determine how much you can actually afford to lose and what your financial goals are. There is a traders' joke among futures traders. The question is, what is the easiest way to make a million dollars trading futures? The answer is to start with two million. In all seriousness this is the reality. You do not want to impact your or your family's lifestyle. This only puts more pressure on you.

  The more capital you can afford to lose without negatively affecting your lifestyle, the greater the possibility that you will be successful. The more money you start with gives you greater longevity and cushion in the event of a drawdown. There will always be drawdowns and losses. There will always be ugly periods. These bad periods can extend not just for months but personally I have lived through periods of durations that were greater than two years. The more capital accompanied with proper risk management such as a risk per trade of 1 percent reduces the emotional drag on your psyche.

  You do not want to be emotionally attached to the aspect of money. Successful traders look at percentages, not money. Thinking of money in terms of itself is a terrible thing for a trader to do. They think of the things they could have purchased or done with the money. I think of money as chips. I am betting and I have a small edge. I have heard traders say, after a winning trade, I am going to buy this car or that car. I know at this point they are destined to fail. I think what happens when they have a losing streak; they clearly will not be buying that car. Trading must be thought of a game. You need to play the game without emotions such as fear and greed.

  Let's begin by determining how much of your savings should remain in your savings account. It's important to keep at least six months of living expenses in a readily accessible savings account, so set that money aside, and don't trade it! You should never trade money that you may need immediately or for daily living expenses. Do not borrow money from your parents or in-laws (even though David Einhorn did and now is managing billions of dollars).

  Take a good look at how much money you can currently afford to trade.

  I would not suggest you even think about trading if you have less than $10,000. The reason I say this is that I am a strong believer that you should not risk more than 1 percent of your account on any trade. One percent of $10,000 is $100. That is really tough to do in the real world. It is the lower limit if you plan on day trading stocks. The above concept accentuates why it is better to have a larger trading account. Better means a greater chance to succeed over time.

  If you have the fear of losing this money, it will almost become a self-professing reality. As well, if you cannot afford to lose this money, my opinion is that you will lose this money either by fear or through mistakes. If you do not have enough money, wait!

  You don't want other parts of your life to suffer when you tie your money up in a trade or lose money on a trade. I promise you, you will have many losing trades, so make sure to consider what these savings were originally for. Never borrow money to trade, and never use money that you can't afford to lose!

  If you do not have enough money to trade, some traders rationalize that they can just specialize in one market. They are deluding themselves. I know there will be those that will disagree with me, however, there will be periods or time frames when nothing seems to happen in any particular stock or market. As well, there will be times in which the volatility will be too great in which they cannot put on a low-risk trade (1 percent of their account size). These traders think to lower the time frame and go to tick charts. They end up being cannon fodder for floor traders or the 10 percenters (consistently successful traders over time). At first thought it would seem that it would be easier to focus all of their energy on a single market and supposedly become an expert in that market. However, in reality I believe that it is extremely hard to always make money in any single market. As I am an open person, I would assume some traders have succeeded focusing on just one market; however, I believe this is the realm of floor traders or market makers in stocks.

  I am a proponent of utilizing a robust trading methodology that trades all markets and time frames the same (more on this in Chapter 2). I want to make myself available for potential opportunities. The way I do this is to trade a basket of diversified markets. I never know which market is going to move. I know that markets go from periods of quiet orderly trading to volatile periods. It is very difficult to trade volatile markets.

  ■ Establish Your Trading Goals

  Before you start, you need to determine what your goals are. What do you hope to achieve with your trading activities? How much time do you have to trade? Another great question is why do you want to trade? Before you trade a single penny, really think about what you hope to achieve with trading. Knowing what your goal is will help you stay motivated when you're facing an inevitable drawdown, and it'll help you all along the way.

  What Really Are Your Goals?

  Maybe this is a very obvious question, and the answer is probably simple: You want to make money. There has to be a trade-off, however, between simply making money and the drawdowns one has to endure to get to one's goals.

  No matter how profitable one's trading is, the volatility of returns must be taken into account. If the volatility is too great, there will be a period when one cannot continue to trade. This cessation in trading could be due to an emotional breakdown or lack of risk trading capital. Consider this example. One trader makes 60 percent returns; however, he goes through periods in which he experiences 40 percent-plus drawdowns. Quantifying these numbers over a 10-year period with an initial amount of $50,000 compounds to $5,497,558.14.

  FIGURE 1.1 DUNN Capital Management: DUNN Combined Fund (DCF)

  Source: Chart Courtesy of IASG.Com

  That is the great news; however, at one point in year 10 you lose 40 percent of that much. Does losing $2,199,023 leave you feeling comfortable? The answer is obvious: probably not! Do you really think he can stomach that year in and year out? Would you invest with him? I would personally find it very hard. In the real world there are trend followers like Bill Dunn of DUNN Capital Management who have had some wild swings. You mostly hear of the fantastic periods, not the drawdowns. There were points at which Bill Dunn managed funds in excess of $2 billion. In his program, the Combined Fund DCF, he is currently managing $22 million.

  Bill Dunn has been managing money since the 1970s. He is considered a legend in the trend following world. Dunn has experienced extreme volatility throughout the years. When times are good, people throw him money, and when he goes through drawdowns, his inves
tors panic. As much as DCF has returned 100 percent one year he has had drawdowns in the 70 percent range. Dunn had five years in a row in which he sustained losses and the following year he returned 100 percent.

  I have heard from many investors that they can withstand a 20 percent drawdown; however, when it actually occurs, that is a different story. They quickly translate 20 percent into what that is in a dollar basis. The fear of the 20 percent drawdown increasing to 30 percent or greater sets in very quickly. In my proprietary trading account I consider how much risk I need to take on in order to generate reasonable returns. This keeps me in the race.

  I believe the lower the volatility in a trading account, the more apt one is to stay in the game. Going through any drawdown is not fun or easy. However, there are many investors that are not satisfied with this either. They want the big returns without the big drawdowns. They seem to want their cake and eat it too, as that phrase goes.

  Traders need to be realistic and mature when weighing between these two options. Reducing the magnitude of a drawdown enhances the probability that the trader will stay in the game by two accounts. This reduces the risk of ruin and makes it much less emotionally challenging to go through big swings not just in percentages but also in real dollar terms.

  Some of the biggest mistakes I have seen are when traders are in drawdowns. They stop to think logically and fear kicks in with irrational behavior. These traders forget their trading plan and try to trade their way out of this bottomless pit of a drawdown. They double up, they tighten stops when they shouldn't, or they will do the exact opposite by widening stops. Basically they are out of control and trading in a rage. You do not want to get to this point. This is why it is a paramount issue to “try” to keep losses and drawdowns to a tolerable level. I want to emphasize the word try. We are dealing with uncertainty, and the only certainty is uncertainty.