The Trend Following Bible

by Andrew Abraham

  Eventually I learned that trying to predict anything was a waste of time and not possible. That is I why decided to follow trends. That is why I have been successful over the years since 1994 even though it has been some journey. I never know when a trend starts or stops. I just take small bets, ask myself how much it is going to cost me to see if the trade will work, and try to follow trends. A small position is like a tugboat. Sometimes these small positions can pull a great deal of weight and show tremendous returns. As an example, I was lucky to have a cotton trade in 2010 and just on one contract $20,000 of profit was attributed. This is a rare case; most trades actually do not work.

  I cannot guess how far a trend will go. It is impossible! No one knows how high or how low a market can go. No one knows when a market will move or a trend will begin.

  ■ Requirements for Successful Trend Following

  Successful trend followers strive for the goal of consistency. In order to achieve consistency you need a solid, robust plan that gives the potential to produce consistent trading profits over time. As I stated earlier, if you want to succeed in trend following you must do your work. You MUST invest both time and money to acquire the knowledge that you need as well as the discipline to follow the plan and the patience to let the plan work over time.

  You are accountable for your trading decisions and actions, and you must take responsibility for your trading.

  You are responsible for your trading results, nobody else.

  Perseverance and Commitment

  With these attributes, over time, success can possibly be achieved.

  Trend following is not for everyone. Yes, there are many advantages, but there are also realities that many do not want to face. One of these realities is that you will encounter many losing trades. If you do not want to lose on a trade, do not start trend following.

  Successful trend followers, regardless of whether they are managing money for others or simply for themselves, have robust trend following strategies and the discipline to stick to their trading plan even through the inevitable drawdowns.

  Unfortunately, even with a tested, proven trading strategy, you are not guaranteed trading success. It takes something else. It takes discipline and patience. A proven strategy is useless without discipline. Successful trend followers must have the discipline to follow their system rigorously. Simply purchasing a trend following book (even mine) does not guarantee your success as a trader.

  A Positive Attitude and Realistic Expectations

  As I have already stated and want to reiterate, trading can be simple, but it is not easy. Along the line, you will face losses, but you need to get up every single morning believing in yourself, the robust methodology, and the potential of compounding money over time.

  Give Yourself a Time for Introspection

  Evaluate yourself. Be honest with yourself. Maintain a trade journal and evaluate yourself. I strongly suggest using it for every trade and then reviewing it. Here are some sample questions and reminders to address in your journal.

  Did you follow the exact plan?

  Did you overtrade this week?

  Did you put on too large a position because you thought the trade would work?

  Did you put on too small a position due to fear?

  Did you let your emotions get the better of you?

  Did you let fear or greed overcome you?

  What about ego? Did you have to be right on a trade?

  If you made mistakes—do not beat yourself up.

  Look out the front window, not the back window!

  I have yet to meet a perfect person!

  Take responsibility for your actions and your decisions.

  Admit a mistake, learn from it, and move on.

  Be Committed!

  Trading success will not happen overnight. It requires commitment, time, and effort on your part.

  There are already too many “traders” in the market who think they know everything they need to, who think they don't have to learn anything; they believe there are trading robots out there that will place their trades for them and make them rich. You and I know that this is a sure path to failure.

  Keep Your Cool

  The markets can behave very wildly and move very fast, and you won't have time to calculate complicated formulas in order to make trading decisions. Think about successful floor traders: The only tools they use are a calculator and pivot points, and some make thousands of dollars every day.

  You follow the trend! Let profits run without any fear or greed. Simply detach yourself, see what is happening, and follow the exact plan.

  You will have an exact plan in which at every point you know exactly what you should be doing. When you are letting your profits run you will be exposed to profitable opportunities due to trending markets. You will not be in areas that are illiquid such as the housing bubble or on the wrong side of major trends such as the dot.com bubble or the October 2008 stock market meltdown.

  I will teach you how successful trend followers both approach the markets and how they think.

  You will have an exact plan. You will need to follow it exactly in order to succeed.

  You will not overtrade.

  You will take low-risk bets with the understanding that these trades do not have to work.

  You will immediately take losses when trades do not work out without a second thought.

  You will allow profits to run when trades do work and not cut them short.

  You will have the proper mindset to overcome all the challenges, drawdowns, and durations of drawdowns.

  You will learn the proper mindset of patience and discipline.

  You will not blame your broker, the market, or even yourself.

  You know there is no perfect methodology or trading system.

  You will not jump into a trade prematurely.

  You do not need to be right. Trading has nothing to do with being right.

  The right mindset is one of the keys to investment success, and most traders fail to understand this.

  CHAPTER 3

  Why Trend Following?

  You have all kinds of ways to make money as well as lose it. Many have tried the buy-and-hold (or buy-and-pray) method of stock market investing or real estate and realized it is not the way.

  Trend following is natural and not that complicated. However, complicated and easy is a misnomer. Trend following probably has to be one of the hardest and easiest things to do because of our emotional baggage.

  Markets can only do several things.

  Markets only go up, down, or sideways.

  Trend following entails following the markets when they go up as well as following them when markets go down!

  When you trade with a well-thought-out plan, you will not take out a large percentage of your business day if you decide to trade daily bars. You might only spend between 30–60 minutes a day as I do when I put on my trades. It is your choice to sit in front of a screen and day trade (which is a definite possibility) or to download daily data and determine what action you need to take, if at all. You can trade stocks, forex, or commodities. The same principles apply to all.

  It is that simple! But it is not simple due to our mental baggage such as fear, greed, and ego.

  Too many times we try to make simple things more complicated! There are those who think simple means unsophisticated or impossible to generate money. They are very wrong and track records going back decades from many trend followers prove them wrong. The key to success or compounding money over time is the ability to stay focused, stay disciplined, follow the plan, and have patience. This is the holy grail!

  Trend following in itself is basically simple. You do not have to overanalyze it. You just have to just do it, as Nike says.

  ■ Why Not Fundamental or Even Technical Analysis?

  Fundamental analysis is defined by an examination of the financial statements of the company to determine its current financial strength, future growth, profitability prospects, and cur
rent management skills in order to estimate whether the stock's price is undervalued or overvalued. One must almost be an accountant!

  A great deal of reliance is placed on annual and quarterly earnings reports; the economic, political, and competitive environment facing the company; as well as any current news items or rumors relating to the company's operations.

  And then with all the analysis the stock or commodity can do the unexpected. That is why I hold very little faith in fundamental analysis.

  Technical Analysis

  Technical analysis is defined by the fact that the stock's current price or commodity price discounts all information available in the market: that price movements are not random, and that patterns in price movements, in many cases, tend to repeat themselves or trend in some direction.

  It's easier (and therefore faster) to learn technical analysis than to even attempt fundamental analysis.

  You can learn the basics by reading a couple of books, but you might be deluded or confused with all the countless indicators and still might not have a plan. Technical analysts look at charts the same way a doctor would look at X-rays. Technical analysts examine the charts for information on the future direction of the markets. Again, once they think they have it figured out, then the market does something unexpected. There are many ideas about support and resistance. Too many traders believe those are lines in the sand, not to be broken. However, they are broken all the time. So again you need a plan.

  Mechanical Trading Systems

  With the upgrades in computers, trading system development has become the rage. Too many make mechanical trading system development a hobby, as a way to compound money over time. Too many traders focus all their time and energy searching for new and elusive indicators and better mechanical trading systems. To some degree, this is an admirable quest. However, having the patience and discipline to follow a simple robust trading methodology is preferable to a complicated “supposedly” mechanical trading system. I had a conversation with an engineer who works on helicopters regarding trading. His astute opinion was that the fewer moving parts in a trading system, the better. He made the comparison to a helicopter. The more parts, the more potential defects or impediments. I thought this was a great analogy. Consider that with enough optimization snake oil mechanical system sellers can make their system look like the holy grail. It is perfect. It sells at the highs and buys at the lows. However, in the real world when money is really on the line, these systems do not hold up and simply blow up. Even if you do not purchase a mechanical system, do not make the mistake of optimization of variables and markets.

  I want to put everything in balance. There are many advantages to a mechanical system. I believe you can increase your chances of success over time because a mechanical system removes ego and the emotional dilemmas from a lot of the decision-making processes. The advantage of a mechanical system is that it does not care if Bernanke is speaking or if the crop report is coming out in the next couple of hours. It is completely removed from the emotional issues that can cloud our judgment. The mechanical system simply spits out buy and sell orders based on preprogrammed criteria. Do not confuse this with trading success over time or negating losing trades. The mechanical system makes our trading plan somewhat easier compared to a trader who has no plan and trades based on his gut. The tough decisions have been made and tested with a mechanical system. Before one starts trading a mechanical system, the trader has done some sort of back-testing as to the validity of the concept. Back-testing is not the holy grail either, though. There are traders who overoptimize or pick markets based on past returns. This is another recipe for losses and disaster. Traders also might doubt the validity of their mechanical system once they experience the inevitable drawdown. The danger is if the trader gives up on the program and tries another one during a drawdown.

  There is no free lunch or anything perfect in trading. Too many traders think they can buy certainty with a robot that trades for them. Contrarily there are traders that think they know the future and trade from their gut. The only problem is that they are following the news or some guru. First they go short, and then out of panic they think they must buy or cover. The trader hesitates because all of a sudden he is unsure what to do or he simply freezes. The market is unforgiving and gladly takes his hard-earned money, as if he were standing on top of a building and throwing up dollar bills. Examples like this exemplify the benefits of mechanical systems. First, a nonoptimized robust mechanical trading plan eliminates the myriad of emotional and psychological issues of trading. Traders are relieved of having to make consistent and pressing decisions. The mechanical system has the rules implanted; they have been tested and hopefully accepted by the trader. The testing gives confidence to the viability of the trading concept as well as monies needed for trading the account.

  In both cases I have attempted to show the reasons we need a well-thought-out plan and need to follow it through thick or thin. Set parameters for entries that are robust, clear, and repetitive; follow the signal with the proper risk and money; and let the possibilities work over time. This gives you the potential for success over time. In conjunction with the entry signals you have to have realistic expectations. Too often traders overexaggerate what they expect. They set themselves up for severe disappointment.

  ■ My Answer: Trend Following

  Let's keep it simple: Money is made if you buy when the market is going up and sell when the market is going down. An uptrend is present when prices make a series of higher highs and higher lows. A downtrend is present when prices make a series of lower highs and lower lows.

  Trading can be simple: You buy when the market is going up and you sell when the market is going down. That's how money is made.

  Trend followers do the hard thing!

  Trend followers buy the highs and sell the lows.

  This is clearly counterintuitive as virtually all market participants want to be smart and buy the low and sell the highs, right? In the real world this is impossible. Only liars and people at parties with a lot of drinks in them can call tops and bottoms consistently.

  Trend following is the antithesis of what we are taught in school. We are taught to rely on intelligence. We want to prove we are smart. Trend followers take responsibility for their trades and do not need to prove anything. Trend followers are committed to compounding money over long periods of time. Trend followers are committed to the plan. Commitment to trend following through the bad periods as well as the good periods is similar to the commitment of an Olympic athlete.

  It is not easy to be an Olympic athlete. Olympic athletes go through rigorous training and have constant coaching. Trend following is no different. Athletes do not become Olympic athletes overnight. They train and go through much pain until they reach their goal. In today's society people want instant gratification. Trend following is not instant gratification. Compounding money is not easy to do in our society that is solely focused on instant gratification. The trend follower's ability to delay gratification and inevitable losses gives him or her the potential to succeed over time.

  Have the deep desire to be long-term consistent and successful via trend following if you want to succeed!

  Liquidity

  One can liquidate one's whole portfolio in minutes. Can you do that with real estate or a hedge fund that has a lockup?

  Transparency

  With managed accounts you will see every position. Hedge funds are secretive and you have no idea what they are doing with your money.

  Profit Potential

  The father of trend following, Richard Donchian, traded for 50 years with this strategy. The fact that Donchian traded this strategy profitably for 50 years proves the viability of the concept.

  Further on I will show you numerous trend followers who have been compounding money for decades. These are real and audited numbers. Richard Donchian traded up until his 90s.

  Trend following challenges the traditional thinking about successful trading and tr
aders. The vast majority of traders want to buy low and sell high. Trend followers do exactly the opposite; they buy high with the anticipation of prices going higher or sell lows with the anticipation that prices will fall further.

  Many of you are exploring trend following due to your recent experiences in the stock market. Maybe you are tired of the buy and hold mantras that have been ingrained in our psyche since the start of the great bull market in the1980s and you have lost a considerable amount of your net worth in the stock market.

  People are drawn to manias like moths to a light. From the Great Depression to the dot-com bubble, people have lost their life's fortune. I remember being told to buy tech stocks before they run out!

  ■ You've Got to Love That Saying!

  People have been destroyed from the recent real estate bubble. Everyone was buying second or third homes and flipping them.

  The house flipping mania was not that different from the tulip bubble hundreds of years ago. There is very little difference between Enron and WorldCom and today's Netflix.

  It was like musical chairs until the music stopped. We are overwhelmed and think we need to have all the information to make prudent financial decisions. Take a look at Figure 3.1 to see the equity curve of the stock market over the past 10 years.

  FIGURE 3.1 Equity Curve of the Stock Market with a Compound Annual Rate of Return of 0.39% over 10 Years

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  Greed, fear, hope, denial, follow-the-neighbor mentality, and impatience are always the same generation to generation. Faster computers, phones with stock quotes, 24-hour Bloomberg, and more!