The Trend Following Bible

by Andrew Abraham

  All of this is not needed in order to grind profits out of the markets.

  My goal is to take you off the rat race and start to try to create income via your trading.

  Even worse than 10 years of not making any money in the stock market is the chart of the Japanese equity market. The Japanese stock market in 1989 was at a high of approximately 39,000; today the Japanese stock market is fluctuating around 8,500 (Figure 3.2). Can you imagine still being a long-term buyer-and-holder? In Japan it has been buy and lose all of your net worth.

  Buy and Hold for the Long Term!

  Stay the Course!

  Buy the Dips!

  FIGURE 3.2 Japanese Equity Market

  MetaStock®. Copyright© 2012 Thomson Reuters. All rights reserved.

  Has this message been touted by an industry with a conflict of interest?

  This is the reality of what happened in the U.S. stock market from 2000 to 2010. What is ironic is that it is not unique. Buy and hold did not do anything for investors from December 1972 until March 1980. This also was a flat period of no profits. Worse are the durations and depths of the bear markets in this century, as shown in Table 3.1.

  TABLE 3.1 Bear Markets since the Great Depression

  Bear Market Beginning Bear Market Ending Max DD

  Sept 1929 June 1932 −86.25 %

  July 1933 March 1935 −33.9%

  March 1937 March 1938 −54.5%

  Nov 1938 April 1942 −45.8%

  May 1946 June 1949 −29.6%

  July 1957 Oct 1957 −20.6%

  Dec 1961 June 1962 −28%

  Feb 1966 Oct 1966 −22.2%

  Oct 1968 May 1970 −34%

  Jan 1973 Oct 1974 −48.2%

  Sept 1976 March 1978 −19.4%

  Nov 1980 Aug 1982 −27.1%

  Aug 1987 Dec 1987 −40.4%

  July 1990 Oct 1990 −21.2%

  Mar 2000 Oct 2002 −49.1%

  June 2008 Mar 2009 −54%

  Average Bear Market: −37.3%

  Buy and Hold since 1942

  Compounded Annual Rate of Return: 8.03%

  Maximum Drawdown: 54%

  Do not be deluded. There are losses and drawdowns with trend following.

  There is no free lunch out there, and the greatest drawdown is always ahead of you, not behind you.

  Once you really internalize the realities of trend following you will be free to decide for yourself. You cannot trust anyone but yourself.

  Countless people lost their life's savings due to various market crashes. Many times the politicians and even market legends come out with all types of reasons to delude you. There were statements that were made during the Great Depression of 1929 that in retrospect will make your hair stand out.

  Below is a sampling of some of that I found through Internet searches.

  Bottom Line

  Have a plan and have the patience and discipline to let it work over time! Here is some Great Depression advice from a few influential leaders in finance, economics, and politics during that time.

  Great Depression 1929 Quotes & Statements

  Have no opinion . . . let the markets tell you what to do . . . and manage the risks. “We will not have any more crashes in our time.”

  —John Maynard Keynes, 1927

  “I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future.”

  —E. H. H. Simmons, president, New York Stock Exchange, January 12, 1928

  “There will be no interruption of our permanent prosperity.”

  —Myron E. Forbes, president, Pierce Arrow Motor Car Co., January 12, 1928

  “No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment … and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding.”

  —Calvin Coolidge, December 4, 1928

  “There may be a recession in stock prices, but not anything in the nature of a crash.”

  —Irving Fisher, leading U.S. economist, Ph.D. in economics, quoted in the New York Times, September 5, 1929

  “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as [bears] have predicted. I expect to see the stock market a good deal higher within a few months.”

  —Irving Fisher, leading U.S. economist, Ph.D. in economics, October 17, 1929

  “This crash is not going to have much effect on business.”

  —Arthur Reynolds, chairman, Continental Illinois Bank of Chicago, October 24, 1929

  “There will be no repetition of the break of yesterday . . . . I have no fear of another comparable decline.”

  —Arthur W. Loasby, president, Equitable Trust Company, quoted in the New York Times, Friday, October 25, 1929

  “We feel that fundamentally Wall Street is sound, and that for people who can afford to pay for them outright, good stocks are cheap at these prices.”

  —Goodbody and Company market letter quoted in the New York Times, Friday, October 25, 1929

  “This is the time to buy stocks. This is the time to recall the words of the late J. P. Morgan . . . that any man who is bearish on America will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years.”

  —R. W. McNeel, market analyst, quoted in the New York Herald Tribune, October 30, 1929

  “Buying of sound, seasoned issues now will not be regretted.”

  —E. A. Pearce, market letter, quoted in the New York Herald Tribune, October 30, 1929

  “Some pretty intelligent people are now buying stocks. … Unless we are to have a panic—which no one seriously believes, stocks have hit bottom.”

  —R. W. McNeal, financial analyst, October 1929

  “The decline is in paper values, not in tangible goods and services. … America is now in the eighth year of prosperity as commercially defined. The former great periods of prosperity in America averaged eleven years. On this basis we now have three more years to go before the tailspin.”

  —Stuart Chase, American economist and author, quoted in the New York Herald Tribune, November 1, 1929

  “Hysteria has now disappeared from Wall Street.”

  —The Times of London, November 2, 1929

  “The Wall Street crash doesn't mean that there will be any general or serious business depression . . . . For six years American business has been diverting a substantial part of its attention, its energies and its resources on the speculative game . . . . Now that irrelevant, alien and hazardous adventure is over. Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before.”

  —BusinessWeek, November 2, 1929

  “[D]espite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation.”

  —Harvard Economic Society, November 2, 1929

  “[A] serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall.”

  —Harvard Economic Society, November 10, 1929

  “The end of the decline of the Stock Market will probably not be long, only a few more days at most.”

  —Irving Fisher, professor of economics, Yale University, November 14, 1929

  “In most of the cities and towns of this country, this Wall Street panic will have no effect.”

  —Paul Block, president, Block newspaper chain, editorial, November 15, 1929

  “Financial storm definitely passed.”

&
nbsp; —Bernard Baruch, cablegram to Winston Churchill, November 15, 1929

  “I see nothing in the present situation that is either menacing or warrants pessimism . . . . I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress.”

  —Andrew W. Mellon, U.S. Secretary of the Treasury, December 31, 1929

  “I am convinced that through these measures we have reestablished confidence.”

  —Herbert Hoover, December 1929

  “[1930 will be] a splendid employment year.”

  —U.S. Dept. of Labor, New Year's Forecast, December 1929

  “For the immediate future, at least, the outlook (stocks) is bright.”

  —Irving Fisher, Ph.D. in economics, early 1930

  “There are indications that the severest phase of the recession is over.”

  —Harvard Economic Society, January 18, 1930

  “There is nothing in the situation to be disturbed about.”

  —Secretary of the Treasury Andrew Mellon, February 1930

  “The spring of 1930 marks the end of a period of grave concern . . . . American business is steadily coming back to a normal level of prosperity.”

  —Julius Barnes, head of Hoover's National Business Survey Conference, March 16, 1930

  “The outlook continues favorable.”

  —Harvard Economic Society, March 29, 1930

  “While the crash only took place six months ago, I am convinced we have now passed through the worst—and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us.”

  —Herbert Hoover, president of the United States, May 1, 1930

  “By May or June the spring recovery forecast in our letters of last December and November should clearly be apparent.”

  —Harvard Economic Society, May 17, 1930

  “Gentleman, you have come sixty days too late. The depression is over.”

  —Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930

  “Irregular and conflicting movements of business should soon give way to a sustained recovery.”

  —Harvard Economic Society, June 28, 1930

  “The present depression has about spent its force.”

  —Harvard Economic Society, August 30, 1930

  “We are now near the end of the declining phase of the depression.”

  —Harvard Economic Society, November 15, 1930

  “Stabilization at [present] levels is clearly possible.”

  —Harvard Economic Society, October 31, 1931

  “All safe deposit boxes in banks or financial institutions have been sealed . . . . and may only be opened in the presence of an agent of the I.R.S.”

  —President F. D. Roosevelt, 1933

  Do not feel bad about what happened in the past in the stock market or if you were deluded by geniuses or legends! Think for yourself with the carefully laid-out plan we will develop in Chapter 6.

  Do not look out the back window; look out the front window. Even the father of trend following, Richard Donchian, virtually lost all of his money in the Great Depression. Richard Donchian's trading account basically went to zero. Donchian was above intelligent. During World War II he was one of the Pentagon whiz kids. He was a cryptanalyst who worked with Robert McNamara, secretary of defense under Kennedy and Johnson.

  Richard Donchian started the first publicly managed futures fund, Futures, Inc., in 1949. He developed the trend timing method of futures investing and introduced the mutual fund concept to the field of money management.

  Richard Donchian is considered to be the creator or father of the managed futures industry and is credited with developing a systematic approach to futures money management. His professional trading career was dedicated to advancing a more conservative approach to futures trading. Donchian traded until his death in his 90s. One of Richard Donchian's famous quotes is, “Nobody has ever been able to demonstrate that a complex mathematical equation can answer the question: Is the market moving in an uptrend, downtrend, or simply just sideways?” He took the complicated and simplified it.

  Confirming this is Marty Schwartz, author of Market Wizards. He is somewhat of a trend follower and uses very simple techniques. Schwartz looks at moving averages prior to taking a position. Is the price above or below the moving average? Simple question with a simple answer! Schwartz believes this works better than any other tool or indicator. He does not to go against the moving averages; he knows that it is self-destructive. Going with the moving averages is simple trend following in the basic and simplistic approach. Trend following does not need to be complicated.

  ■ Ed Seykota and Market Wizards

  Systems don't need to be changed. The trick is for a trader to develop a system with which he is compatible.

  —Ed Seykota

  Richard Donchian has been an inspiration to all trend followers, including Ed Seykota, a leader in trend following and pioneer of computerized trading. Ed Seykota turned $5,000 into $15,000,000 over a 12-year time period in his model account, which was an actual client account.

  Seykota's trading system used exponential moving averages. He improved this system over time, adapting the system to fit his trading style and preferences. With the initial version of the system being rigid, he later introduced more rules into the system in addition to pattern triggers and money management algorithms.

  Another aspect of his success was his genuine love for trading and his optimistic attitude. This factor sustained his efforts to continuously improve on his system, although he never changed the response indicators of the system and instead fine-tuned market stimuli.

  One of the key aspects of trading systems is the testing for the maximum drawdown and duration of drawdowns. The maximum drawdown is the difference from the highest level of the equity curve to the lowest. Bear in mind that there is no actual floor for a drawdown. Your greatest drawdown is always ahead of you. Previous drawdowns will be exceeded. Hypothetical results also can lead to distortion. When testing systems, since the future is unknown, all we are basing our work on is the past, and the past has extreme limitations. We have read repeatedly that past performance is not necessarily indicative of future performance. It is so true. All we are trying to do is give us a possible impression on what to expect.

  Worse than the drawdown is the duration or time period in which you have not made any new money. This is probably what causes traders to either stop trading or start their quest for a new approach. One needs the mental fortitude to continue trading when one has not made money for more than two years. This is reality. Many successful trend followers have durations of drawdowns even exceeding 24 months. I have seen some in the 30-month range. What sets these traders apart from others is their tenacity to keep on going. These traders know they are in a marathon. They believe in their methodologies and systems; however, even with that said, the demons pop up and questions are asked.

  The trading system should have multiple markets and be diversified. As well, the trading system can contain various models that could offset each other. There are traders that encompass multiple time periods even for the same type of system.

  The obvious issues to be aware of when testing a mechanical system are curve fitting and optimizing. Through the wonders of computers today one could find the best performing markets in the past, plug in various indicators, and present a holy grail mechanical trading system. The issue is that in the real world at best this system will underperform and in the most likely case not work and lose money. This same optimization can attempt to reduce the hypothetical drawdowns.

  In today's world it is very easy to test different type of strategies and mechanical systems. The problem is that traders can so easily jump to another time or mechanical system with a couple of clicks of a mouse. Every system, every trader will encounter rough periods
of drawdowns and losses. Traders can get nervous after experiencing a group of trades that do not work. The problem with some of these traders is that this sets them off on their quest for a better mechanical system. They think that all of a sudden they can add an idea that could have prevented the prior losses. What is worse is when a trader is in the midst of a trade and he has tested another mechanical system and it is showing a contrary signal. Confusion and pressure set in. Once you are in a trade, you need to follow your original plan and implement any changes after you exit. You must adhere to your plan. Additions or filters are fine to add to your mechanical system, but not in the midst of a trade. The market does not know your position nor does it care. You need to stay focused and let the odds work out over time. You can never avoid a loss. Do not even try to frustrate yourself. You cannot control the markets. All you can do is control your emotions. After the trade is over, analyze it. Set time aside to invest in your future. The best way to do is this is via a trade journal. Do not let fear, greed, or ego become your personal enemy.

  Over the years after trades I have analyzed what I perceived as mistakes and added filters to my model. I believed in the model as it worked for decades for others; however, my goal was to try to mitigate some very evident mistakes. I was an observer of my actions. I was not a participant in my emotions. I added several risk filters after losses such as sector maximum risk and total open trade risk only after analyzing my errors. This is a world apart from tinkering as in a hobby and trying to build the holy grail. Improvement of my model was a well-timed pursuit. Searching and thinking there was something better than what I had would have been a waste of time. I have spoken to traders that have spent years building a system and never trading it. They always think they can make it better. They think they can improve the performance. My reality is that they have not accepted the risks of trading and that they can lose money.

  I am a proponent of robust simple trading ideas. In order to test these I have used a rolling testing time frame. I test the system over different data periods. I test two-year periods, five-year periods, staggering them from the 1980s to the present. In order to have confidence, the system should present similar results in returns, in drawdowns, and in the number of trades. Even with this, it is only an estimate or guess of what we will encounter in the real world of trading.