The Trend Following Bible

by Andrew Abraham

  Justin Vandergrift got his start at Futures Truth. I would assume his mentor at Futures Truth was John Hill Senior. John has been in the industry for decades. He has researched and developed thousands of trading systems utilizing a multitude of indicators. He has utilized his applied engineering and mathematical background to trading technology. John is well known in the industry due to his magazine that ranks 200 different 100 percent mechanical publicly offered commodity trading systems. With the name Futures Truth, he dispels the false holy grail claims of systems and gives an unbiased truthful approach to systematic trading. He has written several books on trading techniques and mechanical system trading. I spoke to Justin approximately two years ago and do not recall specifically what he did for Futures Truth. I found Justin to be extremely knowledgeable about mechanical trading systems and his focus on risk was impressive. He stated that future profitability is built on today's risk management. All of his trading decisions start with risk management, not charting patterns or technical indicators. This is a point I have tried to express throughout this book.

  During my conversation with Justin he brought up the point that one of his original investors, a doctor, buys into his drawdowns. This was similar to my trading mentality. The doctor has been able to compound money at a greater rate by adding to his allocation during drawdowns. I recently invested with Justin. He was having a 22 percent drawdown at the time and thought it was as good as any time to invest with him. I am surely not buying in at the bottom nor do I have any plans to exit. I hope to invest with him over many years and compound money. I know that it could be a bumpy road as all trend followers experience draw downs.

  Like many other successful trend followers, Justin's system looks for trading opportunities in 40+ global markets in the following market sectors: currencies, energies, grains, U.S.-based interest rates, international interest rates, meats, global soft commodities, and global stock indexes. He uses a quantitative trading system based on a statistical trading model created from research on historical price movements. He uses a money management system to limit the amount of exposure taken in one market. Trade duration can last from a few days to five months or more.

  Justin has the ability to hit the ball out of the park. In 2008 he returned 82.60 percent for himself and his investors. His compound rate of return is approximately 19 percent. These returns are not without drawdowns, obviously. His worst peak to valley drawdown lasted for 16 months from December 2008 till April 2010. During this period he experienced a drawdown of –24.75%.

  There are countless other CTAs and traders that have failed, however, and the previous results are not representative of those of all trend followers nor am I recommending any of them. My point is that compounding of money over long periods of time can bright about great wealth however, the reality is that there will always be drawdowns.

  FIGURE 4.12 Hypothetically, if you invested $100,000 in July 2007, today it would be worth $239,056.79.

  Source: Chart with permission from Iasg.com.

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

  There are always gurus, geniuses, and legends, but they are not the way to compound your way to wealth. Today we seem to have more gurus since the speed of information increases. The sad part is that even educated and intelligent investors follow gurus like a religion. The big difference, in my opinion, is that these gurus many times are false messiahs. I have seen numerous market cycles. It seems with each cycle there is a guru. These gurus have a hot streak and then in many cases blow up. In the 1970s there was Edson Gould with his famous rule of three steps and a stumble regarding the discount rate. Then along came Joe Granville who spoke to overflowing crowds with his wild antics, who later failed. Robert Prechter came to the spotlight in the 1980s with his Elliott wave theories.

  There are even dead gurus such as W. D. Gann. There are Gann courses and Gann software that can even be purchased today.

  All of these gurus pretty much have one thing in common. They were right at one point in their career, the media proclaimed them a guru and afterwards many of their followers lost money by investing blindly by their guidance.

  ■ We Have Our Legends As Well

  In the last bear market some of the best-known mutual fund managers (legends) were deeply negatively impacted. My simple dumb question: as much as Warren Buffett is the poster boy for “buy and hold,” why isn't everyone rich? Why didn't everyone just invest like Buffett?

  Warren Buffett, –43 percent

  Ken Heebner (CMG Fund), –56 percent

  Harry Lange (Fidelity Magellan), –59 percent

  Bill Miller (Legg Mason Value), –50 percent

  Even Worse…Geniuses

  Roger Lowenstein wrote the book When Genius Failed in 2000. The book discussed Long-Term Capital Management and how it imploded in 1998.

  John Meriwether, a famously successful Wall Street trader, spent the 1980s as a partner at Salomon Brothers, establishing the best—and the brainiest—bond arbitrage group in the world. A mysterious and shy Midwesterner, he knitted together a group of Ph.D.-certified arbitrageurs who rewarded him with filial devotion and fabulous profits. Then, in 1991, in the wake of a scandal involving one of his traders, Meriwether abruptly resigned. For two years, his fiercely loyal team—convinced that the chief had been unfairly victimized—plotted their boss's return. Then, in 1993, Meriwether made a historic offer. He gathered together his former disciples and a handful of supereconomists from academia and proposed that they become partners in a new hedge fund different from any Wall Street had ever seen. And so Long-Term Capital Management (LCTM) was born.

  In a decade that had seen the longest and most rewarding bull market in history, hedge funds were the ne plus ultra of investments: discreet, private clubs limited to those rich enough to pony up millions. They promised that the investor's money would be placed in a variety of trades simultaneously—a “hedging” strategy designed to minimize the possibility of loss. At Long-Term, Meriwether & Co. truly believed that their finely tuned computer models had tamed the genie of risk and would allow them to bet on the future with near mathematical certainty. And thanks to their cast—which included a pair of future Nobel Prize winners—investors believed them.

  From the moment Long-Term opened their offices in posh Greenwich, Connecticut, miles from the pandemonium of Wall Street, it was clear that this would be a hedge fund apart from all others. Though they viewed the big Wall Street investment banks with disdain, so great was Long-Term's aura that these very banks lined up to provide the firm with financing, and on the very sweetest of terms. So certain were Long-Term's traders that they borrowed with little concern about the leverage. At first, Long-Term's models stayed on script, and this new gold standard in hedge funds boasted such incredible returns that private investors and even central banks clamored to invest more money.

  It seemed the geniuses in Greenwich couldn't lose. Four years later, when a default in Russia set off a global storm that Long-Term's models hadn't anticipated, its supposedly safe portfolios imploded. In five weeks, the professors went from mega-rich geniuses to discredited failures. With the firm about to go under, its staggering $100 billion balance sheet threatened to drag down markets around the world. At the eleventh hour, fearing that the financial system of the world was in peril, the Federal Reserve Bank hastily summoned Wall Street's leading banks to underwrite a bailout.

  When LTCM Imploded Trend Followers Made a Fortune!

  Futures get somewhat of a bad rap as being wildly speculative or dangerous. Most people are completely at ease with stocks and bonds. But in 1994 bond funds imploded. The Nasdaq stocks during the dot-com bubble imploded. The fact with stocks is that you leverage 50 percent and with futures this percentage is astronomically greater. It is not the leverage itself but the lack of planning and disregard for the leverage. The problem is the amount of leverage used when trading. There is nothing inherently different between Netflix stock and soybeans as far as volatility.
Perceptions and beliefs on the future affect both examples. Netflix stock as well as soybeans can be volatile and risky (just ask anyone who purchased Netflix at $300). There are studies (which I do not give a lot of credence to) that the average annual price moments of stocks are greater than those of commodities. Numbers can be manipulated and massaged. The reality is that anything from a stock share to soybeans to even gold can negatively affect your net worth if you do not have a plan.

  Comparing the leverage of stocks and commodities is demonstrated below. First, consider stock trading. You put on margin at your broker $100,000 in cash and you buy XYZ stock. An alternative is that you can use margin and leverage your $100,000 that you have put up with your broker and utilize it as $200,000. If XYZ stock goes up 5 percent over the coming months, the investor who put up $100,000 has grossed $5,000. Another investor who put up $100,000 in cash and traded the account as if it was $200,000 and purchased XYZ stock grossed $10,000. He made a 10 percent return versus the more conservative trader who did not use leverage and made $5,000.

  Comparing now to futures or forex. If one wants to trade the Japanese yen one needs to place initial margin of $4860 (this amount can change due to volatility) in order to control 12,500,000 yen or approximately $150,000. A 5 percent upside move when a trader is long is a tremendous profit for the trader. Conversely a 5 percent downward move when the trader is long is catastrophic. Traders are not aware that markets can go limit down or limit up. This means they cannot exit their trades. They get sucked down further into the abyss of losses. Traders blow up due to their lack of understanding the leverage at their disposal. Leverage is a double-edged sword. There are times when vast profits can be generated when one uses leverage and the trade works; however, more often the leverage destroys accounts. Traders do not believe it can actually happen to them nor do they understand the leverage. All those late-night commercials on TV that suggest you can control 100 ounces of gold for only $8,500 delude investors. MF Global blew up due to the leverage they used in their bet of European bonds. Out of panic they accessed client-segregated accounts in order to address their shortfall. MF Global leveraged their assets 30 times. Few traders or firms are truly prepared for dealing with 30–1 leverage. Worse is when there are those who do not even understand they are using that much leverage. Leverage can be compared to a Maserati that drives at speeds of 200 miles per hour. I know that I do not have that driving ability.

  The sword of leverage cut off the head of MF Global. The management of MF Global did not have a cushion and were trading way too big. The complete lack of prudence is shocking. Jon Corzine, the CEO, wanted to transform the more than 200-year-old MF Global into a mini Goldman by taking on more risky bets on eurozone sovereign debt. Corzine was notorious for making big bets while he was at Goldman. The success of those leveraged bets gave Corzine negative reinforcement. There are times when even successful traders trade their egos. It is not just ignorance when one abuses leverage. They feel they have to be right. The only thing that is right is the market.

  Given the size of your trading account and your personal tolerance of risk, you need to determine if leverage is for you or not.

  Futures trading is a zero-sum game. When someone loses, someone wins. For every trader betting on higher prices there is an offsetting trader betting on lower prices. Trend followers have an edge and a plan. Everyone who takes on a position thinks they will win, but as in the case of LTCM there are losers as well. Trend followers are also losers at times and losses cannot be avoided. The goal, however, is to “try to keep these losses small.”

  When LTCM blew up in August 1998, in that one month:

  Hawksbill made 80 percent.

  Eckhardt made 32 percent.

  Abraham Trading made 23 percent.

  The Real Geniuses Were the Humble Trend Followers and Their Investors!

  The irony was that some of the largest and smartest investors bought into the Long-Term Capital dream and lost countless millions.

  How did the so-called smartest, best, and brightest traders who graduated from Harvard or Wharton with pedigrees do during the recent stock market rout in 2008? I will tell you: Many of them blew up while trend followers had a double-digit profitable year!

  ■ The Biggest Mistake Traders Make

  The single biggest mistake traders make is thinking that investing and trading are “easy.”

  They allow themselves to fall for advertisements promising, “You can get rich by trading” or “Earn all the income you've ever dreamed of” or “Leave your day job forever and live off your day-trading profits.” Trend following is not retirement in a box.

  The actual tenets of successful trend following in their essence are basically simple and intuitive in nature. However, in practicality trend following is very difficult due to our greed and fears.

  In order to succeed over time with trend following you will need to internalize these tenets and make them part of your trading.

  It is imperative for your long-term success to always cut losses short and take low-risk trades. You will realize when you start trend following, if you haven't already, that many trades simply do not work. The fact that you will be taking low-risk bets and keeping losses manageable are the cornerstone of successful trend following.

  The reality is that trading is inherently risky. If you were to engage in any highly risky activity other than trading, you would clearly spend some time considering how to protect yourself. It can be as mundane as riding a bicycle and wearing a helmet. I would assume before someone jumped out of a plane they would check their parachute. They probably have a backup parachute. In my trading I trade with a backup stop similar to a backup parachute, which I will detail later on in this book. There are those who trade and they do not even consider the concept of a parachute when they jump out of a plane. These traders do not have stops. They do not know where a trade does not work. They believe they can fly like a bird. They believe the trade has to work, until they crash to the ground. Making one mistake while trading can be your last. The markets are unforgiving. Without even blinking several names come to mind of traders who have crashed. Dighton is one from 2011 as well as the famous trader Niederhoffer from 1997.

  One of the first conferences I went to featured Victor Niederhoffer as a guest speaker. Niederhoffer was extremely successful and even managed money for George Soros. He had returned in the 30 percents for more than a decade. In cases such as this, he was showered with money. Investors only saw the 30 percent, not how he traded. They did not look at his daily equity curve. Within a month there can be tremendous volatility. Many times this is masked by the monthly numbers. Niederhoffer even wrote a bestselling book, The Education of a Speculator. During the Asian contagion he was hurt badly by his bet in Thai banks as well as his bet on the S&P 500. On October 27, 1997, the S&P 500 fell more than 7 percent or 554 points. Niederhoffer still felt his assumption was correct and the market was wrong. He thought the proverbial, that the market will bounce back! He had naked put positions on the stock indexes. As Murphy's Law would have it, he ended up being right but his timing was wrong. This was a fatal blow to Niederhoffer. He had to close his fund and left a $20 million debt at his broker.

  As usual greed has a way of making people forget the past. After closing his fund in 1998 Niederhoffer traded his own account. However, in 2002 Niederhoffer came back and opened his Matador fund. He was returning 50 percent per year with his worst year at 40 percent. Again he was flooded with money and in 2007 at the onset of the credit and housing debacle, he closed the Matador fund after experiencing a 75 percent drop. Lightning struck twice with Niederhoffer.

  Sadly, most traders, from the professionals who manage money to the vast majority of other traders, don't address money management until they have suffered an unexpected waterfall in their equity curve. Maybe it is human nature to focus on the positive, and the primary motivation of traders is clearly to make money. When traders put on a trade, why would they really risk hard-earned money i
f they think they can lose it? For this reason, many do not even consider it plausible to lose money. Only after time or a devastating loss they might wake up to the reality that success in trading is like in football: defense … defense and even more defense!

  No one starts trading just to make 7 percent or 8 percent. I recall vividly when people were disappointed during the 1995 bull market that they only made 20 percent for three years in a row. The reason people seek trend following is to do better or achieve above-average rates of returns. These people have their priorities wrong, and preservation of capital should be one of their priorities at the onset. Many new traders are of the mindset that trading is “easy” and they can garnish riches. Thought processes like this are detrimental to one's net worth. I assume you are reading this book because you are truly looking to improve your results and have passed the gullible stage of thinking that trading is easy. Not to be negative, but fearing the market is good. I have a tremendous amount of appreciation of what the market can do to my financial situation. I would not say fear but respect. The lack of fear is what gets traders into trouble. I am a coward when a trade does not work. I do not try to prove anything or fight it, I exit quickly and stay in the marathon to fight another day with the hope that I can catch a nice trend. I want to be able to trade again tomorrow. I know that it is a useless effort to try to fight the markets. The markets are right. The trade did not work. Next, let's try another one and see what happens. The goal is to stay in this marathon without falling down or giving up. The way I know how to stay in the race is to manage my risks and to try to mitigate my losses. Doing so enables me to be available for those rare winning periods and rare big trades that work.