The Trend Following Bible

by Andrew Abraham

  Trend following success can only happen if you trade only in the direction of the trend. There is no second guessing or debating. You do not let your opinions get in the way. You have an exact plan to follow trades that are working as well as an exact plan to exit quickly trades that are not working.

  You follow the trend! Letting 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 in time 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 2008 October stock market meltdown.

  This exact plan does not mean knowing the future. You do not need to know the future in order to succeed over time when trend following. Too often beginning traders struggle to identify the direction of the market. Beginning traders use very complicated formulas, indicators, and systems to identify a trend. They'll plot so many indicators on the screen that they can't even see the prices any more. They think that the more complicated a system is, the better it should “predict” the trends. As a result, they completely lose sight of the simple basic principle: Buy when the market is going up and sell when the market is going down if you can put on a low-risk bet. No one can ever tell when a trend starts or stops.

  You will learn from my book and my mentoring how successful trend followers both approach the markets and think.

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

  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 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.

  CHAPTER 5

  Managing the Risks when Trend Following

  The only certainty in trend following is uncertainty. Due to this constant uncertainty it is imperative to manage the risks. We are surrounded by risks. Successful trend followers know that we do not know the future. Given the fact that we are dealing in uncertainty, we have no choice but to be extremely adamant in our risk and money management approach.

  Larry Hite, a famous successful trend follower from the 1980s, put it very simply: Trend followers make bets when they trade. If you lose all of your chips, you can't bet!

  In other words, you are out of business!

  Many successful hedge funds teach their interns how to play poker. I invested in Green Light Hedge Fund with David Einhorn many years ago via a fund of funds that I was involved with. I was fortunate to meet David and learned another one of his talents besides trading was poker playing. David is not a gambler; however, he would make low-risk bets both in his trading and when he played poker. In 2006, Einhorn finished 18th in the World Series of Poker main event. Contrary to what some say, successful trend followers are risk adverse.

  Trend followers are not cowboys. Every aspect of their trade is calculated with a well-thought-out exact plan. There is no second guessing. Every possibly outcome has been taken into account.

  ■ Risk of Ruin

  The concept of risk of ruin tackles the issue regarding how much of your trading capital you may lose. You cannot recover from this drawdown or trade your way out. The size of your position is arguably one of the most critical elements of your success as a trader. Sound money management lets you survive the bad periods and gives you the potential to profit in the long run over time. There isn't a set-in-stone rule for position sizes even though I stress 1 percent. A lot of personal issues, such as the size of your account, your risk tolerance, and your experience, should all factor into how big a bet you should make. That said, risk of ruin or the possibility that you'll blow up your trading account when you encounter the inevitable rough patch increases dramatically when you increase your risk per trade. The risk of ruin does increase substantially as your risk per trade approaches 2 percent or less of your portfolio size. There is no perfect or ideal portfolio other than one that fits your personality and account size. You need to develop a portfolio in which you have funded adequately. If you trade too large for your account, you stand the distinct chance of ruin or blowing up. This is the worst case and on a lesser level you will experience deep drawdowns and swings in your portfolio. These wild swings can surely stop you from continuing to trade. This prevents you from building your equity curve and compounding money over time. Conversely, if you trade too small, you miss the opportunities the market can offer you. One needs to have a portfolio of markets and be diversified. As one market zigs another can zag. There are long periods when markets do not trend. When you trade a portfolio of markets you open your possibilities of not just trades but also success. The most practical aspect needs to be introspection of your account size. The more money you have in your accounts, the more markets you can trade. Clearly the less money you have in your account, the fewer markets you might/should want to consider or trade. In order to assist traders the exchanges have created mini contracts. Do not let the word mini mislead you. You make a mistake on one of these, and you can seriously hurt your trading account.

  Those futures contracts are called minis. You have Mini S&P 500 and Mini NASDAQ versions of the larger size. The tick value of the E-Mini version of the S&P 500 contract is $12.50 a tick versus $25.00 on the full size. There exist mini contracts on the currencies such as the Mini Yen. The Mini Yen tick value is $6.25 versus the full size contract of $12.50.

  There exists the direct possibility of encountering a series of consecutive trades that do not work and being forced to stop trading. Think of risk of ruin as bites out of an apple. If you are risking 1 percent of your account on a trade, you get to have 100 bites out of the apple. You can quickly fathom the possibility of having 100 trades in a row not working and losing money (not overly likely). If you are risking 2 percent of your account, you get 50 bites of the apple. Think about the possibility of having 50 trades in a row not working

  Continuing our thought process, if you risk 3 percent of your account on any trade, you get approximately 33 bites out of the apple. If you risk 5 percent, you get 20 bites out of the apple, or 20 trades in a row not working. One last example: If you are risking 10 percent of your account, you only get 10 bites out of the apple. I can promise I have had close to 10 trades in a row not work over the years. Basically you risked too much and your trading account is ruined. The concept of risk of ruin accentuates the reason why I suggest you take approximately 1 percent risk per trade.

  The actual calculation takes into account the probability of winning, the probability of incurring losses, and the percentage of an account at risk. I know I oversimplified my apple idea, but I am sure you get the point. You need to believe that anything can happen. There is a six sigma event out there that can prevent you from continuing to trade. I vividly remember the stock market crash in 1987. More than just the stock market, I remember the move in eurodollars. Believe that anything can happen. I have been trading since 1994 and have executed over the years a large number of trades. Over this period of time I have personally seen long losing periods (much longer than I would have liked). The longer you expose yourself to trading, as I have, the more likely you will see these events, and they are not unexpected. If you trade frequently, it is really only a matter of time before you experience a run of four, five, or even more losers in a row. Consider that this can be not just losing trades but also losing weeks or even months. You need to be able emotionally, psychologically, and financially to get through these inevitable periods. You can't be so overleveraged that a normal statistical run of losers ruins your account. Many traders
talk about maximum drawdown, as if there is a maximum limit. Your worst drawdown is always ahead of you.

  Following is the math formula of risk of ruin:

  R = e ^ (–2 * a/d)

  Where:

  R = risk of losing one standard deviation

  e = 2.71828, the base of the natural logarithm

  a = average, or mean return

  d = standard deviation of returns

  You can play with the numbers, but the reality is that if you risk more than 1 percent on any trade, you will surly encounter pain in your trading account at some point.

  I have seen traders lose 10 percent in a couple of days without proper risk management. My day is filled with speaking with traders as well as testing trading ideas. I even heard a story of how a professional trader lost 50 percent of his account over a period of several short days. He was an ex–mutual fund manager and during the volatility in 2008, he froze. He did not follow his plan. Even with all of his experience he did not accept the risk and felt the market would come back.

  ■ The Exact Elements of Risk Management

  The elements of risk management relate to one of the most important topics in trading: stop-loss orders. A stop-loss order or money management stop is a protective stop that needs to be placed immediately upon entry. There are those who think they are comfortable with “mental stops.” However, in the thick of trading these “mental stops” are not activated. I have heard the excuse that if I place my stop, traders on the floor will run the stop. I find this an excuse for blaming. Blaming does not make you money and the market does not care for excuses. In the heat of the moment the mental stop order must be placed and I have seen traders freeze. They wait, they rationalize, and they convince themselves with a myriad of reasons why not to take the trade. This is one of the most common issues I have seen traders blow up. I do not think you want to be one of the 90 percenters (failed traders). Just one bad trade can implode a trading account that took years to build. Mental stop-loss orders are an accident waiting to happen.

  The only time I would agree that mental stops might be used is if a large number of shares or contracts are purchased or sold. However, this is not reality for most readers, and I strongly suggest once your orders are filled you put in your protective stop. The stop loss is a protective stop you have placed in the market if your open trades reaches or exceeds this stop level. The stop-loss order's purpose is to protect you against large losses. It is prudent to take a small loss. The stop loss is only an attempt to mitigate a loss to a preset amount. However, in the real world there exist gaps and limit days, which can and will exceed your stop-loss order. There are absolutely no guarantees with stop-loss orders. Large losses can be detrimental to both one's financial account as well as emotional makeup.

  I promise you there will be many times your stop losses are hit and the market completely turns around again. This is reality. The only way to avoid situations like this is not to trade. If you get stopped out, you need the mental fortitude to put the trade back on if you get a signal. If you don't put the trade back on, you will feel terrible if this trade becomes the trade of the year. You need to be consistent and accept the risks and that you will have countless losses.

  Worse than trying to put in mental stops, there are traders who believe they do not need to use stops at all. This is the scariest of all. These nonstop traders believe they have a winning strategy or system. If they have a winning technique, why would they bother? These nonstop traders soon wake up after a devastating loss in which they let a small loss compound into a nightmare.

  Risk per Trade

  Risk management starts on the trade level. Too many traders and even experienced traders miss the point on how much to risk on a trade. They think in terms of risk management via a fixed dollar amount or based on their overconfidence of a trade succeeding. Neither of these are traits of successful trend followers.

  Overconfidence The greater the confidence, the bigger the risk they are willing to take. A recent example is John Paulson. He made huge bets in regard to the housing crisis and benefited substantially. Paulson made billions of dollars. However, in 2011 his huge bets worked against him and he encountered a drawdown close to the 50 percent range.

  As in the example with John Paulson, this way of thinking can lead one to failure or big drawdowns. Successful trend followers have internalized that any trade is 50/50 and has no guarantee of success.

  Fixed-Dollar-Amount Risk The idea of having a fixed dollar amount per trade would be saying you are willing to risk a fixed $1,000 per trade. The mistake traders make when they risk a fixed dollar amount per trade is that there will be times they will benefit less or even lose more when risking a fixed dollar amount per trade due to lack of position sizing. This is wrong. There are times when you might be able to put on a greater position due to a low-risk trade. At times when these trades work even greater returns can be generated due to position size. Position sizing will be further discussed shortly.

  Successful trend followers are methodical. Very little is left to their personal opinions. Therefore considering this, successful trend followers risk the same amount percentage risk on every trade.

  Consistency is achieved when trading with an exact plan.

  Position sizing is one of the key components in successful trend following.

  Exactly how much to buy or sell is based on the dollar size of the trading account and the volatility of the issue. The volatility is the dollar risk from entry signal to the initial hard stop exit in case the trade does not work. (Further on I will discuss how to determine the hard stop.)

  The concept of position sizing is shown in the following examples.

  You have an entry signal of Buy of share XYZ at $20.00. Your worst-case exit signal or hard stop protection is $17.00; you are risking $3.00 to see if the trade works. If you have a $100,000 account size and you are willing to risk 1 percent or $1,000, you can put on approximately 333 shares. You divide your 1 percent risk on your account size or $1,000 divided by $3, which is 333 shares.

  You have an entry signal of Buy of share ABC at $15.00. Your exit signal or hard stop protection is $13.00; you are risking $2.00 to see if the trade works. If you have a $100,000 account size and you are willing to risk 1 percent or $1,000, you can put on approximately 500 shares. You divide your 1 percent risk on your account size or $1,000 divided by $2, which is 500 shares.

  As we have already discussed, any trade is 50/50; however, if share XYZ moves $2.00 you can profit $666. Contrarily, if your share ABC moves that same $2.00, you make $1,000. This is what can make trend followers who think in terms of position sizing much more successful than others. The goal of position sizing is to attempt to limit drawdowns and prevent them from becoming so large that it causes you to stop trading. You need to be both financially and mentally prepared for the magnitude of drawdowns you are likely to experience. Your greatest drawdown is always ahead of you, not behind your portfolio.

  Changing the Percentage Risk Changes the Equation You have an entry signal of Buy of share XYZ at $20.00. Your exit signal or hard stop protection is $17.00; you are risking $3.00 to see if the trade works. If you have a $100,000 account size and you are willing to risk 1 percent or $1,000, you can put on approximately 333 shares.

  The difference on percentage risk per trade is increased if you are willing to risk 2 percent, and since you are risking $2,000 of your $100,000 account you can put on 666 shares. If share XYZ moves $2 you profit $1,332 versus $666 on the same $2 move. However, you took on more risk (potential loss of $2,000), and taking larger risk per trades can increase drawdowns dramatically.

  As I have presented to you, most trades do not work with trend following, therefore you are more apt to lose $2,000 versus the $1,000 initial risk. Deciding on how much to risk per trade is a personal choice. Many times with new traders greed or a sense of false security kicks in and they are more apt to risk more per trade. However, after going through drawdowns, this hubris subsides and they
learn risking 1 percent can help them achieve their goals of compounding money over time. There is a trading period when if you go through a drawdown that is too steep, it can put you out of business.

  This is the essence of position sizing and seeking low-risk trades.

  One needs to determine one's personal comfort level with risk per trade percentage. The bigger the risk per trade percentage, the greater potential returns; however, there will be bigger drawdowns.

  The problem with drawdowns is there is a drawdown out there that can stop your trading.

  I have seen traders take on too much risk, enter a severe drawdown, and stop trading. I am personally less concerned about the return on investment and more concerned about how much risk I will have to tolerate to achieve my goals of reasonable returns over time.

  I personally risk .75 to 1.25 percent basis points versus my core equity (dollar account size not including open trade equity) on one of my managed account models, and on my other managed account model I risk a maximum of 1.25 percent of my total core equity size.

  To quantify risk per trade, for example on a $100,000 account, on one model I am only willing to risk $750 on a trade and on the other model a maximum risk of $1,250. Core equity is the equity of all my closed positions and my cash positions. Core equity does not include any open profits. If I were to include my open trade equity I would distort to the upside my true account balance and possibly take on more risk.

  That is it! I have and believe over time I will be able to continue to generate reasonable returns only risking these amounts.