The Trend Following Bible
Page 18
The answer regarding intelligence and reasons why markets move, however, is much closer at hand.
Internalize this statement by William Eckhardt: “I haven't seen much correlation between good trading and intelligence. Average intelligence is enough. Beyond that, emotional makeup is more important.”
The way one thinks when trend following is critical to one's success.
It all boils down to attitude. We as trend followers are faced with the dilemma of how to be and remain confident in spite of adverse conditions such as drawdowns and extended periods when we do not make money. If you really think about it, when a trade does not work, we are wrong, and to make matters worse we lose hard-earned money. Clearly trading is risky.
No trade ever has a guaranteed outcome regardless of all the analysis or anything. On every trade one stands the definite risk of losing money.
The funny thing I learned over the years was that most traders truly believe that the trade has to work. They believe they are not taking a risk. They do not fully internalize that they can lose money.
Contrarily, when I put on a trade I ask myself how much this is going to cost me to see if it works. Losses do not cause me any anguish or emotional discomfort. The markets will at times inflict pain or cause frustration. This is the reality of trading. The only way to avoid this pain or frustration is not trade. Our job as traders is to take both the pain and frustration in stride. The markets do not care about you or me. The markets are going to do whatever they will do. You cannot avoid losses or avoid the pain. You need to accept it as a reality of trading. What you need to do is control how you react to the situation. The situation is just the event. Our reactions are what are detrimental to our psyche. When you have a well-thought-out plan that you follow exactly, you build to some degree immunity to your personal reactions. We have accepted the risks that are inherent in the market. There is no fear, greed, or ego that inhibits us.
I have accepted the risk of the trade even before I put it on.
I know that I cannot avoid losses. All I can do is define what I am willing to lose on a trade and let the probabilities work out over time. There is no sense in trying to avoid something that is unavoidable. I have absolutely no fear or hesitation. Fear is immobilizing and works to the contrary; I simply go with the flow. I ask myself, “How much is this going to cost to see if this trade will work?” Using the wording will work is a lot different than saying make money. Everything is in how you think.
I have heard these words countless times from my mentors: Remain confident in the face of constant uncertainty.
The reality is that one needs absolute trust in one's abilities as well as one's trading plan. Without these two attributes success will never be achieved.
Too many traders assume the more indicators, the better.
Many traders start for all the wrong reasons. They are bored, or they are seeking adventure or challenge.
I have a simple reason for trading. First, I love it and it is my passion. Second, I need to support a wife, three children, and two dogs.
My goal is to compound money over long periods of time.
The more analysis, the better, so say the masses!
The more CNBC or Bloomberg or other financial news you take in, the better! However, I am a proponent of keeping it simple. Everything is represented in price. My trading plan is solely based on that with strong measures of risk.
■ Sweet Simplicity
My goal is to get you into this mindset. Learning the proper attitudes and mindset are critical for successful trend following. When I put on a trade, all that I can expect is that something will happen. There are only four possibilities.
■ A big loss.
■ A small loss.
■ A big profit.
■ A small profit.
These are the only possibilities. Immediately I put my stop in without any hesitation, so in essence I avoid the big loss (except there will be times of gaps that I can't control). It is very rare that on any given day the markets will open exactly at the price at which they closed the day before. Most times the opening range of prices is above or below the prior day's close. This is called an opening gap. There are traders that specialize only in trading these opening gaps. Most times these opening gaps are not large. However, when we are dealing with trading, the only certainty is uncertainty. There are times, as rare as they are, in which there are huge opening gaps. The implication to traders can be adverse. Many times this happens in the currency markets when there is government intervention to support or depress currencies. Last year trend followers got hit with both the Swiss franc and the Japanese yen. Late on Sunday night the central banks went into actions to suppress their currencies. Trend followers who were long these currencies got whacked. I was one of these unlucky traders. The magnitudes of these moves were intense. Thousands of dollars per contract were vaporized within minutes. Every trader that was long these currencies going into the weekend encountered a huge hit at the commencement of trading.
Situations like these, even as six sigma as they are, need to be included in the trading plan.
Before the first Gulf War the general consensus was that the prices of crude would go through the roof at the onset of war. As usual you had the predictors on Bloomberg and CNBC calling for crude to exceed $200 a barrel. Traders bought into the story, counting their profits beforehand. On my mother's birthday on January 16, 1991, crude closed at $30.29 a barrel. After the initial bombing of Iraq, it became clear to the world that the United States and its allies had clear superiority. On January 17, 1991, crude opened down $7.50 a barrel or $7,500. All the traders who bought into the fear were shocked. They woke up $7,500 a contract poorer. There are limits in the markets but they can get locked (limit locked). You cannot exit markets like this. The good news with markets with daily price limits is that you can only lose that fixed amount in any one particular day. However, there is a tomorrow and you might experience another day in which you are locked and cannot exit. This scenario is reality and can cause you much greater losses than you could have ever anticipated. There is no way to predict or know or even prevent being on the wrong or right side of such dramatic moves. There is no certainty. We are dealing with the unknown. For the inherent risks in the markets it is strongly suggested to undertrade. Always calculate your risks on all levels. Risk per trade, risk per sector, and risk on the open trade level always needs to be calculated on a constant basis, as shown in Figures 9.1, 9.2, and 9.3.
FIGURE 9.1 Examples of Small Losses and Small Profits
Source: TradingBlox.
FIGURE 9.2 Another Example of Small Losses and Small Profits
Source: TradingBlox.
FIGURE 9.3 Examples of Small Losses With a Rare Large Profit
Source: TradingBlox.
I also know as a trend follower that most of my trades will not work (they will lose small money). Big deal! It is not that I did something wrong or negative; rather, the fact is that the majority of trades when trend following are not profitable.
I laugh when I hear that trend following is not a viable strategy or that trend following is over. Yes, you will go through periods in which you do not make money as well as periods of extended duration in which you will have losses.
In reality, what has happened to me over the last 18 years is that I have had a lot of small losses, small profits, and some rare big profits, which more than make up for the effort that will enable me to compound my money over time.
Another way to think when putting on a trade is how much this is going to cost me to see if the trade will work. I know I have said it already but I really want to reiterate it! Thinking in this manner forces me to take low-risk bets. I know that the majority of the trades will not work and I know exactly what I am risking.
■ Think Probabilities
When one thinks in this mindset, it becomes easy to put on trades. What also lets one put on the trades effortlessly is trust in a robust methodology and knowing that
over time one will make money. Sometimes it is easier said than done when one goes through the inevitable period in which eight or more trades do not work in a row (I promise you it will happen and as long as you have small losses it will not matter). Many times I have seen traders that think the market is wrong, it will come back. The market is never wrong. Do you want to be right or do you want to make money over time? Trend following success is more dependent on discipline than any pure academic achievement.
When you have three or four trades in a row that are profitable, is it easier to put on the next trade? In most cases yes, but it should not be that way. So why should trades that don't work impact you? Every trade has its own statistical outcome and should not cause you any fear, greed, or pain.
Successful trend followers are focused on executing every trade flawlessly. This is what you need to internalize. They are relaxed as they let the probabilities work over time. Every trade is statistically independent from the next trade.
The people who run casinos do not try to predict or know in advance the outcome of any particular hand of cards; however, they know over time they anticipate to make X percent.
Otherwise they would not have all of those wonderful modern casinos. You need to think like the owner of a casino. Take small risks; realize that any trade or any month does not mean anything. Realize that you will make your money over long periods of time, and if you really convince yourself of this, you are on your way to compounding money and wealth.
Professional gamblers as well as the casinos know and understand probabilities. They know that they need a large series of hands to be played and that there will statistically reliable outcomes over time. Ask yourself how many traders think like this. Not many, that is why most traders fail. I want to help you be one of the successful trend followers!
Believe in Uncertainty
Believe in the uncertainty and unpredictability of every single trade.
Any trade, any month, and even any year really does not mean anything. There will be flat years, flat periods, bad periods, and exceptional periods. This is the reality. Trend following is not a get rich quick plan to wealth. It is a compound your way to wealth over long periods of time plan.
Losses are simply the cost of doing business or the amount of money I need to make myself available for eventual big winning trades.
Successful trend followers are in the “Just Do It” mode in which there is no fear or stress. When you get in your car and start driving are you stressed? Probably not as you have a seat belt and you understand the concept of defensive driving.There is no fear or stress when you trade because they have a well-thought-out plan and there is nothing at risk other than their small bet that you are willing to spend to see if the trade will work. There is no being right or trying to avoid a loss. Basically they are not trying to prove anything other than to make themselves available for potential profitable trades and compound money over time.
Accept the Risk; Stick to the Plan
Successful trend followers accept the risk, follow their plan, and have reasonable expectations without fear or stress.
The pillar of successful trading is accepting the inherent risks, accepting the uncertainty, accepting that you will have countless losses. You must keep the losses small. You do not need to adversely affect your lifestyle. I know this is easier to say than do. My broker gave me a suggestion one day after I was complaining about my trading. I thought he was crazy, but later saw he wanted to teach me to accept the risk. He suggested that I withdraw $5,000 in single bills. Go to the top of a building and throw the money off. Watch the money fall and watch the lucky people on the ground pick up my money. Afterwards be introspective and ask myself how I feel and move on.
This is trading. You do something without a plan, the 10 percenters pick up your money. You need to accept the risk and the uncertainty. If you can learn something from this exercise, you are starting your learning curve about trading. You are both emotionally and financially prepared to trade. You have internalized what is at hand. You must be able to lose money. You must be able to move on and dust yourself off.
Successful trend followers know that most trades will not work, yet they know that they have an edge and know that there will a random distribution of trades that work and those that don't.
Remember, a trade does not have to work.
It will be a random outcome.
This brings us to believe that anything can happen when we put on a trade, and there will be an uncertain outcome. This makes us do several things in order to be a successful trader including immediately putting in your stops to protect. By doing so you are following your plan exactly because you expect that virtually anything can happen.
Think of all of those investors who in their wildest dreams would never have expected the NASDAQ to fall as it did or all of the dot-com investors who watched all of their profits evaporate.
Expect Anything
Any market can do virtually anything at any time.
Once you truly grasp this, you realize the utmost need to have stops both for losses and to follow trades that work beyond our expectations. Successful trend followers cut their losses without any hesitation when the trade is not working. Successful trend followers have an exact plan, are organized and systematic, and have determined their risk thresholds.
Successful trend followers have eliminated costly trading errors caused by fear or greed.
Successful trend followers have internalized that they do not need to know the future in order to be profitable and know to expect the unexpected.
Salem Abraham, one of the most successful trend followers since the1980s, through his long work has instilled in me the idea that trend following is a marathon, grinding it out over the years, and the following statement:
Plan for the Unexpected
I have an unshakable belief that anything can happen and will happen.
Basically the only certainty in trading is uncertainty.
You define your risk in advance because you know there will be uncertain situations and things can go to extremes.
My goal is to eliminate the emotional baggage when trading. This methodology of thinking will help you, as it did me.
One thing that helped me to eliminate the emotional baggage was to mitigate my expectations. I have no expectation that any trade will work. I mitigate my expectations of profits.
I believe that I will make money over time, but I never know in which market or stock or when. There are no guarantees as we do not know the future.
Most people when they put on a trade expect it to be profitable or otherwise why would they put on the trade? Successful trend followers know that they will make money over a long series of trades. They have an edge but never expect that any one particular trade has to work.
In order to compound money over time we need to force ourselves out of the unrealistic expectation mode. Every trade is a random event. Because the last X number of trades did not work, who says that trade Y will not be the trade of the year?
Trade Y could be the trade when you sit back and say to yourself, Wow, I would never have expected that to happen.
This leads to the understanding that anything can happen and will happen, trades can go to extremes. Since we know trades can go to extremes, this reinforces why we immediately have stops to protect to the negative and why we have trailing stops that follow big winners to lock in profits for the positive.
Use the NASDAQ chart in Figure 9.4 as an example. No one ever believed the NASDAQ could fall from approximately 5,600 down to below 1,000 and stay down now for more than 13 years.
FIGURE 9.4 Nasdaq Stock Crash
MetaStock®. Copyright© 2012 Thomson Reuters. All rights reserved.
Markets can go to EXTREMES!
Many are not aware of the action of the Japanese stock market from the late 1980s to the present. In the 1980s Japan was an economic superpower. They were buying real estate throughout the world, especially in the United Stat
es.
The Japanese stock market reached a high in 1989 of approximately 39,000. Today, 20+ years later, the Japanese stock market is hovering around 8,500 (Figure 9.5). Can you imagine buying and holding?
FIGURE 9.5 Japan Stock Market Crash
MetaStock®. Copyright© 2012 Thomson Reuters. All rights reserved.
Things can and will go to extremes!
The majority of investors never considered the cotton market as an area to invest in. Cotton went from a low of approximately 6 to a high of 180 on a back-adjusted basis. Fortunes were made and lost with cotton.
Cotton was one of the reasons in 2010 I made close to 40 percent in one of my managed accounts. I entered in the end of July 2010 and was able to stay with the trade until the end of November 2010. You will note that cotton continued to climb but the volatility and risk were too great to take on (Figure 9.6).
FIGURE 9.6 Cotton Massive Rally
MetaStock®. Copyright© 2012 Thomson Reuters. All rights reserved.
Do you remember what you were paying for gas in 2008 when everyone was calling for peak oil? There were calls that gas would go over $7 a gallon or even more. Crude oil got up to approximately $147 a barrel to crash down to the $34 dollar a barrel range (Figure 9.7). Where were the experts? They were wrong. Trend followers made money as crude oil went up as well as down. Fortunes were made and lost. T. Boone Pickens, the oil guru, lost a fortune while his neighbor Salem Abraham (whom I invest with), the trend follower, made a fortune.