The Trend Following Bible

by Andrew Abraham

  FIGURE 10.17 Natural Gas

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  Getting whipped around in wheat was not an exercise I like repeating; however, it is reality. I had three trades in a row that did not work. The difference between me and other traders is that if there were a fourth trade to try, I would gladly accept the risk and see what happens. I remember Paul Tudor Jones speaking about how many times he tried to catch a silver trade until it finally worked. This is the mindset. The last trade has no bearing on the next trade. They are statistically unique occurrences and our job as a trend follower is to let the odds work out over time. Ed Seykota's answer to whipsaw trades was very simple: “Do not trade.”

  The wheat trade on December 29, 2010, was a trend breakout to the upside. I exited with a small loss of –.6 percent or –$2,125 on January 11, 2011. The trailing average rate of change got me out of this. It is extremely important to honor your stops. There is no “the market will come back.” At times it can get brutally worse. Wheat fell from the $1,050s to the $800s, which could have been a HUGE loss. What to glean from this is that I can have numerous trades in a row that do not work in a particular market. Due to these losses I do not arbitrarily decide to stop trading that particular market. Any market can completely surprise us, and we need to make ourselves available to all opportunities. This is in complete contradiction to many that look at the past results of a market and cherry pick which markets they decide to trade. Past results are not indicative of future results (Figure 10.18).

  FIGURE 10.18 Wheat

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  I finished the year 2010 with all the small losses, small profits, and a handful of nice trades up net +11.20 percent.

  I have not seen my equity peak of November 2010 until today (March 23, 2012). Some would think 2010 was a fluke; however, as I discussed in the prior chapters, there are only four options that could have occurred.

  Big Losses—Did not have any of those as I had immediately placed my stops in the market. I was fortunate that there were not any big gaps or limit moves against me. These are out of my control and will happen.

  Small Losses—The majority of my trades ended up as a small loss.

  Small Profits—I had many small profits of less than .2 to 1.2 percent.

  Rare Big Profits—I was fortunate to have had position sizing enhance some of the trends that I caught and extended for months at a time.

  I followed the basic tenets of trend following that so many cannot. I let my profits run and I cut my losses short.

  This is trend following.

  The year 2011 was not one of my better years as well as not one of the better years for many trend followers. I will detail what transpired in 2011.

  Really nothing happened in January 2011 other than the typical small losses until mid-February. There were seven trades and no trends. On February 10, 2011, I had a breakout signal on silver. The trade shown in Figure 10.19 stayed until May 5, 2011. Silver hit almost $50 and imploded. I gave back a nice chunk of my profits. The velocity of the fall was shocking. Within several short days silver crashed. The profit on this trade was $8,971 or 2.4 percent (Figure 10.19).

  FIGURE 10.19 Silver

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  Throughout the month of February and all of March nothing but small losing and small winning trades. Seventeen trades transpired until the Swiss franc trade started working (see Figure 10.20). I entered the Swiss franc on April 20, 2011. I stayed with this trade until August 26, 2011, when it started to implode. I got in at 1.1272 and the Swiss franc ran up all the way to 1.4233. In one day the Swiss franc fell approximately 800 points. I exited with my trailing stop of 1.2554. This trade was profitable but the giveback was ugly. However, this is the reality of trend following. We never get out at the top. However, this trade fell apart very quickly. I profited $15,950 or 4.2 percent. I cannot stress how important it is to honor your stop. There are many who are of the “It will come back syndrome.” I have seen too many people destroyed by this syndrome such as by the Nasdaq or Enron trades as glaring examples.

  FIGURE 10.20 Franc

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  Months passed and nothing but the typical losses and some small profits. I had many small losses below the –1 percent range and some profits of the .2 to 1 percent range. Not until July 17, 2011, did I have a trade that made up for all of the small losses. I had a gold trade in which I entered a trend breakout to the upside (see Figure 10.21). I entered at 1,563 and due to the tight stop was able to trade two contracts due to position size. This enhanced my result. I stayed in this trade until September 22, 2011. Gold got up to almost $2,000 and I exited via my average trend following trailing stop at 1,765.5. Gold was all over the news and the rantings of breaking $2,000 were headlines. Headlines are the dread of trend followers. Once the Wall Street Journal starts speaking about a particular market, the writing is on the wall of the end of the trade. However, it is never prudent to follow the news. I trust my methodology and trust it to keep me in the trade while it is working and get me out quickly when it is not.

  FIGURE 10.21 Gold

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  One of the reasons that 2011 was a lacking year was the lack of trends. The only way to make money is if one of these markets moves either up or down. Nothing happened until November 2011. Natural gas broke down on November 7, 2011. At 4.025 I had a signal to go short. This was a big trade; however, the year was lacking some trades that trended. I ended up the year 2011 with a long S&P 500 trade on December 30, 2011. I am still in this trade at the time of this writing. I entered on the breakout signal at a price of 1,251.00 (Figure 10.22).

  FIGURE 10.22 SP 500

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  In the year 2011 I had approximately 90-some trades. However, the vast majority did not work and what was lacking were those rare big trades that make the year. The year 2011 ended with a small loss of –2.1 percent.

  In my model in which I trade a unit size of $150,000, which I called Global Diversified, I am willing to take on slightly more risk for more potential upside.

  My beginning trades in 2009 were the typical small losses and small profit scenarios. They are almost too many to start listing. One trade that did work to some degree was a gold trade. It was your typical breakout trade, which I purchased on November 3, 2009, at $1,091. What is interesting is the trade right before did not work. If I had used the prior trade as a basis for the next trade I would have lost potential profit. The prior trade has absolutely nothing to do with the next trade. One must take every trade via one's plan. I exited this trade on December 11, 2009, as I was taken out by my trailing ATR stop. No rocket science, just repeating the same action over and over again and letting the market give me endless opportunities. Some of these present opportunities while most do not. I profited approximately 1.1 percent on this trade. There was no additional position sizing; it was a one lot for the unit size (Figure 10.23).

  FIGURE 10.23 Gold

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  On the same day, November 3, 2009, I had a soymeal trade. This was a nice quick loss. I lost approximately $1,835 or –1.2 percent and exited by November 6. A month later I had a trade to go long on soymeal on December 14, 2009. This trade also did not work. I exited within a week on December 21, 2009, with a loss of –$1,575 or –1.1 percent. I did not stop trading soymeal because of these back-to-back losses. One must take each trade as it comes. There is no second guessing or picking or choosing which trades one wants. If you do this you are guaranteed to be part of the 90 percent club of losing traders. If I did not take my small loss, the situation would have been grave as soymeal fell strongly. There's nothing wrong with taking small losses. They a
re unavoidable! (See Figure 10.24).

  FIGURE 10.24 Soymeal

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  Sugar was a nice trade. Not that I did anything other than follow my plan. I entered with a breakout trade to the upside on December 11, 2009, at 15.66 with one lot per unit. This trade trended and on February 5, 2010, I was taken out by my trailing stop at 18.97. The trade resulted in a profit of 2.5 percent or $3,632. This offset some of my losing trades. This is exactly what transpires. Small losses and small profits … over and over again (Figure 10.25).

  FIGURE 10.25 Sugar

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  I experienced six trades in a row that did not work. One right after the next, nice. In soymeal I lost –1.1 percent, wheat lost –.9 percent, soybean oil lost -.8 percent, lean hogs lost –.8 percent, silver lost –.7 percent, and last but definitely not least, soybean oil (AGAIN) lost –.1 percent. What is important to note is that all of these losses were small. None of them were either financially or emotionally devastating. Just have to keep on putting the trades on and see what happens. Another way to think about it, which I do, is how much is this going to cost me to see if this trade will work. I like thinking in this fashion as it demonstrates I have no expectations, as well as the fact that I realize that the trade does not have to work. After my nice series of losses I was fortunate to have a series of some trades that worked. I had three trades in a row that worked. The problem is that they did not work enough. I had a wheat trade that I got in on January 12, 2010, and exited on February 16, 2010. This wheat trade resulted in a .5 percent profit or $763 per unit. There was a Eurodollar trade I entered on January 13, 2010, for a .4 percent profit or $600 per unit. This Eurodollar trade lasted until April 5, 2010. As well, during this period I had a corn trade when the grain complexes seemed to start moving in unison. I entered on January 13, 2010, and was eventually taken out of this trade on February 22, 2010, by my average true range trailing stop. The corn trade resulted in a .5 percent profit or $650 per unit. What is noted is that I filled up my correlation risk by having both the corn trade and wheat at the same time. I do not want to have more than 5 percent of my portfolio in any one sector. If I allocated heavier in a sector my correlations to risk would increase dramatically. My goal is to generate reasonable returns over time, being cognizant of the risks I am taking on at every point.

  As Murphy's Law would have it, my next three trades did not work. One after the next did not work. I had a long yen trade in which I entered on January 27, 2010. This trade did not last long, as I exited being taken out by my trailing average true range stop on February 18, 2010. This trade resulted in a loss of –$1,144 or –1 percent per unit. The next trade that did not work was lean hogs (again). You have to just keep on trying to catch the breakout. You cannot pick and choose which trades you do not want to take. I went short the lean hogs on January 27, 2010. It is not common to have more than one trade in a day. I do not trade that often, and a good trading day is a day in which I do not trade. This would mean the trades that I have already entered might be working or there is too much volatility in the market so it is time to try to avoid the noise. The lean hog trade did not work and resulted in another small loss. I exited on February 23, 2010, via my trailing average true range stop. The lean hog trade resulted in a loss of –$955 per unit or .7 percent per unit, livable loss but not fun. The grind continued with a small loss in natural gas. This trade was entered on January 29, 2010, as a short trade. It was a quick trip. I exited via the trailing average range stop on February 8, 2010, with a loss of –$1,313 per unit or –.9 percent of the account. My luck started to improve with two trades in a row that worked. They worked to some extent but not a home run. On February 12, 2010, I had a breakout signal to go long cotton at 30.75. This trade lasted until April 8, 2010. I was taken out of the trade by the average true range trailing stop. What is to be noted here is the patience to let trades unfold. There are no emotions such as fear, greed, or ego. Just let the trade unfold and follow it. Your biggest profits are made by simply doing nothing. This was not the case with this trade but it was an okay trade. The trade made +1.45 percent per unit or $1,965 per unit. On February 18, 2010, I went short natural gas. This would be the first short trade in the implosion of natural gas. This trade exemplifies that trend followers do not catch tops nor exit at the bottom. We take pieces out of the trades. I had a breakdown signal to sell natural gas at 7.04. This trade continued until May 15, 2010, till a price of 6.145 was taken out by the average true range trailing stop. The short natural gas trade returned from the short side +1.6 percent per unit or $2,163 per unit. What is notable about this trade was the prior loss encountered on January 29, 2010. This loss had nothing to do with trying to go short once again. You have to have losses in order to have profits. The goal, however, is to try to keep them small (Figure 10.26).

  FIGURE 10.26 Natural Gas

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  As one starts to understand at this point from viewing all these trades I am simply accumulating small losses and small profits. The next two trades were losses but were kept to a manageable level. I had a signal to go long the Japanese yen on February 25, 2010. The entry long price was 1.1364. This trade did not work and I exited with a loss on March 10, 2010, at a price of 1.1141. The trade, likeall other trades, was exited via the trailing average true range stop. The trade resulted in a loss of -$1,469 per unit or –1 percent per unit. Also, on February 25, 2010, I had a long trade on 10-year bonds. I had a breakout signal at a price of 110.20 and was taken out on March 24, 2010, for a –.8 percent loss per unit or –$1,222 per unit. This trade really never did anything after I had the buy breakout. There are times, however, when the trades start working and then turn around. You have to give them enough room to retrace; however, at times this causes not breakeven trades but losses. You cannot be afraid to take a loss. You must accept the risks when putting on a trade. No trade has to work. Finally, it was nice to stumble into a trade that worked to some degree. The S&P 500 generated a buy breakout on March 1, 2010, at a price of 1,060. I rode this trend until I was taken out on May 4, 2010, at a price of 1,129.5 via my trailing average true range stop. This trade resulted in a +2.4 percent profit per unit or $3,388 per unit. This S&P 500 offset some of those nagging small losses; however, I was still on my quest for some nice big home run trades that occur infrequently (Figure 10.27).

  FIGURE 10.27 SP 500

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  The rest of the month I had my numerous small losses and very small profits. None of them overly interesting to point out. Just the typical noise while trading. However, on March 22, 2010, I stumbled into a nice short Eurodollar trade. This was a breakdown trade, which I stayed with until June 21, 2010. What is interesting with this trade was the amount of open trade profit I had to give back. I entered my short at a price of 1.3435 and exited via my trailing average true range stop at 1.2406; however, the lows of this trade went down to the 1.18 range. As I have stated and restated, you never get out at the bottom. You have to be flexible in your expectations. You cannot control a trade. You have to follow the plan exactly and let the chips fall where they will. You will always have times when a trade really works that you will give back. You do not have to think you left chips on the table. You followed the plan, you made a little money, pat yourself on the back and move on. Do not think for one second that you or anyone else will know where the bottom of any trade will be. The short Eurodollar trade netted out +4.5 percent per contract per unit or $6,356 per unit. This made up for a lot of losing trades. However, I was not really profitable for the year at this point. Just a lot of work for nothing. This is why patience, discipline, and controlling ego are so important. There was no one to whom I would brag about this trade. It does not matter. It is just one trade in a long series of trades. One makes money over
long periods of time. Any one trade or any month really do not mean anything. This is why I compare trend following and trading to a marathon. Yes, it is grueling, but over time, when you have compounded money, you can appreciate all the hard work that went into it. There is no get rich quick. There is putting on the trades over and over again and having the patience to let the concept work over time (Figure 10.28).

  FIGURE 10.28 Euro Dollar

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  Nothing much happened in the month of April except, as I told you it would happen, I got somewhat impacted with a gap against me. I had a breakout signal again for cotton. I went long on April 21, 2010, at a price of 39.54. The trade lasted until May 5, 2010, in which I was taken out by the trailing average true range stop. I have attempted to risk only 1.25 percent of my account on any trade. However, due to a gap that went against me I had a larger loss. These will always happen and worse will be limit moves in which you cannot exit. This is the reality when trading. I lost 1.5 percent on this trade. This was not devastating but much more than I anticipated or wanted to lose to see if the trade would work. On the cotton trade I lost $2,105 per unit or 1.5 percent when I exited at 35.48. The only way to prevent issues like this is not to trade.

  Patience is a virtue when trend following. It is as if we are fishing for trends. On April 28, 2010, I caught a nice fish. It was a 10-year bond version. I entered the long breakout at 110.57 and had the patience to ride it up till September 9, 2010. There would be those who would be unhappy with this trade. I had some open trade profit and the trade reversed and was taken out by my protective average range trailing stop, locking in $7,519 per unit per contract. Great, this was a +5.3 percent profit on the trade. However, what is so typical and what makes trend following so hard, I was taken out and the trade reversed and continued its trajectory upward. I exited at 118.17 and after being taken out the trade reversed and ran up to approximately the 122 range. That is a lot of money. However, I stuck with my plan. I did not look out the back window and complain (no one would care, anyway). More importantly, in order to educate I did not try to chase this trade. I did not have a signal. I did not feel bad. Just have to stay in the Nike moment and just keep on putting them on without any emotion. No greed. No fear. Just grind them out and let's see what happens (Figure 10.29).