Trading is mental. Doubt me? Want to go some other direction instead? You will be broke in no time.
Bottom line: I go looking for answers where most people can’t or don’t know how to go. Digging for trend following trading lessons is my lifeblood.
Plenty of people write books telling you that they know what will happen tomorrow. Do you really want to bet on the words of people who say they know what will happen tomorrow? Doesn’t that just feel like a roll of the dice at the craps tables?
Exactly. It is nonsense.
However, I do not want you to take my word. I am going to take you on a trading journey. This journey will have you meeting and learning from eleven traders, all with a similar point of view and trend trading philosophy. These men have literally pulled in billions of profit from the market for decades. They are true trading winners who have shared with me their lessons to moneymaking success. In turn, I am sharing their wisdom with you.
What are the most common threads among these men and their successes? They were all self-starters not born with silver spoons. They did not start with inheritances (but you could have). They figured out how to win, when everyone said they’d lose. They never quit. As diverse as their stories are, they all make up an inspirational foundation you can use to start making a fortune over the course of your lifetime.
Lastly, and this is important, the lessons that you will learn in this book, the lessons that I will pass along to you, the lessons that these top traders will pass along to you, are rare. These men do not offer extensive insights to the general public. They have trusted me to present the moneymaking story of trend following, and their paths to it, accurately.
I am going to keep the details of the traders’ successes out of the chapters to a great extent, and let their trading wisdom shine. But please be aware that these traders are the best of the breed. Many of these men started with nothing and turned nothing into gold. Consider a few details about some of the trading teachers you’ll meet:
Gary Davis, Jack Forrest, and Rick Slaughter run Sunrise Capital Partners. Their continuous trend following track record extends for 30-plus years.
David Harding, through his firm Winton Capital, has a continuous track record for 20-plus years. Harding has generated a fortune of nearly $1 billion.
David Druz saw his trading account dip to $1,500, 30 years ago. Today, his continuous track record since 1981 has allowed Druz to make millions, trading comfortably from his office in Hawaii.
Kevin Bruce, who started with $5,000, amassed a fortune of $100 million trading trends over 20-plus years.
Paul Mulvaney, who has a 10-year track record as a trend following trader—gained over 40 percent in the month of October 2008. Yes, the craziest month of the last 30 years, and he killed it.
This is not a complete list. It is a taste to let you see that you are learning from top winners, not anonymous Internet chat room characters pushing the typical news of the day. Carefully explore the chapters to come. I promise you will be surprised and intrigued at the lessons within.
New Edition Note: As the reprint of The Little Book of Trading was underway, Cole Wilcox of Longboard Asset Management (Chapter 9) volunteered to contribute a second Foreword. His trend following comments and stories add a valuable new perspective. Ignore his wisdom at your profit peril!
Foreword
Cole Wilcox
Trend following, in simplest terms, is about investing in positions that work, liquidating what doesn’t, and managing your risk to survive over the long term and ultimately to thrive. If that sounds like what every investor ought to be doing, you’re right. But in practice, it’s as different from conventional behaviors as anything you can imagine. Trend following really isn’t following the crowd. It actually goes against the trading patterns practiced by the majority of the market. And therein lies the opportunity.
Where are the above-average returns, and what is the most sensible, reliable way to access them? These are obvious enough questions for any thoughtful investor. After all, if you just want the average of what any given market has to offer, you simply buy the index and hold it. But if you want above-average results, you can’t do what everyone else does. So what do you do?
As mentioned in Chapter 9 of Michael Covel’s The Little Book of Trading, my partner Eric Crittenden and I asked ourselves this question and spent a decade, and uncountable cups of coffee, seeking answers. It wouldn’t have taken us nearly as long if we had believed our findings the first time around, or even the second, third, or fourth. But what we found was so different from what we’d been led to expect by conventional wisdom that we had to test and retest until there could be no doubt.
80/20
In business, the 80/20 principle has become a common rule of thumb. For instance, you may have noticed that 80 percent of revenues come from 20 percent of customers, or that 20 percent of your customers generate 80 percent of the complaints, or maybe you’ve noticed that 80 percent of sales are made by 20 percent of your sales staff.
Fascinatingly, this principle is seemingly observable everywhere. The majority of career points are scored by a minority of world-class athletes, a small group of career politicians will serve a disproportionate number of terms, most scholarly publications are produced by a few elite academics, and the bulk of award nominations go to a clique of superstar entertainers. Even in your garden you’ll notice that 20 percent of the pea pods produce 80 percent of the peas.
This rule of the vital few, known as the Pareto principle, is a proverbial law of nature. It describes the outcomes of competitive encounters between atoms, cells, animals, humans, businesses, and nations. Regardless of the context, we observe that the majority of the performance comes from a minority of the participants.
Our research confirms that financial markets are not immune to this phenomenon. The first study, titled The Capitalism Distribution, explored the annual performance of all U.S. stocks from 1986 to 2011. The results were compelling: capitalism produces a surprising number of extreme winners and losers each and every year. Over the 25 years studied, nearly 20 percent of stocks were significant underperformers and lost at least 75 percent of their value. Similarly, nearly 20 percent of stocks were significant outperformers. The remaining majority of stocks netted nonsignificant returns. The Pareto principle is thus apparent: in any given year, the excess returns are concentrated in select stocks with extreme performance.
Next, we tested whether the rule of the vital few is characteristic of all global markets and all asset classes. We investigated the risk-adjusted returns for a basket of 105 global futures markets from 1991 to 2010. The underlying asset classes included stocks, bonds, commodities, and currencies. We found that in every year, nearly 50 percent of the futures markets surveyed made new historic highs or set new lows. As with stocks, it is these select extreme performers that are responsible for the majority of the profitable investment opportunities. In totality, it seems that the rules of competition are in full effect in the world of financial markets.
Comp: Please place the following query in the margin of the above paragraph: AU: Please confirm 50 percent here, as other examples of "select extreme performers" cited were the top 20 percent, not 50 percent
It’s an Ocean Out There
What this reveals is that success and failure are much more unevenly distributed than we tend to believe. Unexpected events are likely to occur all the time, if the expectation is a symmetrical distribution. The idea of some sort of steady-state condition of slow, progressive growth for which portfolios have been traditionally designed doesn’t really exist. It’s an ocean out there, full of waves and riptides, storms, and a few hurricanes, too. Why try to trade it as if it’s a calm, evenly flowing river?
Our findings show that if you fail to include the minority of high performers in your portfolio, you forfeit all the real return opportunities. If those few high performers are the ones making the real impact, why balance out the portfolio with a bunch of nonperformers? In
effect, why waste risk on investments that promise little real return? Why not focus all your efforts, and all your risk, on identifying those power plays and simply riding them for as long as they sustain their exceptional characteristics?
This line of thinking leads inevitably to trend following, a systematic, rules-based approach founded on using empirical data to identify difference makers and efficiently jettison the rest. Trend following can position investors to take advantage of these outlier events and ride them, like market waves, for as long as they continue strong.
Trend following allows investors to cover large opportunity sets of stocks, currencies, commodities, and fixed income. It has the added benefit of working on both long and short trades, meaning investors can earn in diverse market environments. This makes it a robust strategy for efficiently navigating the investment ocean and generating sustainable compounded growth.
If Your Portfolio Were an NBA Team . . .
If your portfolio were a National Basketball Association team, trend following would seek to position you to own the LeBron Jameses, Kobe Bryants, and Dwight Howards of the world. There are many able players in the NBA, but only a handful of difference makers. At a certain point very early in their careers, probably as far back as junior high school, these elite players began to distinguish themselves from the rest. When these data trails started to appear, a sharp trend follower would recognize them, and seek to buy into these exceptional performers.
Success in trend following isn’t predicated on selling the top performer to buy a portfolio of undiscovered talent prospects. The trend follower isn’t a predictor of which specific price trend will continue to be a winner. Rather, trend following simply recognizes trends that are already developing, and follows them through to their full potential.
When Kobe Bryant was excelling at Lower Merion High School in suburban Philadelphia, his trend of excellence was already apparent. That’s why Duke recruited him, the Charlotte Hornets drafted him, and the Los Angeles Lakers traded a starting center for him. The Lakers president, Jerry West, paid an ample price for Kobe, but it more than paid off and continues to do so today.
Live to Trade Another Day
Trend following is about finding those difference makers, and holding on to them as long as their performance remains elite. But trend following is also about letting go. And this is just as important, if not more so. Predetermined stop-loss points are set to prevent taking unmanageable losses. It can be hard to admit that you’re wrong and to sell for less than you paid, but when the trend is over, when the wave is spent, if you’ve stayed on it you can only sink.
Not to wear out our sports metaphors, but imagine having to sell your shares in Tiger Woods! That could give you real heartache. Let’s say you owned shares in Tiger when he was winning majors, before the surgeries and the divorce. Then his performance drops and so too does his value. You remember how great he was and how valuable back in the day. It makes you hate to let go now. The combination of fear and greed can exert a heady influence on investors, locking them into losing positions far too long. What if he pulls out of his tailspin? What if he comes back to win majors and break Jack Nicklaus’s record? But as a trend follower, you’re committed to systematically eliminating your biases in order to protect against unmanageable risk.
In fact, Tiger looks like he’s coming back, and he may well do that. But anyone who has attempted to forecast his comeback has been wrong on national TV more than once. Trend following simply acknowledges that, at the end of the day, winners are distinguishable from losers only because they are currently winning.
Trend following treats risk as a kind of commodity in itself. Like fuel in your gas tank, investors have only so much risk to use before they run out. Once you’ve used up your risk, you’re done. Once you’ve burned through your risk, even if the greatest opportunity was right under your nose, you couldn’t take advantage of it.
Trend following recognizes this fundamental reality of investing, so it focuses on managing risk, rather than managing reward. It resists wasting risk on investments that can’t and won’t earn significant returns. Average positions can go bad, but they very rarely metamorphose into significant earners. Similarly, trend following sets limits on losses. Like Tiger Woods, failing positions may pull out of their tailspins, but is the risk manageable if they do not? Trend following, done correctly, insists you consider that though parting with such positions can be sweet sorrow, keeping them may be an unbearably bitter pill.
Limiting your downside in this manner has fundamental earning implications. It allows you to create asymmetric payoffs in which your average winner is always bigger than your average loser. This is the trend following recipe for positive profits over time.
Trend following is data driven, not news driven. It’s based on actual market prices that determine profitability, not interpretations and analysis. So, when executed correctly, it’s immune to the politicking and herd mentality of Wall Street, CNBC, and other opinion influencers. When the data says buy, you buy. When the data says sell, you sell. That doesn’t mean you’ll always get it right. Hardly. Trend following can provide a framework in which you may be wrong much of the time, but when you’re right, you’re right in more profitable ways over the long term.
Only when you understand the ecosystem in which you are investing can you make informed choices about which strategy to deploy. During our decade of research, Eric and I took a long, hard look at ultra-long-term sets of global market data. It became clear that crisis, in one form or another, is a regularly recurring element of financial markets. These disruptive events are like waves rolling through the markets. It doesn’t make sense to try to navigate them in a canoe, which is what many conventional investment strategies amount to-a vehicle built for a smoothly flowing river. By contrast, trend following is much more of a seagoing vessel, built for the swirling, sometimes stormy ocean-like conditions markets organically produce.
Does trend following guarantee you safe and profitable passage through the investment ocean? Of course not. Like any investing approach, it’s only as effective as the process of the people deploying it and the market opportunities presented. But clearly trend following gives investors a framework to manage risk and respond to market realities. And that’s a ride that can be well worth taking.
– Cole Wilcox
Co-Founder and CEO/CIO,
Longboard Asset Management, LLC
Today, at Longboard Asset Management, formerly Blackstar Funds, Wilcox and Crittenden focus exclusively on managed futures and offer their trend following strategy via a mutual fund, the Longboard Managed Futures Strategy Fund.
Foreword
Cullen O. Roche
Trend following—it sounds so simple, doesn’t it? As Dennis Gartman of the Gartman Letter often likes to say: “If the chart is moving from the bottom left to the top right, then I like it.” And to the untrained eye, that’s all trend following is. It’s identifying a trend and riding it. And as the famous saying goes: “The trend is your friend . . . until it ends.” And that’s where trend following adds so much value. Trend following is not just about identifying great investments. It’s about using rules and techniques to manage the risks associated with these investments. What appears to be a very simple strategy at first glance is actually a sophisticated, multidimensional, and vital technique utilized by successful investors all over the world.
I should be clear that I am not a pure trend follower. I use a multistrategy approach primarily due to my belief that no two market environments are ever the same and that markets are highly inefficient. What works in one bull market or bear market will not necessarily work in the next bull or bear market. This is why trading requires a great deal of flexibility and an ability to conform and adapt to new environments. At the core of my work are risk management and the establishment of a systematic approach. Trend following has been absolutely vital in helping me develop the foundation of my investment strategies.
When I
graduated from college with a degree in finance I was your typical hungry young investor. But I was lost. And so I did what most investors do, and I began reading the works of those who had already succeeded in the business before me. I printed out every shareholder letter by Warren Buffett, and I read all of the standard books from A Random Walk Down Wall Street to One Up on Wall Street to The Intelligent Investor. And then one day my father gave me Michael Covel’s first book Trend Following. It didn’t look like anything fancy at first glance, but the powerful message conveyed in the book changed the way I viewed investing forever.
You see, trend following isn’t just drawing a line on a chart and hoping it continues from the bottom left to the top right. Trend following is about studying the history of market movements, creating a game plan, having rules, learning how to apply those rules, understanding money management, and utilizing a risk management approach. It isn’t about using all the failed techniques that the Wall Street establishment has sold to the small investor for so long. Trend following is about thinking outside the box and understanding that the techniques of trend followers are applicable to all markets and all trading strategies. You don’t have to agree with the strictly technical analysis aspect of trend following to know that the techniques applied by trend followers are absolutely vital components of any good investor’s success story.
The Little Book of Trading Page 2