One of the more important aspects of trend following is that its users understand the importance of psychology in markets. I like to say that a market is the summation of the decisions of its participants. Markets are inefficient because the participants are inefficient. Thus, the participant with superior emotional control has a decisive advantage. As Michael says:
Trend trading is not a holy grail. It is not some passing fad or hyped-up secret black box, either. Beyond the mere rules, the human element is core to the strategy. It takes discipline and emotional control to stick with trend trading through the inevitable market ups and downs. Keep in mind, though, that trend followers expect ups and downs. They are planned for in advance.
This irrationality was on full display in 2008. At the beginning of 2008, before one of the greatest periods of wealth destruction that the world has ever seen, the average Wall Street analyst had a “sell” rating on just 5 percent of the stocks covered, and recommended a “buy” or “hold” on the other 95 percent. Wall Street doesn’t prepare you to understand when to sell. You see, Wall Street is always thinking of new ways to get you to buy or hold its new products. If you’re a car salesman, it’s difficult to make money if you tell everyone who walks onto the lot that they shouldn’t buy. Trend following closes the loop by not only helping you decipher the right times to buy, but also helping you to manage risks, develop a systematic approach, and identify when to sell. And the results speak for themselves. While the average U.S. equity investor lost 50 percent of his or her money, trend followers crushed the Standard & Poor’s 500 in 2008 because they had preestablished risk management structures in their portfolios.
According to an ancient proverb, “failure to plan is planning for failure.” Trend followers succeed because they have implemented an investment approach that focuses on risk management and strict adherence to rules. And whereas you don’t need to be a trend follower to succeed in the investment world, you certainly need to understand the importance of risk management, the establishment of rules, and planning in advance. If not, you are destined to fail. Michael’s Little Book of Trading is a must-read guide to help you succeed in the shark-infested waters of the investment world.
—Cullen O. Roche
Founder and CEO, Orsus Investments, LLC
Proprietor of Pragmatic Capitalism
Chapter One
Stick to Your Knitting
Gary Davis, Jack Forrest, and Rick Slaughter
While today Sunrise Capital is a very successful money management firm, it did not start that way. It began with three visionary men who dared to be different. They saw opportunity and chased it. One of the founders put it this way: They stick to their knitting. They follow their trading rules. I said this in the Introduction, but it bears repeating: To learn trend following trading, to make a great deal of money with this strategy, requires confidence. The best way to instill that confidence in you is to show you, start to finish, successful traders’ paths. As you read this book you may find yourself asking why it is relevant when these traders started. You may be asking why it is relevant to learn about their performance in the 1970s, 1980s, 1990s, and so on. It’s relevant because it shows consistency of strategy. This is not some “got lucky trading” method that works for one month, one year, or one decade. It has worked literally month by month for decades. In fact, by the time you finish this book I hope you look carefully at consistency of performance at all times for all strategies—not just trend following. If you find a strategy that doesn’t have performance proof behind it, you’re gambling. With that out of the way, let’s jump in.
If you learn anything from this book, let it be the simple lesson: Stick with it. There will always be distractions: Breaking news banners, surprises, and unpredictable chaotic events are everywhere, but you can’t let yourself be fazed. Here is one big secret: Top traders don’t pay attention to that stuff. They have found, through hard work, diligent study, and perhaps a little luck—that their ability to stick with a trading plan is far more important than knowing or worrying about what their neighbor is doing.
Go back with me to the mid-1970s. Jack Forrest, a doctor practicing and teaching in San Diego, had built up his savings to begin trading his own account. It wasn’t a lot of money, but it was enough to get going. He began investing in stocks, but it didn’t take long for him to see that commodity futures, and their big up and down moves, would be much more lucrative.
Like many, Forrest got his start trading with fundamentals—understanding balance sheets, supply, demand, and so on. He realized that his ability to analyze markets was not very good. He talked to local brokers and they had no clue either. No one seemed to have a logical or systematic approach—a trading system. Many were just gamblers. Others chalked up their trading to having a feeling for what was going to happen. We have all had those experiences. That’s how most everyone is initially exposed to the markets.
Some people say, “Boy, it really looks like fundamental analysis has a lot of potential.” If you ask why it has potential, the usual response is “It just does.”
But when you realize that a seat of the pants approach to the markets, otherwise known as using fundamentals, doesn’t work, what can you do? Head toward systematic techniques to trade the markets.
That means looking at what has happened historically. It starts with reading stories about famed investors such as Jesse Livermore, Dickson Watts, and Richard Donchian, and other great traders who have used systematic approaches throughout the years. There is no shortage of these kinds of books to check out. One major commonality from these authors and their decades ago wisdom: Get on the big move and stay with it.
The obvious questions: “Well how do you get on the big move?” “Try different things?” “What are those things?” “Buy a set of trading rules from someone else?”
Forrest started experimenting with technical trend trading ideas, and the idea of channel breakouts.
Channel breakouts occur when a stock or commodity is trading in a tight channel, then starts trading at a price higher than the top of the channel. What do I mean by tight channel? Apple is trading at 300, 305, 300, 305, 300 and then boom jumps to 325. It is breaking out of the “channel” of tight prices.
As Forrest went along experimenting, buying breakouts was working well, so Forrest began trading that way. Some traders take years to find a profitable system, but Forrest had some luck on his side in that he found the right kind of approach—an approach very different from what most others were practicing.
With these kinds of trading rules you can become totally systematic. You can write your rules out and follow them with rigid discipline. Forrest’s first system was very simple: buying weekly breakouts. It was a 12-week breakout system. Enter long or enter short when the market makes a 12-week high or low.
What markets can you trade like this? While the markets were different when Forrest started—all physical commodities—systematic trend following rules allow you to trade almost all markets today. That means stocks, currencies, gold, oil—you name it.
Night Class
While Forrest was doing his own research and trading, he had an interesting experience early on. He took a night class from legendary trader Ed Seykota, during the early 1980s. Seykota reinforced trend trading rules and trading psychology.
Seykota was teaching a four-week channel breakout system with a filter—only to be applied if the market was going up (from the long side). He did not apply the system if the market was decreasing (no short selling).
A filter is set up as a hurdle for taking a trade signal (your breakout). You would only trade from the long side if the most recent six-month breakout was up.
Trend following can be simple, but sticking with it is the hard part.
It was more than just rules though. Because Seykota had been so successful with a systematic approach, it gave Forrest the confidence that he too had a shot at that type of success.
It’s the same reason I want to introduc
e you to successful trend following traders throughout this book: to give you that same confidence.
Teaching Friends
Jack Forrest and Gary Davis were both doctors working in research at the University of California—San Diego. They were also tennis partners. Forrest desperately wanted someone to bounce trading ideas off of and who could trade his same systematic trend trading way, but he had no luck initially finding a trading comrade.
Forrest had about a five-year start on Davis before they even began discussing trading. Even though they were good friends, Davis had no idea of Forrest’s trading passion.
How did Davis finally learn of Forrest’s passion? It all started with the mention of pork bellies while sitting on the beach after a tennis match. Yes, they were talking pork belly futures contracts—the type traded at the CME. Pork bellies? Just a fancy name for bacon.
While talking about pork bellies on the beach that day, Forrest said that he had “all of these books on trading” and told Davis that if he was interested in learning about the markets he was welcome to borrow them. Davis powered through almost 20 books in a week’s time. It was the beginning of his trend following trading career.
Does this sound like an accident? Does this sound like Davis had no preset plan to be a trader? You would be correct. Davis enjoyed his faculty work, but never thought it was the perfect spot for him. He felt like a misfit among the rest of the faculty.
The First 17 Trades—Losers—or Don’t Ask Around
Davis was just about to turn 34 as he started trading with a trend following program he had learned from author J. Welles Wilder, Jr. He lost on his first 17 trades, but once he made one tweak, which he believed is the only reason he is still trading now, he was back in the game.
What was Davis’s Aha! moment? Dissect people who have been successful in almost any form of trading long-term and who have been trading some form of trend following or momentum trading.
Successful fundamental traders often have great success because they’ve been in the right place at the right time.
After recovering from his first big losing streak, Davis realized that he had no idea what anybody else was doing—beyond his book reading. One thing he did know was that most traders last six months and lose all their money. Worse yet, it seemed successful traders lasted three years and then lost all of their money. He expected that his trading career would follow in a similar fashion.
More apt to be involved in independent study, Davis never did like talking to other traders much. He felt the key to his trend trading strategy was to stick with his plan, not changing rules around after looking at someone else and saying, “He has got this great idea. Oh, I’ll try that.”
As Forrest and Davis were each going down their separate, and growing trading paths, their future partner, Rick Slaughter, had already known for some time that the markets were where he wanted to be. He could remember literally being at his grandfather’s knee learning about stocks.
As a young man, corporate law was Slaughters’ interest, but plans shifted. On his twenty-first birthday he placed his first trade. He was one of the first to program a trading system into a computer in the 1970s. Not long after, Slaughter set up shop and was trading trend following systems for clients.
Friends and Family Plan
Davis came to the conclusion, after a period of rigorous and profitable testing with his own money, that there was significant potential in scaling the size of his trading strategies. He sought the help of friends and family for capital to seed a larger pool of money.
Davis founded and launched what would come to be known as Sunrise Capital Partners (known as Sunrise Commodities at the time of inception) in 1980—with the gentle prodding of Ken Tropin (who then was with Dean Witter brokerage, but who today runs one of the most successful trend following firms in the world).
Davis was not super high tech at the time. He preferred handwritten charts and price quotes from the print version of the Wall Street Journal. That should be an inspiration for those of you who want to make excuses for not having the perfect this or that. Just do it, right?
However, there is an even larger lesson at play here. Today, many are at a disadvantage in testing their trading ideas. It is a computer-generated love affair now with commercials promoting 24/7. However, it takes experience to be able to recognize what’s real and what’s luck coming out of the data. Back in the days before the popularization of computers, testing was done by hand. You saw every trade on paper. Everything was obvious. Back then all you needed was to look at a chart, and the longer you looked at a chart, the more you realized how similar they were.
The latest gizmo or hype is not the key to your trading success.
Davis continued on his trajectory of success with Sunrise, and by the mid-1990s was successfully managing over $200 million and routinely delivering double-digit annual returns for investors. Forrest at this point had met and become partners with Rick Slaughter. The two were enjoying success as a team, albeit at a more modest level of assets under management than Davis. Acting on instinct in early 1995, the three industry pioneers merged to form Sunrise Capital Partners.
Markets Are Not Efficient
Many people think you can’t beat the market. Markets are efficient they say. The academics believe it as religion. The story goes something like this: Even if you see a discrepancy in the markets, by the time you try to take advantage of it, it will be gone. So, instead buy a mutual fund and hold on until you are six feet under. Trend followers don’t accept that jaded worldview.
Rick Slaughter may have been young, and a touch arrogant about some things in life and perhaps in the markets, but he never bought the efficient market hypothesis. When he was exposed to Eugene Fama, the founder of the efficient market hypothesis, he was in graduate school and the theory was just taking hold. Slaughter perceived a hole in it. He could not see how markets were efficient, when he and many of his peers were consistently making money. His thinking, then and now, is vastly different from that of almost all typical Wall Street views.
The reality? Markets are often in “tail” situations that can produce sizable profits—profits that, over time, will significantly outweigh losses that may occur when markets are not operating within tails. When I say tail, think back to that stats class you probably hated. The tail of the bell curve is what I mean: extreme events that are supposed to be very rare, but actually happen quite regularly in the markets.
Meaning, we all know the world is chaotic. We know surprises happen. We know that trying to explain the world with a perfectly symmetrical bell curve, a normal distribution, is not smart . . . so why not build a trading strategy to take advantage of that?
How do you do this? Once a potential trend signal is hit within a market, various filtering techniques take place (not exactly the early ones mentioned with Seykota, but in the same spirit). You need to look at the volatility of the market in question and determine whether the movement is simply noise or, instead, the onset of a price trend. Because it is impossible to know the difference in many instances, as a general rule, you should scale back the size of your initial trade in a situation where there is high volatility, placing relatively larger initial trades in times of lower volatility.
The key is to make sure you never miss a potential big trend. You always want to put some kind of trade on when your system says enter as your price trigger hits. If you are wrong, you have stops to protect your capital, to protect your downside.
Believe in the basics: The trend is your friend. It is a powerful tool and that means you can never miss a trade. After all, you never know which move is going to be the mother of all moves.
One of the lessons you can learn from the men at Sunrise: They jump on every trade; however, how much they risk on those trades changes over time, as well as how many pieces those trades are broken into.
Are most trades going to be profitable? No. But you don’t know which ones are going to be winners or losers, so you have to move on
every trade. Am I being redundant? Just a little! But this is so important to accept.
Just as you move on every trade, you must protect yourself on every trade. Protecting your downside is critical to trend following success, but sorely taken for granted by most investors—even by the so-called legendary fundamental investors who pollute TV regularly.
Follow the Leader
Logical rules are mission critical! So do like the leaders do. At the time a trade is placed, regardless of its size, assign it a pre-set stop loss so that in the event a perceived trend immediately reverses, only a very small amount of capital is lost. In addition to this predetermined money stop, all trades should be assigned a pre-set trailing stop that will activate, and then accelerate if a perceived price trend begins to fulfill itself. You do this so if a trend reverses after a run-up in price, at least some of the profits earned from the trade are realized. You want to try to have the highest exposures on when a trend is most likely to continue and the lowest exposures on when a trend is least likely to continue. Generally speaking, you want to trade all markets in a similar fashion. However, there are some markets and sector-specific rules that help differentiate them. It is not unusual to have money stops, trailing stops, and profit targets in a market such as wheat that are different from those used in the euro.
Expanding Your Horizons
A core theory of trend following is that when markets have a certain movement or momentum, and once they start in motion—they tend to stay in motion.
Have there been changes in the last 30 years to affect these basic beliefs? Sure. Market volatility over the last 30 years has been tremendous, but the change in opportunity has equally been tremendous. Today you have the opportunity to diversify into areas that wouldn’t have been possible 30 years ago.
The Little Book of Trading Page 3