Now, diversification is great, but only if you have the rules set in place to control your moves. Most people just don’t do what they’re supposed to do. Jack Forrest was blunt: “Your trading needs to boil down to rules, money management, and that is it. These are the logical rules, and we don’t change them unless we have a good reason to.”
Forrest sees your trend following success in simple terms: You can buy rules from someone, make them up yourself, or buy some and make changes so they become your own. But most people aren’t willing to put the time in. You should be smiling at that. That’s motivating. If most people won’t put in the time, or can’t do it, or just have some excuse—that opens the door wide for you.
Trend trading is a rollercoaster. Having the wherewithal to stay with it when the rollercoaster is roaring downhill is essential.
It’s too easy to find other ways that seem to work at the moment of chaos, but if you’re changing your rules around all of the time, you have no chance. Take that to the bank.
Knowing What You Don’t Know
Gary Davis never felt like he knew anything in the beginning. He was an intelligent doctor and worked hard, but approaching trading like a research scientist may have been his real genius. The one thing he firmly understood after trend trading research was that if he didn’t follow his plan, he had nothing. It was pretty clear that if he just did it, he’d make money.
One of the nice things about being a mechanical trader is that mechanical trading is not time intensive. The research can be time intensive, but the actual trading isn’t. You just have rules, you follow them, and you don’t deviate.
Almost anybody that follows markets knows that they react in certain ways once momentum starts, and especially as it builds. Moves eventually get excessive, stop, and go the other way. To not understand that about markets is to not understand anything about human nature. Davis saw this early.
White Noise
Watching the news, reading financial magazines, and listening to the President, is not how you make money in the markets. Davis is clear on this: “You don’t make money by explaining how things happen and you don’t make money by guessing what’s going to happen in the future. You don’t know what’s going to happen in the future. The things that occur in the future that make you money are all things you couldn’t figure out were going to happen.”
It always makes for an interesting story to say, “Well, this is going to happen because this or that.” That is information everybody already knows. It’s already baked into the market price.
Most traders, and most people, think a good result or big profit happens only because they are smart. That is pure fundamental reasoning. Playing your results is a dangerous game. By playing your results, you play into believing your own hype: “If I made money on it, it was a good idea. If I didn’t make money on it, it was a bad idea!”
This is not necessarily true. A lot of great trades that should have won don’t end up winning, but just because it was a losing trade doesn’t make it a bad idea, or make it a wrong trade.
Davis painted the lesson with sports, “You are a football coach. It’s fourth and inches and you’ve got an 85 percent chance of making a first down to end the game, or you can punt, give it to the other team, and you’ve got a 70 percent chance of winning the game. People will evaluate you on whether you made the first down, not whether you assessed the odds correctly. And if you don’t make the first down, many will say it was an awful decision. If you make it, they’ll say, ‘You had guts.’”
That’s the wrong way to think. You want to try and make assessments of the odds. “If I do it this way, what are the odds?” Are the odds with me or are the odds against me? That’s something that you can’t do very well with fundamental trading.
The Big Money
I know that you want to get rich in a nice straight line that only goes up. No can do. It doesn’t work that way. You can’t imagine your account having some volatility? Don’t trade! If you’re going to trade for yourself and you want the chance to make the big money, you will face periods where your account value can drop significantly. Meaning, if you want the chance for your account to go from 100 to 200, it might go to 60 before it goes to 200. That’s life. Does it have to be that volatile? No. In fact, when Sunrise trades for their clients they aim for less return and less drawdown. Drawdown is the measurement in both time and money of an account’s losing period. These are choices.
The experts who write books on fundamental analysis, appear on financial TV with daily predictions, or worse the ones who write articles saying that you can’t be the next Gary Davis, Jack Forrest, or Rick Slaughter—while ignoring 30 years of positive performance—are just wrong. I would argue that critics in the face of performance proof are delusional. Their fears and concerns are a broken record, while at the same time the trend men keep producing.
However, some academics are concluding that taking a systematic approach to the markets is viable. They are learning, as trend traders already know, these strategies can make you money and reduce your overall portfolio risk. You really can take any reasonable systematic approach, track multiple markets, and have the chance to make serious money in the long run.
But don’t be fooled—it takes hard work.
People always want the big moneymaking strategies, and they exist, but it takes practice to win—just like learning to play the piano. Most people are not willing to sit down, get a good teacher, and practice. Trend trading success is very analogous to learning an instrument. There’s no difference. People would like to make the big money, but no one is going to give it to you. You have to work and do something for it.
That something, in the case of Sunrise Capital, is sticking to an ideology. This is how Sunrise has been able to stay strong as a systematic trend following company. Their success is an inspiration for everyone.
Chapter Two
Someone’s Gotta Lose for You to Win
David Druz
David Druz has been trading as a trend following trader for more than three decades. He, like many in this book, did not start with millions, and when he and I talked he made sure that I understood one of his biggest insights, perhaps the single biggest reason he made his fortune: Life is not fair, and everyone doesn’t win. In fact, markets are typically structured with a winner and loser. Druz believes the evidence shows overwhelmingly that somebody has to lose for you to win. That might sound hardcore, but hold your judgment. There is more.
Imagine you have a friend named Charlie, a fraternity brother a couple years ahead of you in college. You are attending the University of Illinois at Urbana-Champaign in the 1970s. Your buddy Charlie starts trading with $2,000 and a year later has run that up to around $500,000. Oh sure, Charlie appears to be brilliant in his trading and absolutely fearless, but how is he doing it?
After graduation Charlie comes back to school on weekends to visit his girlfriend. He always has wads of bills in his pockets. Many guys in the frat love it because Charlie buys rounds and rounds at the college bars. But wasn’t there at least one guy who wanted to know how Charlie did it, instead of how much he could spend on bad keg beer?
David Druz was that one guy. He pestered Charlie and ultimately landed his first job through him. Druz ended up working at the Chicago Board of Trade (now the CME Group) during summer vacations. This was tedious work in the research department of a brokerage house. Lots of paperwork and not exactly real close to the moneymaking action on the floor.
You have to want success. You can’t be halfway there. Go all in. Go for it!
Druz took computer programming in college and had been given leeway at the brokerage firm to play around with his programming ideas. He had a knack for testing trading ideas—meaning, “What happens if you always buy here and sell there?” He soon started working on his first trend following mockups (what he would call systems) during those summer breaks.
He was in his own world, happy to not know anything about anything. Do you eve
r feel that way? All he knew was colloquial stock market wisdom that had been circulating among all Chicago traders. At the time the buzz was all about “the big cycle.” People were talking about four-week cycles and six-month cycles and so on. Amazingly, there are people today nearly 40 years later promoting the exact same drivel on CNBC and across Internet chat rooms.
Druz soon determined there were no cycles and that daily news guys and prediction prognosticators were full of baloney. Although he had figured out that there were no persistent cycles, Druz still didn’t assume anything going forward. He would hear people declare this or that, and he would respond, “I’m going to test that. I’m going to see if it’s true.” That’s how he got his feet wet testing trading systems.
Once again, testing a trading system means having a rule to buy here and a rule to sell there. Once you have established a rule, you take market prices; Apple, silver, oil, or gold (who cares, the market!), and you test it to see if your buy and sell rules work for making money.
Even though he loved his job in the markets, Druz soon entered medical school to hedge his bets. Yet he still took his vacations at the brokerage firm—working. Medicine was interesting to him, but he was 100 percent fascinated with the markets.
Did he have lots of money? No. The only money he had was $5,000 in stock that his father had given him. Druz cashed that out and put it into his account. At that same time the brokerage firm offered him a job, a full-time job to quit medical school and go work for them. They offered Druz $50,000 to start. That was really good money in the 1970s.
A slightly drunk friend told him, “Dave, don’t take that job. You can be a really good trader, but if you take that job, you’ll never be a great trader. You’ve got to get a nest egg for security. You don’t want to trade with scared money. Finish medical school, be a doctor, and then you’ll be a great trader.”
Does that make sense to you? Maybe not at first blush, but it was the wisest piece of information anyone ever told Druz. He has since seen many people over the years trading with scared money—meaning they would make decisions on the value of the money to them (read: emotional decisions about a new car, suit, or wife), and not follow the exact rules of their trading plan. “Don’t quit your day job” is another critical success lesson—write it down and tape it over your desk.
Druz took his $5,000 and started to trade. He wasn’t very good at first, and his account dropped down to around $1,500. At that point he had hit rock bottom and trading success was beginning to move out of sight.
He then received a message from his brokerage firm, “You got a fill on your trade.” Druz said, “I don’t have any orders in. I’m out of business.” The brokerage replied, “No, you had a ‘Good Til Cancelled’ order (GTC) in and it is ‘limit up’.” Druz was back in business! The universe apparently would not allow him to quit—he truly believed that.
You too might think sometimes, “If I only had one more chance,” but when the next opportunity or chance does come around again you have to be willing to get in the game and play again—without thinking about your negative first experience. Second chances are telling you something. Heed their advice.
The Chart Doctor Finds A Mentor
After trading on his own for some time, Druz was doing well enough that other doctors around took notice. His first trend following fund began in 1981 purely because other doctors at the hospital wanted their money traded.
Doctor Druz, however, was getting burned out from a hectic emergency room schedule—no normal sleep! He was faced with a choice. The markets were his passion, and he could see himself going that direction for the long run. So in 1991, about nine years into private practice, burnout officially hit.
Although he was doing very well without formal training, Druz wanted a mentor. He had read Market Wizards and Ed Seykota was the star. It just so happened that Seykota was famous for teaching many top trend followers going back to the 1970s.
Market Wizards alluded to the fact that Seykota lived near Lake Tahoe and so, as luck would have it, Druz happened to be near Lake Tahoe one day and stopped at 7-Eleven to look in their phone book. Seykota was listed. Druz wrote his number down, and got back on a plane headed for home.
When he got the courage to call him, Seykota answered. They talked for a little bit about trading and Seykota said, “Why don’t you send me some of your trades and call me in a week and we’ll talk again?”
Druz got off the phone and began copying charts. He drew in the trades where he entered, where he exited, and where his initial stops were. He sent them express mail to Seykota.
The next week Druz called Seykota. He didn’t recall their conversation. Seykota said, “I talk to a lot of guys. I talk to guys all the time.” Druz said, “You told me to send you all of my trades and to call you!”
Druz was frustrated, “Ed, look around your desk. Do you have an express mail envelope there?” “Yeah, I got one.” “Did you open it?” “No, I haven’t opened it.” “Well, open it.” Druz was upset that he had stayed up two nights in a row preparing all the charts. Seykota finally began looking through the charts and said, “Oh. This is really interesting. I see what you’re doing here. You trade a lot like I do. But there are a few things you need to work out. Why don’t you come be my apprentice?”
You can’t help but think of the classic Star Wars scenes with Yoda counseling Luke Skywalker: “Do or do not . . . there is no try.”
Druz became Seykota’s first official in-house apprentice.
It was the most remarkable experience of his life. It was Zen. Druz saw Seykota as a genius. Not just smart, but like Einstein or Mozart. Given that I had spent time with Seykota too, I knew what Druz was talking about.
Seykota sees through you. You have no defense mechanisms. Most of us go through life with mechanisms to protect ourselves, but with Seykota, forget it. You’re totally bare-naked, so to speak, and it’s hard on the psyche. It was initially very hard for Druz to deal with.
However, the experience with Seykota gave Druz confidence. Do you ever do that? Reach out for help? Reach out for a mentor even when you are already having great success?
There is always more to learn. New insights, especially psychological ones captured through another person, are the hallmark of a true winning trend following ethos.
The Source of Profits
Long trend following track records are not luck. If they were pure happenstance then Druz, for example, wouldn’t trade for clients.
He believes the reason trend following traders have an edge goes back to a common sense realization tracing back to his early training at the brokerage firm. Trend traders are trying to capture risk premium from the hedgers. What does that mean?
Hedgers are a type of market player. They typically have a position in one market in an attempt to offset exposure in some opposite position. The hope is to minimize their exposure to unwanted risk. Speculators (i.e., trend followers) assume risk for hedgers. Speculators accept risk in the futures markets, aiming to profit from the very price change that hedgers are protecting themselves against.
Hedgers who trade futures are in the risk transfer business. They receive insurance against adverse price moves. What are futures? A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. The U.S. federal regulatory agency of the futures industry is called the Commodity Futures Trading Commission (CFTC). Whereas some futures contracts may call for physical delivery of the asset, others are settled in cash. The terms “futures contract” and “futures” refer to essentially the same thing.
Hedgers are net losers in futures markets over the long run, and Druz’s trend trading approach is based on capturing this risk premium.
The idea is that you want to buy strength (buy high, not low) and s
ell weakness (sell short as the price drops), which is the opposite of hedging behavior. Your winning trades as a trend following trader will be less frequent, but larger on average. These winning trades happen when prices strengthen or weaken well beyond expectations—which is when big trends form.
You can tell when the hedgers, as a group, go from long to short and short to long. They are always on the wrong side of the big moves—primarily because, unlike speculators, they are using the markets to protect themselves. Druz thought, “This makes total sense,” and realized his real trading opportunity was to capitalize on their losses. The job of the hedgers is to transfer risk and lock in business profits for their company. Their job is not to make money in the futures markets. Their job is to utilize those markets to allow them to run an efficient business.
You can never lose sight of the fact that the futures markets are a zero sum game (for every winner there is a loser). For you to win, someone has to lose. It’s astonishing that many never consider this.
However, if your trading plan stays opposite hedgers, if you employ good money management (meaning you don’t bet the farm on every trade), and you diversify (trade more than one market), you can find a mathematical edge to win in the long run. Stay consistent over time with that strategy, and you can make the big money.
By being opposite hedgers, Druz became a trend follower by default, not by design. This is in contrast to trading systems that are specifically designed to capture trends (which is the successful approach seen in most other chapters of this book).
Keep It Simple and Start Small
Do you need a really big company to be a trend follower? Do you need a company at all? It’s unfortunate that many think you need a large research staff of hundreds of PhDs, or a large firm established in a finance capital like London or New York to be successful. That is definitely not the case. Druz is proof positive that you do not need a large overhead to produce large profits.
The Little Book of Trading Page 4