The Little Book of Trading

by Michael W Covel

  Look at Ed Seykota, for example. Druz noted that Seykota doesn’t have a staff and he blows most of his competition out of the water. It’s just him.

  If you are working with very short term trading, or sophisticated PhD stuff (whatever that might be), that’s a whole different game. Maybe you do need a PhD army for different trading strategies, but we are not discussing those strategies here.

  Follow the Leader

  Designing your own trading system can seem complicated at first. If you design a system to capitalize on longer-term trends, once you appropriately integrate portfolio-selection and money management strategies (extremely important!), it is surprising that your choice of system or parameters thereof is often quite uncritical over the long run. Certain types of systems do perform better than others, and selecting certain clusters of variables within a system will affect system performance.

  But what really counts is this: Once a system’s algorithms and parameters are established, the system must be followed exactly and religiously. A system cannot be second-guessed or used intermittently. Values of variables cannot be altered. Parameters cannot be arbitrarily changed. A robust system works over many types of market conditions and over many timeframes. It works in German Bund futures and it works in wheat. It works when tested over 1950–1960 or over 1990–2000. Robust systems tend to be designed around successful trading tactics not designed around specific types of markets or market action. And here is the amazing thing about robust systems: The more robust a system, the more volatile it tends to be!

  Druz gives this advice: “There are whole families of trend trading ideas that seem to work forever on any market. The down side is they are very volatile because they are never curve-fit. They’re never exactly fit to any particular market or market condition. But over the long run, they do extract money from the market. You want to be focused on how you divvied up the risk in your portfolio, how much risk you take in each market, how many contracts you trade in each market, that’s the stuff that really counts . . . if you have money management wired, you can let volatility go because you know it doesn’t have any correlation with the risk of ruin. You can use volatility to your advantage.”

  “Put your Affection on Portfolio Selection!”

  Trend following is not rocket science. You can do this, but you are going to want to focus on one area more than you might imagine. Often neglected, but an extraordinarily important ingredient in your trend following trading, is your portfolio selection and portfolio weighting. Let’s take a look at some recent markets. By far one of the most amazing markets of the last few years has been cotton.

  Now, let’s suppose you had a portfolio that consisted of one market and you happen to pick cotton. Any kind of trend trading system you use would make money. Now, let’s suppose that you pick cocoa. Almost any kind of trend system that you come up with would not make money. Success was completely dependent on which market you picked.

  Many times, over the years, systems traders have contacted Druz for his help. They’ll send him their track records and say, “Here is my system, can you give me any advice?” He invariably will look at what markets they are trading and can tell right away whether or not portfolio selection was considered.

  Many miss the importance of portfolio selection completely. You can make rules to narrow down your portfolio to something manageable from the thousands of markets available.

  What is a key lesson about portfolio selection? There’s a pervasive mindset that every market should be weighted equally. That’s not true. It doesn’t work that way. Druz learned that from Seykota.

  Seykota had a trade on in the German Bund. Seykota decided to add more to his Bund position. Druz said, “Ed, you already have a Bund trade on.” Seykota looked at Druz like he was from the moon and said, “Oh.” Druz continued, “Now you can diversify. You don’t want to be correlated?” Seykota plainly, but with great wit and wisdom, said, “The Bund is the best market out there now.”

  Druz said, “I think we should really take a trade in T-bonds for diversification.” Seykota did not see the logic. He saw Bunds as the best market at the time and explained that he was going to continue taking another trade in Bunds instead of T-bonds.

  This is not saying that you want to put all your eggs in one basket, that’s not the concept, but the idea is that your weightings of the markets don't need to be uniform. That simple Seykota wisdom hit Druz. It was an Aha! moment.

  Stick Around for the Dance

  In a world where people fixate on buying low or cheap, don’t forget that some trend following traders don’t get into markets until they are so scarily high that you might feel it is crazy to still buy. That mentality runs square against almost every common Wall Street axiom over the last hundred years, but it is exactly how Druz has made a quiet fortune while staring out over the Pacific from his Hawaii home.

  And you don't have to have a thousand PhDs in your organization to trade trend-trading rules. Don't give up, and don't think just because you don't have the so-called right background or degree, or that you don't have a huge staff, that you can’t be a trader making big money.

  The Druz experience is all about getting the little guy to see himself making money. The little guy can win. Druz is proof.

  Your goal is to be around forever making money at this game. The best way you can go about that is by making it hard to be knocked out.

  Chapter Three

  No Guts, No Glory

  Paul Mulvaney

  Paul Mulvaney wants to make the most money possible over the course of his lifetime. And so far he’s headed in the right direction. Mulvaney is known as the trend following trader who made over 100 percent in 2008, but I’m willing to bet that there will be more 100 percent years to come. His insights are especially useful for readers who still dream about getting rich—not the opportunity for a couple of thousand dollars a month in retirement income living at Del Boca Vista Phase III (Seinfeld fans are with me).

  Look at baseball. The home run hitter is the one we pay to see. Everyone wants to be there when a 500-foot home run is blasted into the upper deck. Even if you know nothing about baseball, balls hit far into blue sky inspire awe.

  Trading is no different. Making the most money possible is what captures our imagination. It’s what we all want, even if some of us are deathly afraid to admit it. Unfortunately, in today’s culture, wealth building is something frowned on, especially if you end up with more than your neighbor.

  That attitude did not stop Paul Mulvaney. He generated returns of 11.6 percent and 45.5 percent in September and October 2008, at the exact time Lehman Brothers’ collapse was scaring the wits out of everyone. Home runs? An understatement. Unapologetic wealth creation—check.

  Is he a trend follower? Yes.

  Mulvaney’s returns challenge the widespread view that trading based on mathematical models, the ones built on historical chart patterns and trends, don’t work. His full-year return in 2008 was in excess of 100 percent. That return should grab you by the throat with some discomfort. Where did those returns come from?

  Numbers Obsession

  Mulvaney started programming computers in his mid-teens during the late 1970s. Programming at an early age instilled a systematic mindset that carried into college and into business. Initially he did in-depth trend trading research while working at Merrill Lynch. And by the time he had left to hang up his own shingle, he had devised essentially the trend trading system he uses today.

  The start, his launch, was in essence, “Other trend following traders have been very successful. I can be too.” From there he proved their success and techniques to himself. He dug deeper, learning and testing his ideas against their achievements so he too could be very successful.

  Mulvaney tried to find out everything he could about everyone else’s profitable trend trading, but it only amounted to snippets. There was not a lot of trend trading detail in his world at the time.

  His background allowed him to begin
writing trading simulations (think TradeStation® today). It was second nature to him. Programming was what he was trained to do.

  It was not that difficult to come up with a simple trend following model and test it. Knowing that there were big trend following firms profitable over long periods of time, and that they were all using similar trend following strategies, his direction was set.

  Discovering channel breakouts has been a link throughout numerous start-up stories. Mulvaney was no different. He exits positions at a predetermined stop-loss point. Nothing emotional, like breaking news, ever leads him to override his system, not even a shock event (think the Japan earthquake).

  His entry methods have always been simple (read: breakouts). It’s what happens later that matters. Preparing for what could happen is what you should be spending most of your time on. How you compute the amount you are willing to risk for every trade, and how you exit your big winners, that’s what counts.

  I quickly learned other key, big picture principles and lessons from Mulvaney.1 These points are not about a particular linear order. These are crucial pieces of the puzzle that just need to be absorbed:

  Don’t be afraid to trade smaller and more obscure markets. Orange juice? Trade it. It works. You can make money there.

  Strive to produce a home run out of every trend that you can get money on. But every trade has a defined stop-loss point, so you know exactly how much you can lose. If the trade starts to go in your direction you only exit if it starts to turn against you. Make no predictions about how far a trend might run. You just let it go because you can never know how far it might go. All you know is that when a market starts to move, there are forces that you can’t understand at work. Don’t ask, “Why?”

  Aim to make high absolute returns in rising or falling markets. You want to generate returns in all market conditions by taking long or short positions across a diversified range of markets.

  Markets don’t move from one state to another in a straight line; there are periods of shock and volatility. You have to deal with those unsettling but inevitable events, but there are many, many commercial systems that have been generating strong, albeit volatile, returns for a long time. Mulvaney opined: “There are definitely firm grounds for believing in Santa Claus.”2

  You want your trend following method to be very general. You want it to continue to work, meaning it can’t be dependent on any unique set of market characteristics. Trend following’s robustness and volatility go hand-in-hand. The ability to take punches to the chin and remain robust is part of the reason you will be able to thrive and survive.

  Unfortunately, despite all of the evidence, many find it hard to accept the inherent return in trend following. They like to argue that trend following is lucky. You should pursue trend following because of its superior absolute profitability. If friends, brokers, or your professors don’t get it—that’s fine. They don’t know and you can’t expect them to know unless they are doing the same homework as you.

  Go try trading using fundamentals alone. Go lose some serious money. Isn’t amassing a comprehensive set of economic data for all markets worldwide impossible? It is vital to focus on what is happening rather than on what should happen. Trend following is about what is happening now. It is a very pragmatic strategy. Never lose sight of the famous saying by John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.”

  There is no perfect trading system. It’s like being able to define the perfect game of golf or tennis. You can only compare one person’s game against another’s. There is no absolute answer. Some trade for huge returns, some trade for moderate returns. It is a choice you need to make.

  Should you trade short-term trends? Unequivocally, trend followers should go for the long term—trends that can extend for over a year. Long-term trading avoids the short-term randomness inherent in markets.

  Don’t take profits. What do I mean? If the market is up, don’t get out because you think you already have enough profit. Exit on your stop losses only. Profit taking interferes with the unlimited upside potential that you want to have, in theory, on every trade.

  If you have a system, and you regularly override your system, you are essentially waving goodbye to the incredibly valuable body of statistical research from all trend followers over the last 30 years.

  As a trader, you always want to prevent drawdowns from occurring, but trying to avoid them completely is absurd. In fact, it’s not volatile trading that you should be scared of; rather it’s trading that promises to make you money every month. That’s the strategy where you wake up one day broke.

  Sticking to your system is much more important than the actual details of the system. It’s you against the world, not you and your buddies commiserating in a chat forum.

  Mulvaney’s trend trading is profitable on 54 to 55 percent of days, but on only 25 percent of trades. Obviously those 25 percent of trades are more profitable than the 75 percent of trades that are losers. Many traders have a hard time accepting the numbers. If they only dig a little deeper they can see the profit margin.

  No Prediction

  If you turn on CNBC you will see talking heads spouting daily about forecasting and prediction. They can’t all be full of it? We really can’t predict? Econometric researchers have tried to forecast or predict where markets were supposedly headed for decades, but they continually fail. Have they rightfully and finally concluded that it is a fool’s errand to try and predict the future? No, I don’t think so! They will never stop.

  Trend following strategy, taking a completely different philosophical stance, is built on surprises, not predictions. When surprises are planned for in your trading strategy, when predictions are known as folly from the outset, it is much easier to sit back and let the market run its course.

  That means, of course, saying no to the efficient market hypothesis (EMH). The markets are clearly inefficient enough that trend followers, using fairly uncomplicated trend following rules, can and have made serious money for decades.

  If enough traders have won with trend following over enough time using broadly similar techniques, then that can only mean the markets are inefficient, and wise investors and traders should take advantage of it.

  I covered many top trend followers in my first book, Trend Following. John W. Henry (owner of the Boston Red Sox), Dunn Capital, Campbell and Company, and Millburn Ridgefield were some of the early trend firms that influenced Mulvaney.

  He could look up to them, see their success, and be inspired. Undoubtedly, they all shaped his belief that he too could be a trend trading success.

  However, Mulvaney doesn’t believe that he is on the cutting edge of trend following technology because there is no cutting edge technology in terms of trend following. He admits to his system’s being quite old fashioned. That is how you should view it too. Let’s look at a few more of his big picture principles.

  Prices are random variables. That’s all they are. Does that mean if someone asked you what markets you were trading you could look at them and say, “You know what, I have no idea, absolutely no idea what market I am trading. It’s just a number.” Yes, you could say that!

  You don’t need to know anything about the fundamentals. You are a data miner who looks at data objectively and emotionally to try and find a way to profit. It’s a game, folks. It’s the board game Risk. Play the numbers.

  Be prepared to risk a certain percent in each market before your stop is hit. If you have many positions on at the same time, that can lead to high daily, weekly, or monthly swings in your account balance. There is always a non-zero chance that things can blow up and you lose everything, but there has to be risk to obtain that reward.

  Unlike David Druz, Mulvaney sees other speculators as the source of his profits. Looking back at September and October of 2008, much of his gain came from short positions in stock index futures. Who was long in stock index futures? During that time it could only be speculators.

  Ho
w does it work out in practice as Mulvaney willingly risks it all to achieve his big money returns? Look at his top 10 trades over the years (Exhibit 3.1). Look at how critical it is to not miss a trade. The percent of profit derived from certain big trends can make your whole year.

  Exhibit 3.1 Top 10 Trades since Inception

  Sticking With It

  I am not saying trading is easy. After all, how much good in life comes easy? But if you stick with your strategy through thick and thin, and master it, you have a chance at real freedom—not being stuck with Suze Orman or Dave Ramsey droning on about reducing credit card debt or how to debt finance your house. (By the way, how has that advice worked out for millions? Exactly.)

  That said, there are horror stories about people who abandoned their systems at the wrong time. They always say, “If I just would have stuck with it!” Well, they didn’t, and in some cases the decision to stray from their long held approach was a career-ending move. Discipline is a critical factor as you head down the trend-trading path.

  Let me give an example about sticking with it. The biggest crises Mulvaney had was during July and August 2007, where he had his two biggest down months consecutively. A 42 percent drawdown was the result. In the aftermath he went back and reexamined everything. He examined every possible misstep, considered all assumptions, but in the end concluded that the system was valid.

  One of the tests performed in the aftermath was rerunning his trading results against a whole range of different levels of leverage. Mulvaney is notorious for managing his leverage—even if he uses a lot of it.