The Little Book of Trading

by Michael W Covel

  However, Mulvaney objectively asked what would have happened if he traded with more or less leverage than he actually used? He discovered that had he used lower leverage he would have actually generated a bigger drawdown (read: bigger loss) during the crisis.

  That seems intuitive, does it? Hold your judgment.

  When his account finally bottomed in August 2007 at the depths of a 42 percent drop, a new gold position kicked in and started making money. By the end of August, he had made new money and had crawled away from the low of his drawdown. At a lower level of leverage, theoretically, he would have captured a smaller recovery from those new gold positions that were kicking in, and actually his system would have taken a slightly larger maximum drawdown.

  I just saved you and made you a fortune.

  Another interesting lesson you can take from 2007? And let me say if you are not understanding why 2007 is related to 2011 and beyond—you are still not with me about trend following.

  For that year the best performing single market for Mulvaney was the Canadian dollar. The worst performing market was the Australian dollar. When you put those charts up on the wall, staple them up there, on the face of it they look highly correlated (zigging and zagging at the same time). In fact, those two currencies are reasonably correlated most of the time, but the Australian dollar was too volatile during this time period to make money. From a trend following perspective it kept going down and stopping out, then going back up and forcing a reentry. This kept happening with lots of small losses. It pays to examine facts and not just think you know. Let the numbers win.

  Be objective. Subjective analysis is for long-term losers.

  Risk and Volatility

  Many equate risk with volatility. They think big returns that come from high reward trend following systems (like Mulvaney’s) are much, much riskier than actuality. In fact, acceptance of higher risk in a trend following investment can actually lower the risk of your stock and bond portfolios because when trend following zigs, typical stock and bond investments zag. However, that is a very difficult concept to get people to accept.

  Risk of ruin, otherwise known as taking too much risk so you have no more money, has to be your foundation. Mulvaney, for example, will only stop trading his system if his account value drops to a point where he can’t trade his strategy. So risk of ruin is that real point where he can’t actually trade all of the markets that his system dictates to trade.

  Believing in the value of your system to the extent that you would continue trading until you literally didn’t have a dollar of capital left to trade is the conviction of a winner. The lesson? If you can avoid blowing up, you should continue to trade your trend following system. That’s the only way to get rich. Or, maybe, you can invent the next Facebook. That’s another option.

  Follow the Leader

  Sit in on part of my interview with Mulvaney to hear more of what makes him a leader to follow.

  Covel: When you talk about creating terminal wealth what do you mean exactly? Bill Dunn is approaching 80 years old and he’s clearly not dialed it back from the chase for big returns. Trend following legend Richard Donchian traded into his 90s. How do you perceive your trading as you move forward in life? Do you perceive there’ll be a time where you change your desire for absolute returns or do you say, “You know what, I’m 46 years old. This is what I love. This is what I want to do and I’m going to try and hit the biggest home run I can over the course of a lifetime”?

  Mulvaney: Yes. Just keep going for the home run. If I take a 100 percent drawdown while trying to make that home run, then fine. Then I’ll say, “Well, great, I had a great run at it.” I have had two separate 12-month periods when I generated over 100 percent. Eventually when or if I overdid it, and it brought me down, great, I would still not be dissatisfied with my career if that happens.

  Covel: I was speaking to a very successful firm with a 30-year track record. They give the client what he wants, which is less volatility. However, the guys that run it said, “We don’t trade for less returns for our personal accounts. In our personal accounts, we want to get rich. We trade for trend following absolute returns.”

  Mulvaney: That’s what I do. Most good traders take more risk with their own money than they will with client money.

  1See: “Trend Following and the MCM System—An Interview with Paul Mulvaney.” The full interview is available at www.trendfollowing.com/whitepaper/mulvaney.pdf.

  2Michael Covel, Trend Following: Learn to Make Millions in Up or Down Markets (Upper Saddle River, NJ: Person Education Inc., 2009), 17.

  Chapter Four

  In a Land Far, Far Away from Wall Street

  Kevin Bruce

  Years ago I interviewed for a trading job at Salomon Brothers in New York City. That was in 1994 and the firm was still very powerful. I still can recall seeing their massive football field–size trading floor at the top of World Trade Center Seven, which was lost on 9/11. At the time, long before I ever knew about trend following, that seemed to be the only way you could get rich trading.

  Kevin Bruce is living proof that there is no need to be in New York, London, or Chicago—flaunting a sharp business suit and trading in a sky rise. Bruce is a small-town guy from Georgia with no ancestral connection to Wall Street, who has not only made it on Wall Street but conquered it. Heed his path.

  Bruce spends his time far away tucked in quiet spots in Richmond, Virginia. He works out six times a week at his local YMCA, and still drives his 1996 Ford pickup. With a net worth of nearly $100 million, he prefers to live life just as he always did before making that fortune. He is low profile. Most people have no idea of his wealth. He says, “I guess that means I’ve done a pretty good job of just being me.”1

  He follows a trading strategy first developed while he was a graduate student in finance at the University of Georgia. His strategy tells him when to buy and sell and how much to buy or sell, based on the odds of that trade being a winner or a loser. He trades in all markets across the board. You name the market and he trades it. Does he have expertise in all of these markets? No.

  To be a trend following trader, your trading approach must work equally on all markets. You do not want to say, “I’m going to trade this system in the yen and this system in corn and this system in some other market.” If your system is not good enough to work on all markets, then it should not be used.

  However, waking up with that principle in your head would probably not occur naturally. Nor did it for Bruce. He went to the University of Georgia in the late 1970s and took a course in agricultural economics. It was mostly oriented towards hedgers (think farmers trying to protect their crop values six months before the harvest season), but in order to keep students interested in the class the teacher had to get creative. He let the students practice trying to make real money by keeping track of hypothetical trades (called paper trading). It was all “I will buy here and sell there” rules.

  Bruce’s work to develop a mechanical trading system germinated completely from the desire to win the trading game. He ended up beating his classmates in the contest. How did he do? At the beginning of the year he had $10,000, and three months later it was $30,000. Of course, it was only paper money and trading is easy when there is no real money on the line, but the trend following methodology he had developed was sound.

  What would you do? What would you take from that experience? From his hypothetical trading experience in college Bruce decided, “Why not try it for real?” He was 22 years old and opened up a small account at his local brokerage—just like many of us have done at one time or the other. No more practice trading! It was real dollars and cents time.

  At the end of the year the $5,000 that Bruce had saved from odd jobs had mushroomed into $14,000—all from trend trading. He figured he had made it big. Bruce went and bought a Barcalounger, a 19-inch RCA color TV, and the biggest set of stereo speakers he could find. Why not, right? Splurging on a big win is something we all like to do. However, don�
�t judge that spending binge just yet—freedom was the real goal.

  While Bruce was crafty in his early trading, almost tripling his initial seed money, he was really crafty in the way he built up his $5,000 nest egg. When he was about 15, he started the practice of packing a lunch and taking it to school. The cafeteria food wasn’t great, but he could buy a lunch for just 35 cents. Bruce would meet other kids in the bathroom daily and auction off his home-style lunch. He would then eat the cafeteria lunch—and would usually net about $2. Nice trade!

  In the late 1970s, $5,000 was a pretty good sum of money, but that money was there for him to pay for his college. It was an enormous risk to be trading that money. If he lost the $5,000, that was it.

  However, Bruce was so confident in his trading research that he was willing to risk it all without blinking. In fact, there was no doubt that if he lost the $5,000, he would have tried it again, because he had absolute conviction.

  The great trend followers do not quit. They practice. They learn. They stick with it.

  Teach Yourself to Be Great

  Can you teach yourself to trade? Do you realize how important learning on your own is if you really want to be a successful trader? Everything about Bruce’s trading is self-taught. He started in the basement of the University of Georgia library: The school had old editions of the Wall Street Journal on microfilm. In the basement dungeon, he would compile his own record of the open, high, low, and closing prices for all markets.

  At the time, Bruce was actually working at a gas station at night, and between cleaning bugs off windshields and pumping gas, he had time to think and research—which is where he would analyze that price data. Bruce had a Texas Instruments handheld calculator that helped him sort through price data collected from the library. He figured out how to mathematically define a trend (in order to profit from its movement). It was a basic trend trading system. It was the same system he had used for the trading game in school with slight tweaks. Ultimately, it was the same one he would use with real money in the decades to follow.

  Focus on the Show!

  You have no focus? You can’t find focus? Stop now. Throw this book away and go do something else.

  Seriously.

  Look at what Bruce accomplished. He never paid attention to what was going on around him, even after taking an initial bank job after college. While he was working at early bank and brokerage jobs, he would go to lunch with the office guys because that was what was done on typical corporate days. Some of the guys traded cotton, others traded soybeans, but it all depended on what their favorite market was—which did not make much sense to Bruce. Why should you have a favorite market? You should not!

  Initially, Bruce wanted to be a corporate lawyer. His uncle, a judge at the time, convinced him that 60-hour work weeks were probably not the lifestyle he wanted. And even if he stuck it out for a law career, the big money wouldn’t come until he eventually became a partner. He thought, “I don’t like the sound of that.”

  Figure out early what you want to be. If you really want to be a trend following trader—start now!

  Bruce had figured out at 22 that he wanted to be a trader. Many of us never figure it out. We never decide. We just go through the motions, hoping for the lottery gods to smile on us.

  Even if you decide that you know the way you want to go, there will be obstacles. After graduation Bruce went to work for a fairly sizeable savings bank in Atlanta, but they were risk adverse and would not let him trade his trend following way.

  Later he shifted to a small bank in North Carolina and stayed for about four years—since they gave him the opportunity to trade. It was a move up. Finally, in 1986, he landed a bank job in Virginia where he could trade as he wanted—with the opportunity to make big trend trading money.

  His motivations were never about a desire to have a Lear jet, a Rolls Royce, or three beach houses, but growing up in a lower middle-class family in a small town in Georgia showed him first-hand how people lived who never aspired for more than what they grew up with. Bruce saw how little freedom that mindset granted, and he wanted no part of it.

  Do you want to have a boss telling you what to do? Do you want to be able to go on vacation when you want? Do you ever just want freedom? That was Bruce’s motivation.

  Playing Games

  I have found, in all of my research into trend following and great trend following traders, that games have played a crucial role. Around the age of 10, Bruce’s brother taught him how to play chess. An early lesson was to let your opponent make small mistakes early in the game while looking ahead to take advantage later on.

  Bruce once had the opportunity to go to New York and see one of the major brokerage firms’ trading floors. He found it like Battle Star Galactica, with more screens and lights than you could imagine. He decided: “I couldn’t think in this environment.” You can never make decisions when the market is open; everything is like a flight plan, it’s got to be pre-planned. Trying to make decisions when the market is open is going to lead to emotional decisions. Everything must be thought out ahead of time. Know what you are going to do if it goes up, if it goes down, and if it doesn’t do anything. When all that is figured out, you put your system on autopilot. It almost sounds too simple, but that’s the way you need to do it, and that’s why you don’t need to stress out about anybody’s opinion.

  If you get a couple of pawns ahead in the game and start trading pieces of equal value—you can lay the groundwork for winning. You trade your bishop for your opponent’s bishop, your knight for their knight. When you get down to the end of the game you can end up with two pawns and a king and they’ve only got the king. In chess, if you can take your pawns and advance them all the way to the other end of the board you can turn them into a queen—which is the most powerful piece on the board.

  It is the same in trading. Your opponent’s mistakes early in the game can be used to win the game later. How does that exactly translate into trading? It’s about finding your edge, your edge to win the game. You need to learn that you need an edge to win. (See Larry Hite’s example of edge and expectation in Chapter 5.)

  Risk!

  When Bruce initially began his last bank job in 1986, they had a way to measure the risk of their trading with a concept called a risk unit. A risk unit was the equivalent to the market risk on one 30-year Treasury bond. Initially Bruce’s allowable risk units were 10. He could take the market risk of 10 Treasury bonds. They may have been equal to two Canadian dollars or five Swiss francs or six corn contracts (remember futures are traded on exchanges like the CME Group; futures trade in contracts and stocks trade in shares).

  Soon the bank realized that Bruce’s style of trend following trading was minting money and they ramped up Bruce’s risk units over time. As his trading progressed, and continued to grow, bank management became more confident in Bruce, and more importantly, he became more confident in his own trading. His trend following trading soon turned very large. It was especially large for a publicly traded, sleepy, midsize southern bank not really expected to be making money as a trend following trader.

  There is a larger lesson here for you, though. Risk, and measuring that risk, should always be first in line. However, to the detriment of many, risk and measuring it are often ignored. There is great truth in the idea that if you take care of the downside, the upside will take care of itself. That means you have to have money to play the game. Protect yourself from losing all of your money, and when the big trend comes you can ride it.

  One of the big mistakes you can make is to always look up at the stars and think about how much money you are going to earn off a trade. If you do not look down first, trouble! In every situation you need to think about what can go wrong and what will you do if it does go wrong?

  Where do you get that discipline? It can begin when you are very young. It can begin with sports or chess or other forms of competition. You start to understand that you can only win if you’re consistent. If you do not do the ri
ght thing over and over, you don’t excel at it. No excellence, no reward.

  Build on a Foundation of Confidence in Your System and in Yourself

  All successful trend following traders bring a unique story of how they made it to their understanding, but more importantly they all bring a unique element critical to their success. Bruce’s distance from Wall Street may have been his secret weapon. He did not play the Wall Street game like it was supposed to be played. He did it his way. It was unconventional.

  What do I mean? When Bruce took a job with a bank early on in his career, he was looking forward toward a goal. He made an almost unheard of career move in those early days. He cut a deal where he only was paid a fixed percentage of whatever dollar amount he made. Now that is great if you’re making money, but not so good if you’re not. If you don’t have a good year, you will be eating franks and beans instead of steak. That can quickly mean no steaks at The Palm, but rather 99-cent burgers at Burger King.

  However, this wise deal allowed Bruce to trade as a trend following trader for the bank—to great trading size. The better he did, the more money they wanted him to trade. The more money he traded, and with continued big performance numbers, the more he made. Does that mean you will have the ability to cut a Bruce-like deal? Maybe, maybe not, but that is not the point. The true lesson is his way of thinking. He thought outside the box. He was making the rules three steps ahead. How many people work for a bank and create the autonomy and freedom Bruce did? Not many.

  However, before you go thinking that the bank story was the secret to his success, hold tight. Bruce made his first million by the age of 30. That was his own money and his own trading—as far away from Wall Street as you could be. No excuses.

  1Paula C. Squires, “Betting on Futures: Trader Comes Up More Than Even,” Virginia Business, June 2004.