The Little Book of Trading

by Michael W Covel

  When asked how he came to the decision to join International Standard Asset Management (ISAM), Hite painted a lesson: “Many years ago, I had a client, a gentleman in the baked-goods industry, who came to me after having sold off his business for $10 million. In discussing his investment options, I told him this kind of thing doesn’t happen often, and he corrected me, explaining that he had indeed done this very type of deal several times. He went on to explain that he had an incredibly simple formula for success. First, he kept to an industry he knew very well, which was bakeries, obviously, and second, he only partnered with men in their mid-thirties. This was young enough to have energy and youth, he pointed out, but old enough to be tempered by experience. I could immediately see the beauty of this fellow’s philosophy, and I always kept it at the forefront of my mind when I considered ventures of my own.”2

  1Larry Hite speech, February 7, 2003.

  2Harriet Agnew, “Managed Futures: It’s the Hite Club,” Financial News, February 28, 2011. See: www.efinancialnews.com/story/2011-02-28/managed-futures.

  Chapter Six

  Stand Up, Dust Yourself Off, and Keep Going

  David Harding

  Who doesn’t want to make a billion dollars? Yes, I imagine there are downsides to that type of wealth, but it must be one helluva ride to produce that kind of success—especially from essentially nothing. Is it a reasonable goal for you to make a billion dollars? Well, the odds are probably not on your side for that.

  However, sometimes in this world, this crazy and often chaotic world of ours, people win the lottery. They buy a scratch-off ticket and win millions. They didn’t practice. They didn’t struggle. They didn’t do anything except buy a scratch-off ticket.

  On the other side are people like David Harding. Harding struggled mightily early. However, Harding stuck with it for decades and is now a true billionaire. Don’t get me wrong—Harding, like many success stories, has had luck on his side.

  However, that’s not the takeaway here. The takeaway is perseverance. The takeaway is not quitting. That’s how Harding really hit it big. Without perseverance, Harding would have had no chance for luck to shine through.

  What can you do? You can learn to think like a trader who has made a billion dollars. And if you think like him, and if you model how a trader like that views the world, you can put yourself in a place to possibly make your billion. Note, I said possibly. The real reason, the honest reason to think like a billionaire, is to make your first million. Anyone with guts and determination can figure a way to make their first million, but you have to stick with the ups and downs.

  Known as the commodities king (primarily because the press always talk about some of the markets trend followers trade as opposed to their strategy), London’s Harding could be called an overnight trading sensation—only 30 years in the making.

  His trend following trading has produced, on average, nearly 20 percent a year for 20 years. Let that digest for a second as you ponder the buy and hold investments in mutual funds you may have, slowing eating away at your capital and your sanity.

  These days, the white-haired financial wizard (still under 50) enjoys collecting books on economic history, some dating back to the 1860s. In my time with him, he carried that distinct American entrepreneurial spirit center stage, along with a salty tongue of randy one-liners, all wrapped in a quintessential British flair.1

  It All Starts with the Tedious Grind

  Harding is bright. No doubt. He graduated with a degree in physics from Cambridge University, but without the requisite hard work, a degree like that doesn’t make him a trend following winner today. Plus, last I checked, physics is physics. It was not a degree in trend following.

  Early on, Harding devoured technical analysis books and saw the benefits of trend following, but he quickly realized that he wanted scientific analysis in his trading.

  He originally started at someone else’s firm to learn. “I went there because I didn’t want to sit in an investment bank and make money. I wanted to know if you could do [trend following] from outside the markets looking in. ‘Could you be on a desert island and make money trading?’ [That] was the question I was asking myself.”2

  That kind of question was only going to be answered through hard work. Imagine yourself spending every day drawing hundreds of charts by hand. Harding did. He bound every chart into big leather folders. It became his leather bound book of charts so to speak. Why do this? Research! If you believe that all markets can be made the same through the analysis of their price movements, then you have to prove it to yourself too. You have to do the homework by staring at the price data and staring at the charts.

  Harding added, “The only thing I ever wanted to be was a quantitative trader, because I think like that. Just like a violinist needs to play a violin, I need to take a quantitative approach to markets. I’m only interested in the maths.”3 (“Maths” is the very British way to say it.)

  This is not new, however. Investment success and maths have been hand-in-hand for centuries. It is not something that just happened suddenly in the late twentieth century. Today may be a golden era for the two to work together with the explosion of computers and globalization, but using rules that allow you to count is anything but new when it comes to making money.

  The two great waves of our time opened up huge opportunities for traders to do clever things. Investing globally around the world with math and computers, and pursuing more trend trading strategies, are just a few of the advantages.

  Think about it. If you are looking at many markets, and you have rules that require constant recalculating and monitoring, is it really a shock that there are many more opportunities to make money in global markets as opposed to just 20 years ago? Said another more pedestrian way: Trend following is the only style of trading that you can operate out of your bedroom. It is the only style of trading that doesn’t require you to stare at a monitor all day. Those are not small differentiating factors!

  Don’t Get Caught Up in Labels

  The trend following approach to markets is really a science. It is an unpublished science, but it is a real one. Harding was clear, “You could get the thick leather bound volumes of papers on it if there was a willingness to open the kimono, as the horrible modern expression has it.”4

  He trades everything using trend following systems, and it works. By simulation, he can come up with ideas and hypotheses, and test those—just like other traders we have seen so far. Over the years, what he has done, essentially, is conduct trend trading experiments. But instead of using a microscope or a telescope, his computer is his laboratory instrument. And instead of looking at the stars, he is looking at data and simulation languages.5

  Trend trading strategies take money and turn it into more money. It’s a pretty simple principle.

  When looking at market data there are many different charts, versions of charts, and indicators. So what exactly is the relevant data to look at? Price data. You can trade futures, exchange traded funds (ETFs), and a host of different instruments as a trend following trader using price data alone. That said, many trend followers trade futures contracts because they are a liquid, cheap, and effective way to trade on a global basis.

  While it is not relevant to your personal trend following trading, it is relevant to know how professional trend followers are labeled if you plan to invest with a trend following firm.

  Many are described as CTAs, which means Commodity Trading Advisor. It is a regulatory category in the United States. However, it is a major misnomer since trend followers don’t trade only commodities. They trade everything from stocks to currencies to cotton to Swiss francs to cocoa.

  Many trend following firms are also labeled as managed futures traders, which is another confusing misnomer. That term, like CTA, doesn’t describe the trading strategy style either—it refers back to the instrument being traded.

  Harding is not dogmatic about describing himself as anything, but finds it to be a necessity for clients
. Clients take comfort in fitting him into a box. He finds boxes are better than nothing, and with a wide smile he offered: “Otherwise, we’d be miscellaneous and who would want to be miscellaneous?”

  Trader’s Kryptonite

  Harding’s initial research decades ago led to a simple conclusion: Trend-trading systems worked, or at least back then he found that they had worked. Of course it’s not enough to say that, because something has worked, it will go on working, but Harding noted that it is a matter of record that trend following has gone on working for a long enough time for him to set up two very large and successful firms centered around trend following.6

  At the root of these successful firms, and at the root of your potential trading success, is a relatively straightforward concept: control risk. It can’t be said enough. To not respect risk is Kryptonite for all traders.

  A definition of risk is uncertainty of outcome. Risk means that you can’t control the end result of a particular situation, but if you take on a gamble, the risk has to be worth the perceived reward. Risk, however, is not specific to investment markets. Risk is something that everybody takes on every day. We all face risks from all angles at all times.

  Every time you drive a car, every time you fly in an airplane, you are taking a risk. You calculate that risk. You know there is a one in a million chance, for example, that when you go on a car trip, you are going to die. You don’t, however, let that stand in the way of going to visit your sister. Or do you?!

  We all take risks and have become perfectly comfortable with risk to achieve a desired outcome. But there is always a small amount of uncertainty in that outcome as with all human activities. All activities, trend following included, have uncertainty in outcome.

  For example, the nature of risk is apparent in the field of medicine, for when you get a disease the conversation with a doctor can quickly turn to a conversation about mortality. You may die earlier than you otherwise would have as a result of indulging in some risky activity—skiing, for example.

  People take different risks. Some sky dive, some fly, some smoke, and some travel. Some take much greater risks than others, for some higher reward, but it is all still risk taking.

  Others, like the elderly gentlemen on the park bench, probably figure that he doesn’t need additional risk and will happily see out his last few years avoiding it, feeding the pigeons, and playing with his grandkids.

  Because people have different desires and attitudes toward risk taking, it has to be assessed differently for each individual. Everyone takes risk in investing and trading, but the differentiating factor is that very few attempt to estimate their risk choices with mathematical tools.

  For example, some blindly move their money into investments with heavy, but undefined, risk on the line. You should never participate in a game where you have not accurately assessed your downside. Accurately measuring the risks you are taking can insure that you are taking wise risks, those right for you and your lifestyle.

  Once you have that foundational thinking, it carries over to the markets seamlessly. What is the major uncertainty of outcome across the spectrum of investments for everybody? Trying to acquire a vast amount of wealth!

  Between 95 and 99 percent of the human population is interested on some level in acquiring more wealth. Some desperately want to be very rich. Some just want a little bit more money, perhaps to buy a slightly better house or a new car. Some just want to save for security.

  Clearly, people are eager to pursue more ways of acquiring more wealth, but there is no way to acquire more real wealth without taking risk. Even putting your money in the bank is not a zero risk because the value of your money changes over time (read: inflation).

  And there are ways of measuring risk. There are ways of quantifying it. They might all be deeply imperfect, but there are ways to start measuring it. However, you don’t want to make the mistake of being blinded by science. The old saying, “A little knowledge is a dangerous thing” rings true. For example, some calculate risk as standard deviation of return.

  Standard deviation is a statistical measurement that sheds light on historical volatility. It shows how much variation or “dispersion” there is from the “average.” For example, a volatile stock may have a high standard deviation while the deviation of a stable blue chip stock may be lower. A large dispersion tells how much a return is deviating from the expected normal returns.

  But standard deviation is not the way to properly measure and/or assess risk—especially if you are a trend following trader. Why?

  As a trend following trader you will make your money far outside the bounds of normality. This means you will make your big money in the “tail” of the bell curve.

  What constitutes as “far outside the bounds of normality?” When a portfolio is put together, it is generally assumed that the distribution of returns will follow a normal pattern. Under this assumption, the probability that returns will move between the mean and three standard deviations, either positive or negative, is 99.97 percent. This means that the probability of returns moving more than three standard deviations beyond the mean is 0.03 percent, or virtually nil. However, the concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter tails increase the probability that an investment will move beyond three standard deviations. Distributions that are characterized by fat tails are what we see when we look at trend following returns.

  Okay, I know that is a mini-class on statistics, but what do you want? Do you want to gripe or do you want to make money?

  Don’t get caught up constantly trying to lower your risks. Think of yourself as running a risk targeting business where you go find risk. No risk, no reward!

  Conventional Wisdom

  It is generally accepted that if you invest money in a well-diversified portfolio of stocks, and hold them forever, that you will do quite well. But how many people do that? Occasionally somebody dies, some widow who is 93, and relatives learn that she is worth $48 million because she's done exactly that—hold on forever. She bought some stocks available to her when she was young, she didn’t watch CNBC, and at the end of a lifetime she dies unknowingly loaded. Sound like a plan for you? Not really.

  CNBC is for people who want to do things more actively and that’s not a blessing. Being more active in your investing or trading is a curse, especially if you don’t know what you are doing. The chances of someone knowing the bare minimum of trading, and watching CNBC for success, is probably less than 1 percent. Real successful traders don’t watch the news for the their decision making cues.

  If you're an outsider, not working at J.P. Morgan for example, and you are trying to be an active trader, a day trader, a swing trader, someone watching tick by tick all day long, then you are up against a big hurdle trying to beat professionals. You might have confidence to believe that you can beat professionals, but are you really cleverer than everybody else?

  This idea that you can beat the pros as an active trader by following the news will be an expensive proposition—guaranteed. You may indeed be cleverer than average, but you’ve got to be quite a lot cleverer than average. There are many great, clever people out there and they spend their lives 24/7 working to extricate profits from the markets. At least with a trend following philosophy you have a chance.

  Harding was struck by the curious fact that interest rates in the United States are set by a so-called high priest of government. Market forces are not the driver.

  Follow the Leader

  Take it from David Harding: Outcomes, or what actually happens, don’t tell you very much. The process is what is so important.

  But of course, most people draw their conclusions from outcomes. They see what happens and they say, “Oh, that’s what happened and therefore, I can draw this or that conclusion.” You could almost label that way of thinking as superstitious, but it’s erroneous; it’s wrong. You don’t want to make decisions for the wrong reasons. If you’re going to make the wr
ong decisions for the wrong reasons, then it’s not going to be good for increasing your wealth.

  Not the Art, the Science of Trading

  I have seen it for years. People want to debate the success and viability of trend following trading. They complain that it’s just a theory and that any type of theory can neither be true or false. Of course, all theories are conditionally true and every scientist knows in his heart of hearts that what measures the interestingness of scientific theory is utility; how useful it is, how interesting it is, and whether it gives an interesting insight. There are lots and lots of possible theories that lay out boring predicates that no one is interested in.

  Now if a theory makes an interesting prediction, like the orbit of Mercury will be slightly different from where it appears to be, or where it would be with Newtonian mechanics, that captures attention. If it's true, that’s testable, and if it’s true, then you could split the atom.

  There is a huge consequence from that story. It's all terribly interesting and the interestingness was obvious to everybody. The minute it was done, it was on the front page of the New York Times. Even though nobody understood relativity, everyone understood the significance of it. It’s not controversial. People intuitively understood the measure of a scientific theory in that example, its utility and usefulness.

  Harding ran with that foundation. “I think the efficient market hypothesis is quite useful too. One prediction it makes is that it is difficult to beat the markets. It’s just saying that the market knows better than you do. So the assumption that the market knows better than you do is quite a sensible and useful assumption. It certainly would lead you to approach [beating the markets] with humility and modesty.”

  Warren Buffett compares playing in the markets against people who believe in the efficient market hypothesis to playing bridge against people who don’t believe in looking at their cards.