The Little Book of Trading

by Michael W Covel

  In other words, clearly with your speculator’s hat on, you want to be playing against others who don’t believe at looking at their cards, or playing against opponents who believe in efficient market hypothesis. That’s a good trading direction to take if you want the chance for wealth.

  I don’t know how anyone can argue against the notion that the success of systematic trend following trading is a living and breathing, profit making refutation of efficient market hypothesis.

  Stay Humble

  Even though Harding has been very frank, there is some reticence. He knows talking too much about trend following is a retrograde step for his business’s commercial prospects.

  Why would a competitive man want to encourage you to become the next billionaire? He doesn’t have a mission to spread trend following wisdom or propagate this style of trading. He is not interested in sponsoring academic trend following courses or making the world a better place filled with wealthy trend following traders. He is entrepreneurial man who, after all, wants to win.

  Follow the Leader

  Leaders don’t forget that investing is a betting game. Investing is a form of gambling; it is betting. They are both intellectually similar activities, but of course you should have no interest in playing a game where, according to the laws of the game, you cannot win.

  If a game has a payout ratio of less than one—and gambling games have a payout ratio of less than one—it means the longer you play, the more certain you are to lose. In any game, once you know that, there should be no interest. However, for some it is just that fact that pushes them to play more. They want to beat the odds. Prove everyone wrong. Unfortunately, the house wants to win more than you, and the house can always last longer than you and your money. Oh sure, maybe you occasionally gamble for pleasure and it can be rational for people to gamble knowing that they’re going to lose for the pleasure of it alone. Some get a lot of pleasure from the small probability of a very large win. They get far more pleasure from that small probability than the chance they will ever win the huge money. If you’re essentially doing something irrational, it doesn’t mean your behavior is irrational because, in theory, you are not doing it for primary financial reasons. Now, if you are doing it for financial reasons . . . trouble ahead!

  Entrepreneurism

  For those lucky enough to study Latin in their youth, you recall the verb “speculari,” which translates as “to observe.” Speculators, while often vilified in the press, are observers, which is very much the position you want to find yourself in as you go about making money in the markets. You want to stand outside of the political and economic system (chaos!) and observe. The best defense that can be made of people profiting from speculation is George Soros’s defense: You are playing a game that anyone can play and you play by the rules laid down.

  However, once you accept speculation as an accepted direction, determination enters the arena for everyone’s potential success. Harding’s grandmother used to say “Patience and perseverance made a bishop of his reverence.”

  Harding opined, “Determination is the same as having wings. If at first you don’t succeed, try, try, and try again. Madonna always says, ‘I’m like a cockroach.’”

  Meaning, no one could kill Madonna.

  You have to take those views to heart, especially during tough times. You might ask, “Once you’ve made enough money, why keep persevering?”

  In Europe many would say that if you’ve made enough money, however much that may be, you should go do something worthwhile with your life. It’s a slightly more American notion to climb to the top because it’s there. It used to be more English, but now it’s more American to go and conquer “it” because it’s there.

  Harding sees that philosophy as a fantastic tradition that only exists in America. When he was 20 and living in the United States, he read Ayn Rand. He was struck by her politics and economics, not because he is a lifelong convert, but because he didn’t see her kind of entrepreneurial writing in Europe. He didn’t see those ideas there.

  Harding was also influenced by another precept: You have been given abilities and it is your duty to make use of them. Religious people make that argument. They say if God has given you abilities, then it is your duty to use them.

  That is not necessarily easy since fear of failure is a very real factor for many, but you can be driven by fear of failure to some extent. It can bring out the competition in you.

  Everyone has something in the world they are good at. Harding’s talent is analyzing distribution of the financial price dynamics (fancy way of saying trend following). And he has been doing it for 20-plus years. He makes really good money at it. Consequently, he believes it is God’s way of telling him to do more of it.

  1Colin Fernandez, “Rambler with an Interest in Bible Studies Is the City’s Highest Earner at $60 Million a Year,” September 27, 2010. See: www.dailymail.co.uk/news/article-1315366/David-Harding-Citys-highest-earner-60m-year.html.

  2Simon Kerr, “Winton Capital Management: Simon Kerr Talks to David Harding,” The Hedge Fund Journal, September 2005. See: www.thehedgefundjournal.com/magazine/200509/interviews/simon-kerr-talks-to-david-harding.php.

  3Ibid.

  4Ibid.

  5Geoffrey Newman, “Intuition and Hard Facts are Behind Winton’s Success,” Business, September 10, 2008. See: www.theaustralian.com.au/business/wealth/intuition-and-the-hard-facts/story-e6frgad6-1111117404721.

  6David Harding interview, Hedge Funds Review, May 20, 2010. See: www.hedgefundsreview.com/hedge-funds-review/news/1649591/video-interview-david-harding-founder-managing-director-winton-capital-management.

  Chapter Seven

  Throw Away the Fundamentals and Stick to Your Charts

  Bernard Drury

  We’ve all been trained to expect stories. The most commonly asked question by investors is: “Where is the market going?” People want a prediction. They want to hear a story that will give them the edge needed to beat out their neighbor in the markets. Following the forecast of how many iPhones will be sold next year, if the Brazilian coffee crop will be as expected or not, or if the Fed will influence interest rates—is not the way to make big money. Bernard Drury is a great example of a trader who, early in his career, followed that way of thinking. Only later did he come to the realization that trend following was a more direct path. He let go of fundamentals. For that reason alone he shows that you can change the way you view the world—even if you have been set in your ways for decades.

  Drury graduated cum laude from Dartmouth College with a degree in Russian. His trading career began in 1978 as a grain trader for the Louis Dreyfus Corporation. Drury spent the next 15 years as a commercial grain trader, grain market researcher, and proprietary trader for his own account. He was all about understanding, and then trading based on fundamentals.1

  What exactly do grain trader and researcher mean? Here is an excerpt from Reuters, which gives an example of using fundamental analysis in the grain markets:

  U.S. grain markets will get their direction this week from old-fashioned supply-and-demand fundamentals after being pushed around recently by outside influences such as movements in the U.S. dollar and the price of crude oil. The U.S. Department of Agriculture is due to release its estimate of corn and soybean crops on Tuesday morning. It will provide the market with plenty of data to chew on and should drive price movement throughout the week. The government also will provide its first estimate of how much winter wheat acreage was seeded in the United States last autumn. Another key for the grains markets will be weather in South America, where farmers in Brazil and Argentina are harvesting soybean crops. Analysts were expecting U.S. corn production to fall from earlier forecasts as harvest delays and wintry conditions forced Midwest farmers to shut down harvest operations before the cutting was completed. An average of estimates pegged the corn crop at 12.821 billion bushels, down 100 million from the government’s December forecast. Snowstorms across the Midwest during the past week contributed to
the light sales on the cash market as most farmers did not want to brave icy roads to deliver supplies to elevators and processors.

  That stuff never ends. There is so much of it online you could lose your mind trying to keep track of it all. That’s what it means to be a fundamental grain trader. Does that sound like something you could do? If you think you could, how long would it take you to assemble all of that expertise? How many years of your life would go by? And even if you were smart and studious enough, would having all of the expertise to translate fundamentals allow you to know the right time to buy or sell in the markets to make money in the long run?

  That’s the conundrum you face. You don’t want to get caught up in the idea of using fundamental analysis to trade grains, corn, wheat, and all other markets. That applies to Intel or the U.S. dollar. Same point. Lots and lots of data, but with no guarantee at all that the fundamental analysis would actually make money.

  The Traditional Way

  I met Drury at the Yale Club in New York City. Being a suburban kid from the Northern Virginia area, I am still not sure what goes on at the Yale Club, but it is where I first began to understand the unique trading education that Drury’s experience could impart.

  His early fundamentally driven ambitions reflected what he saw as the best potential success that he could reasonably achieve in the markets. He saw traders around him who were 10, 15, and 20 years older. He was well aware that these were some very successful, wealthy, and prominent grain speculators and they were all using fundamentals to make money.

  Consequently, Drury was rigorous with his fundamental studies.

  He spent 20 years accumulating fundamental expertise in grain markets. He developed great respect for those traders who were sector specialists. However, while pursuing an executive MBA at the University of Chicago, his studies with Professor Robin Hogarth in the area of decision making amidst uncertainty had a lasting influence.

  While in his MBA program, Drury took a class on modeling and became even more interested in quantitative, research-based approaches to trading (read: trend following). Drury explains: “I entered that U of Chicago program as a grain trader, but I already was accustomed to creating and applying econometric models to evaluate grain pricing situations. The studies with Professor Hogarth increased my curiosity about the ways in which models, or expert systems, could be applied to situations such as trading.”2

  The Switch

  Imagine you are a really good trader who trades only one market. You trade corn. Or maybe you trade GE. Maybe you trade silver. The big problem: Applying principles of diversification is very difficult with one market alone.

  After school, and early in his fund management career, Drury was trading $25 million in client money. However, he was having major problems with futures markets and their position and liquidity limits. He was becoming too much a part of the market in assorted grains. Meaning, the market was no longer big enough for him to trade smartly, and his concentrated trading was part of his problem.

  But there was a larger issue at play. If you are a sector specialist, taking advantage of infrequent, but very important, price moves that may occur in a given market—not just grains—is very hard. Technical trend trading systems are much better at dealing with the major outright price moves.3

  It was time for a change. Diversification was becoming a necessity.

  That said, an evolution from a single market specialist to systematic trend trading was not overnight for Drury. First, he joined Commodities Corporation (CC) in 1994 as part of its trader program.

  Commodities Corporation was a trading firm, and trading incubator, based in Princeton, New Jersey, that was particularly noted for their trend following trading. CC launched the careers of many notable traders—such as Michael Marcus, Bruce Kovner, Ed Seykota, and Paul Tudor Jones. Goldman Sachs bought CC in 1997.

  Commodities Corporation started as a fundamentally driven trading firm too, but eventually they came to realize that trend following trading was the real breadwinner.

  Drury operated independently under the CC umbrella (see more in my book, The Complete TurtleTrader). But it was a bull market in the grains in 1995 and 1996 that led Drury to finally shift away from fundamentals to a 100 percent systematic trend following strategy.

  Those huge bull markets in wheat and corn, for example, could not have been successfully traded by fundamentals alone. He saw that. He lived it.

  A further trigger to 100 percent trend following came in the form of Ed Seykota (whom he met through Commodities Corporation). Seykota compelled him to do more research in the technical trading area.

  I made the decision that I would give up the use of my experience as a sector specialist in favor of adopting a systematic approach in which the most important benefits are the application of very extensive research, consistency of method, and diversification.

  He continued,

  For example, if we are curious about a trading rule, we run a simulation across a portfolio of about 70 instruments and 15 years of data. If we run a simulation on three or four systems together, then we get an even more robust result. This type of research provides some benefits that are difficult for a discretionary or fundamental trader to have.4

  Follow the Leader

  There are different decision-making frameworks between fundamental and trend following traders, and you need to understand what yours is.

  In the past Drury could talk about grain markets all day long, as that was his passion. When Drury was a fundamental trader he would talk about value extensively. For example, if the corn market was at $2.25 and you thought it could go up, you might formulate something such as: the price could go down $0.15 and it could go up $0.60. That’s an attractive risk to reward so you would put on a position. But if it goes half that distance what do you do next? The risk-reward has shifted greatly. There is probably new information that is supporting your original hypothesis, but the risk-reward has shifted. A prudent trader who is operating on a value premise might reasonably exit or lighten up based on these shifted odds. By contrast, a technical trader who is following price action may act very differently. A fundamental trader might call the beginning of a trend right, when he perceives a value opportunity, but will often have difficulty taking advantage of pronounced trends. In other words, the same market information can lead to drastically different trading actions, because of different decision-making frameworks between fundamental and trend following traders. From a risk standpoint the fundamental trader is actually taking on risk by giving up on the potential big trends. By trying to be so risk averse, the fundamental trader actually is taking on more risk.

  Source: Bernard Drury, “2010 New York Round Table,” Opalesque.

  Drury’s Core Principles

  I want you to see some of the detail that drives Drury’s current trend following trading. These bullets, like ones seen in Chapters 3 and 5, give concrete precepts worth emblazing across your daily trend following life:5

  Don’t have a discretionary reaction to your drawdowns (meaning when you are on a losing streak). Your new position sizing (how much is right to bet on each trade) is always calculated based on your daily account value, so the size of your new positions will decline when your account value drops.

  Decide to be in or out of each market. Out of 30 traded markets, for example, you might be positioned in each market about two-thirds of the time, and out of the market about one-third of the time. Those are rough guides as it often all depends on whether markets are moving.

  Over multi-year periods when (in simulation) a given sector or group of markets does well for a time, it will be followed by poor results for a time. There is an ebb and flow, but unlike with the tides, there is no way to predict trends.

  Calculate the risk on your trade prior to entering your trade. Simple enough, but often ignored. Trading position size needs to reflect the volatility of the market at the time of your entry.

  A portfolio should be broadly diversified, includin
g approximately half of your total trades in financial markets (interest rates, currencies, and stocks) and half of your total trades in physical commodities. You want to enter into incipient trends, exit with discipline when those trends fail, and remain with winning trends for long periods. Drury primarily trades with futures markets, but you can consider exchange traded funds (ETFs) too.

  CNBC Interview

  One of the best ways you can learn trend following is to look at the performance track records including annual rate of return for professional trend following traders (many are listed at the end of this book in Appendix A). It is proof. It is confidence for your own trading. For example, Drury’s strategy made 75.65 percent during the crisis year of 2008. That is not a mutual fund return.

  Early in 2008 many trend followers had long positions in crude oil as it moved up close to $150 a barrel. At the time metals and grain markets were also strong, but nearly all markets began to reverse in late July and early August. Many trend followers, including Drury, exited from long positions and eventually went short—betting to make money as markets headed down. Remember, up and down you can make money.

  During his 2008 success Drury gave a rare interview on CNBC.6 The CNBC host wanted to know how Drury did “it.” A simple sounding but loaded question if there ever was one!

  In his answer he brought it back to the price data. He applied his trend following model to the price data, and without having any insight as whether crude oil would go up or down or sideways, he was looking for certain price configurations. Drury got his entry signal in oil, and went short. Did he know crude oil was going to go up to $150? No. Did he know it was going to fall to $60? No. But the pendulum swings both ways, so he wanted to be along for the trend ride.