No trend following model is clairvoyant. Nothing and no one can predict what direction crude oil will take next month or next year. As a trend following trader you try to exploit trends for as long as they may continue, and you must work with what the present price data is telling you to do in the context of your trading system. That means living in the moment of now.
Crisis Times
Yes, I know, and Bernard Drury knows, that this approach to trading often has very successful runs when others are headed to the poorhouse with an inferior trading strategy. When the next crisis time happens, such as in 2008, trend trading will produce trading opportunities—huge ones at that! That is a much better option than just buying gold. When you are a technical trend trader, and you are applying very strict risk rules to your portfolio, you have a chance to make money during downward spirals. You don’t have to just sit there and take it.
How does that translate? Consider current fears of a bond market collapse or hyperinflation. Could it happen? Sure. Or it might be disinflationary forces that carry the day, with interest rates remaining low and bond markets staying strong. In either event, your process for managing your trend following portfolio must be grounded in rules that allow you to win no matter what happens. You can’t be guessing.7
Worse yet, consider an underlying premise of many hedge fund strategies (the ones touted in the press so often): mean reversion. Mean reversion is when a trader believes he has found a mispricing in an extended market and expects a return to normal prices (whatever normal is). This is exactly what many hedge funds do. It never works in the long run. That kind of thinking blows up with regularity.
As a trend follower you do just the opposite. You look for directional moves (read: trends) to persist. Don’t make it more complicated than that.
Winners Always Adjust
What’s so interesting about Drury is the real education you can take away from his career that can help you to make money. He began with fundamental trading. Not just in college, or for a year or two after college. He traded as a fundamental grain trader for 15-plus years. He led a very narrow trading life focused very specifically on one group of markets, and after 15 years he figured out that it wasn’t too late to convert. He arrived at his trend following understanding in a much different manner than most every trend following trader that I have learned from—and that’s quite a few. Lesson: There simply is no singular path to systematic trend trading success.
All of us are afforded new information every day of our lives. The issue is not if you are lucky enough to be exposed to trend following in this book; the issue is what will you do now that you know about trend following?
1“Monthly Performance Report,” Drury Capital Incorporated, October 2008, 3.
2“Alternative Market Briefing,” Opalesque, November 11, 2008. See: www.opalesque.com/AMBarchive/Newsletter_BB_11112008.html.
3“Monthly Performance Report,” Drury Capital Incorporated, October 2008, 3.
4Bernard Drury, “2010 New York Round Table,” Opalesque.
5E-mail correspondence with Bernard Drury.
6CNBC Reports, interview with Bernard Drury, November 13, 2008.
7E-mail correspondence with Bernard Drury.
Chapter Eight
Study Hard and Get an A+
Justin Vandergrift
There is only one factor that you can control when you start trading: how much you are willing to lose. You cannot control how much you will make. You cannot project that desire no matter your good intentions or happy thoughts. You can only stop, for sure, a losing trade. That is in your power. The great traders understand that you must know how much you can lose at all times. That is the essence of risk management. It is the essence of Justin Vandergrift’s progression to becoming a successful trend following trader. His story and lessons are yet another inspirational and confidence building example that you can take to your own trading. Study up and succeed.
Trading calls some at an early age. Imagine you are 10 years old and your great uncle begins teaching you about stocks. At about 15, your dad shows you futures trading (he is trading the sugar market). Immediate fascination grabs your mind.
You thought sugar was something you bought in five-pound bags at the grocery store, not a market that could be traded for profit? Who wakes up and thinks that you can buy and sell something like sugar to make money, even if you have no need for the sugar? I know I didn’t years ago.
Vandergrift spent his teen years drawing market charts on grid paper (this was before computer charting). Being close to the numbers created an intimate connection, something lost now with computer charting and all the fancy software packages. (Gary Davis in Chapter 1 made the same point.)
It was not long before Vandergrift was taking odd jobs, like bagging groceries and other menial tasks, just to save money to trade sugar through his dad’s account. It was not all roses. He learned the harsh lesson early on that trading has ups and downs. Losing hurts; therefore, how do you find a way to win?
After all, winning is everything in the trading game. That is the same mentality most of us have when we are growing up. Everyone usually wants to win. I played baseball in college. I was very competitive. Always wanted to win. Is everyone into sports? No.
Vandergrift was the youngest in his class. He graduated from high school at the age of 17. Not only was he the youngest in his class, he was undersized. How did that motivate him? How did that drive his sense of competitiveness? He knew the only way to win would be in the classroom rather than the playing field. He figured 9 out of the 10 “high school jocks” (his derogatory reference!) would not amount to much on the financial playground, and that was where he intended to thrive. Most athletes think the only type of drive that matters happens on a playing field. In actuality, many of the most competitive people never step foot on a field, but it does not mean there is any less will to win.
I do not care what you do in your life, trading or whatever, that drive to win, that drive to excel, that drive to beat the competition had better be there. If not, take a job working for the man and take what your buy-and-hope mutual fund has to offer. Life will be much more secure and vanilla that way.
Starting Out
Vandergrift went to the University of North Carolina at Charlotte. The library had an extensive collection of trading and investment books, and he spent all four years reading as much as he could find about how to win in the markets. Most of what he read was trash, but he took the stance that every book had some beneficial nugget, some useful morsel, no matter how small.
He quickly noticed that most books had a trading method or system, even books written in the 1950s. All had a technique you could apply and use to trade. During college he bought SuperCharts—which was the precursor to TradeStation. TradeStation gives you the ability to program trend following rules and test out system ideas. If you have a trading system, idea, or method you want to test and see how it might perform, TradeStation can graphically show you the results. You want to enter on a 100-day breakout and exit on a 100-day breakout, and test it over a diverse number of markets, and boom, you can see the results quickly. This kind of experimentation builds confidence before you ever risk real money.
This was the beginning of Vandergrift developing his own trend following trading system, but that was not yet going to pay his bills. A job was going to be needed following college.
His resume? That was not working too well. Sending resumes out was not enough to get a job then, nor is it today. His cold calling started.
Vandergrift had a process that every month he would try to interview a successful broker in town, thinking that would be his calling. One cold call led him to the only commodity guy in town.
Vandergrift wanted to sit down over lunch. The commodity pro said no to lunch, but he did offer, “If you really want to get your feet wet and you want to get into commodity futures, you need to go see this old man up in the mountains in Hendersonville, North Carolina.”
He
continued, “Go see John Hill at Futures Truth Company.” Vandergrift picked up the phone and called.
Let me stop for a second. What would you have done? Call immediately? Delay? Procrastinate? Make excuses? Go apply for a job at Burger King instead?
Vandergrift graduated on a Saturday and went to work on Monday. He was ready to go and ready to learn the ways of trading.
John Hill’s firm called Futures Truth, which is where I first met Vandergrift, purports to independently rank and evaluate trading systems. This was a dream job for Vandergrift. He was able to see trading systems that worked and ones that didn’t. Many systems, and you will find this too, fail for a prime reason, namely a lack of risk control. The ones that performed well did so because of universal trading rules (again, trade all markets the same way) and risk control (again, don’t bet the farm on every trade).
You are going to find in your education that there are some universal schools of trend following trading: high/low breakouts, single moving average crossovers, multiple moving average crossovers, and Bollinger Band breakouts.
I have talked about breakouts in trend trading already, but let me address other basic trend following systems.
Moving average: An indicator that shows the average value of a security’s price over a time period. They are used to emphasize the trend and smooth out price fluctuations. A trading system using two moving averages would give a buy signal when the shorter (faster) moving average advances above the longer (slower) moving average. A sell signal would be given when the shorter moving average crosses below the longer moving average. The speed of the systems and the number of signals generated will depend on the length of the moving averages.1 For example, to calculate a 50-day simple moving average (SMA), add the last 50 closing price values and divide the sum by 50. There are other, more complex ways to calculate a moving average, but the simple moving average is still the most commonly used. Typical values are 20 and 50 days, although 50 and 200 days are also frequently used.2
Bollinger Bands: A technical analysis tool invented by John Bollinger. They consist of a set of three curves drawn in relation to market prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, and that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted.
There are differences in various trend following entry and exit techniques; however, most entries and exits, regardless of precise entry/exit, occur at very similar times. Don’t get too excited about when to enter. While entry and exit is an overwhelming focus for new traders, it is only a small part of the recipe for winning in the trend follower’s cookbook.
What is much more important? Money management is far more imperative to your success than worrying about a perfect entry. Why? We all have limited money! So what is the right amount to trade on each trade? That brings the risk theme seen across other chapters back into the equation. Risk creates the profits. If there were no risk, then there would be no incentive to trade. More simply, trading wouldn’t pay if it were easy. That means controlling risk has to be your obsession.
Early lessons in place, Vandergrift did not last long at Futures Truth. The entrepreneurial bug bit him.
Putting a System in Place
Introducing a system component into trading is the only way for you to reach the discipline needed to possibly make the big money. Most retail investors blow up, or have a short lived trading career because they don’t have the discipline to stick with their system. They are always looking for the quick buck, or the quick fix.
Sadly, every year millions of accounts literally collapse from basic mistakes. What is the most common mistake? You put a trade on, it starts losing money, but your gut tells you to hang on because it’s going to work out and go your way. You end up holding on too long to a losing trade. But it has to come back up? No, it doesn’t.
A trading system takes that emotion out. It takes the wishing and wanting out of the equation. This type of thinking appeals to everyone once they understand it. Just let the system do what it needs to do, and everything will work its way out in the end. That is the success process.
Vandergrift, like many of the trend following traders, found through intense research that the only systems that really worked over time were long term trend following in nature.
However, his real Aha! moment came when he put money management into his trading system equation.
When most people tell you that they are a trend follower, all they are doing is looking at a 100-day moving average or a Bollinger Band system—just like the ones I mentioned. But that’s it. They have no money management plan.
Let me give an example to put this in context and better explain the importance of money management. There was a local group of traders near Vandergrift in North Carolina. They had established a money management firm. At one point, they received a “Trader of the Year” award in Futures Magazine, a major trading publication.
Vandergrift was friendly with them and watched their trading. He could see that they traded one futures contract for 10-year Treasury notes and one contract for euro dollars. He wondered, “You have to be kidding me. Why would you do that? Just on a margin level 10-year notes are three times that of euro dollars. Why wouldn’t you have three euro dollars for every one 10-year note?”
What would you do? Would you try to figure out the discrepancy? How would you go about it? Vandergrift picked up the phone and called to ask why they treated all markets the same when it came to measuring risk.
They quickly cut the conversation off and said, “This is what we do. We are not entertaining questions. This is it.”
This was a problem waiting to happen. Vandergrift soon watched their trading program implode. He knew that risk management centered on trading markets equally, from a risk perspective, was mission critical. You just can’t favor one market over another. That’s what this group did and their program failed. Watching someone go broke in real time was quite educational.
The experience from watching someone implode, in a sense, delayed Vandergrift’s trend trading progress. Had that firm not gone through the pain they did, he would not have put so much research and faith into money management. It may have taken him going through their same meltdown experience for him to learn their same lesson.
Follow the Leader
If you have a portfolio of markets, and you receive a trend following signal to enter, you want to risk an equal amount on every trade. This is foundational to your success. Ignore this wisdom and going broke is the likely alternative.
Think about this trading example. You hypothetically start trading two markets. In the first market, risk is defined as $1,000. On the second market your risk is defined as $250. In order to manage these trades and keep everything equal, you will trade one futures contract of the first market and four contracts of the second market. You’re not favoring either one of these markets. This becomes critical, especially in the futures market, when you start trading markets like grains and currencies together. A grain contract, most of the time, is smaller, meaning it controls less capital than that of most currency markets. If you don’t trade more contracts of corn to compensate for the larger contract sizes of currencies, you are going to end up favoring currencies over the grain contracts from a risk standpoint.
Big Picture Philosophical Points
What are your goals? What do you want? How much do you want to make?
Vandergrift was stark: “If I die tomorrow are people going to remember me because my standard deviation of average annual return was XYZ in relation to my compound of average annual growth rate? No. They will remember me because of the wealth that my trading created. That is the whole motivation for me. My trading is not for some arcane statistical measure that no one really understan
ds. I want to make people money and change their lives.”
What is your motivation for trading? Are you trading for any other reason than to make big money? If so, stop trading.
For you to reach that level of confidence and that level of contentment, it is critical for you to learn from other traders.
I learned a tremendous amount from trend following trader Bill Dunn. Vandergrift had a similar learning experience, too, from Dunn. He learned more from watching Bill Dunn’s track record, his month-by-month performance numbers (see www.dunncapital.com) versus reading every article in Futures Magazine or any of the well known technical trading journals.
The conviction Bill Dunn has had for his trend following trading system and his ability to stick with it since the early 1970s is proof of what can happen when you go for the home run. Yet Dunn is not in it to hit only a home run, rather he is out to hit grand slams. That is what he does, and he has done it exceptionally well and consistently for decades.
Accepting Vandergrift’s belief and accepting Dunn’s track record is not easy. There are so many distractions that can knock you away from the real goal. Look at CNBC programs on air every day. They talk about the greatest stock now, the greatest this, the greatest that, whatever the distraction may be, but none of them regularly brings up the fact that the NASDAQ is in a 10-year drawdown. No one wants to report that the S&P has returned nearly zero growth from buying and holding mutual funds over the last decade.
Trend following is not that. It is not average. It is above average.
Vandergrift talked about average. He was talking with a doctor, a very successful doctor. The doctor kept talking about index investing and the S&P 500. Vandergrift stopped him short:
“When you went to medical school did you ever want to graduate with a C average?” The doctor said, “No.” Vandergrift replied, “Do you want to send your kids to a C school?” He said, “No.” Vandergrift countered, “Then why are you doing that with your money? The S&P is an average. It’s an average of the 500 largest companies in the United States. It’s an average. It’s a C index. Why would you want to invest to get average returns?”
The Little Book of Trading Page 10