That is one of the most important questions any would-be trend following trader must ask, but it does not stop there.
Piling On
Above average returns really start with compounding.
You want to know the difference between being rich and poor in the United States, or in life for that matter? Three percentage points—that’s it. If you take a 12 percent annual return compounded monthly, over the course of 30 years, basically the working career of the average person, every dollar that you invested will be worth $35.94.
If you compound a 15 percent annual return compounded monthly over 30 years, can you take a guess of the return difference? Is it 10 percent better or 50 percent? No. Every dollar invested would be worth $87.54 a difference of 143 percent over 12 percent.
It is only three percentage points, but compounded over 30 years that makes a tremendous difference. That is why you have to shoot for the higher return. Even if it is two percentage points more—it is a huge difference.
1“Arthur Hill on Moving Average Crossovers.” See: http://stockcharts.com/help/doku.php?id=chart_school:trading_strategies:arthur_hill_on_movin.
2See: http://eresearch.fidelity.com/backtesting/viewstrategy?category=Trend%20following&wealthScriptType=MovingAverageCrossover.
Chapter Nine
You Can’t Know Everything
Eric Crittenden and Cole Wilcox
The essence of agnosticism is not knowing one way or the other, and not attempting to put a firm belief onto what you do not know. These days I am so used to the concept of making money in up markets and down markets, regardless of the market, that I sometimes forget how foreign that concept is for the average trader or investor. It’s like a rollercoaster, up and down, up and down, up, up, down, down—with no predictable pattern as to when up will happen or down will happen. The idea is to wait and let the market move in a direction–either way–and then follow it. Eric Crittenden and Cole Wilcox exemplify this critical principle in their trend following trading.
Over the years, many hedge funds, commodity trading advisors, proprietary traders, and global macro funds have successfully applied trend following methods to profitably trade in global futures markets. Very little research, however, has been published regarding trend following strategies as applied to individual stocks (even though 100 years ago trend following started on stocks). Oh sure, many trade stock indexes that have been around for decades, but there has been less focus on trend trading individual stocks.
Crittenden and Wilcox noticed there were no public firms applying trend following to individual stocks and they could not figure out why. It didn’t make any sense, since that’s where much of the money in the world was going.
They developed a trend following approach for stocks. Their basic plan was to buy breakout stocks and use a trailing stop as they advanced. To do this effectively you have to be wired to understand the relationship between risk and reward, an understanding that skews the odds in your favor.
You want to view yourself as a professional speculator—regardless of silly attacks on speculators coming from the President and the press. Speculation is our lifeblood. It is a necessity since it helps to set the price in a free market. Without it, we are nowhere.
And as a speculator, price action, or movement, is what matters because it is the only thing that shows up on your account statement. Faith in something else less specific such as buy and hold, index investing, and so on is a highly addictive and incredibly expensive drug. Successful investors and speculators should have a very skeptical and visceral reaction to group handholding. It’s just not where you want to be for long-term success.
Follow the Leader
Trend following works on stocks, too, and who better to teach us than two guys who wrote a paper called, “Does Trend Following Work on Stocks?” It outlined their strategy. They use a 10 ATR stop. ATR stands for “average true range.” The true range is simply how far a stock moves in a given day, like standard deviation, but it includes the gaps—if a stock gaps up or gaps down. So for General Electric (NYSE: GE), its average true range might be $0.80 right now. That is the typical daily move, including the gap. So they multiply the ATR by 10 and trail that from the purchase price, which is the all-time high. Their stops on average are about 28 to 30 percent away for a typical stock. For a really volatile stock, it might be 50 percent away. For a really quiet stock, it might be as close as 10 or 12 percent. The average true range measures the volatility of the stock in question, so your trailing stop loss is adjusted according to each stock’s volatility. That type of thinking, a counterintuitive system—that’s what you want.
Starting Out
Wilcox started with zero money. He came from a family without great wealth, so he had to focus on survival from the beginning. Nobody was going to be there with a checkbook to back him.
In his first job as a broker he had one shot at making it, and surviving. He knew the stark truth deep in his gut that nobody was going to recapitalize him if he failed. He knew that he had to make his clients money. Making a 100 percent effort at all times did not allow much time for relaxation. He was a 19-year-old kid at the time, not knowing anything except that he couldn’t waste time and couldn’t afford a catastrophic loss.
There was a developing philosophy too. Perhaps it is one you can relate to: Wilcox never accepted what others told him. He always asked questions to get to the truth regardless of consequences—even as a child.
Crittenden’s first job out of college was teaching. He taught business math, database programming, and spreadsheet programming in high school.
However, he quickly shifted gears. One of the wealthier families in Kansas had their family office in Wichita. Crittenden was offered a job that paid a lot more. No more teaching!
This family was no slouch. They started with about $250 million in 1996 and bankrolled that to close to $900 million at the time he started working there—which was the height of the dot-com bubble.
However, there was a not so rosy undercurrent. Sometimes, for some people, once they have made a certain amount of money, they begin to take to trading differently. Crittenden was comfortable looking at the disaster scenarios, trying to assess their probability. He was blunt, “These people were not really interested in managing their risk.”
He tried to explain scenarios by which they could lose money in short order. They didn’t want to hear any of what he had to say. They wanted Crittenden to be a happy cheerleader, not a risk manager.
Eventually markets started to go down in 2000 and this wealthy family started increasing their leverage. They were trying to make their money back on losses, and fast. However, they didn’t sell losing positions. They actually started selling winning positions in order to free up capital to recapitalize the losing positions. Crittenden saw the unfolding disaster: “No, you can’t do that. That’s how you go to zero.”
The personalities in this wealthy family changed. They became different people. They were of a certain manner on the ride up, kindhearted, decent people, and they lost their way to some degree on the ride down. It affected their psychology. It became all about making the money back, but they didn’t make it back.
Watching that round-trip disaster affected Crittenden dramatically.
He became so disengaged that he wrote a letter to the family voicing his disagreement with their overly aggressive risk appetite. If he was concerned with politics and protecting his job, the letter—a version of “take this job and shove it”—was not a wise career move.
However, jobs were not Crittenden’s or Wilcox’s calling. It was entrepreneur time—or it would be once they met. As Crittenden finished working for the Kansas-based family, he decided Going to California was the song to play. It was time for a fresh start. On the way there he was passing through Arizona to see his mother. He liked the state and decided to stay. He floated resumes around, and in a classic small world story, one made it across Wilcox’s brokerage desk.
Crittenden reca
lled seeing Wilcox at his office for the first time. His shirt was untucked and he had a headset strapped on. He looked like he’d been in a 12-round fight with George Foreman or someone who just needed water. Crittenden thought to himself, “This is your typical day?” It was not something he wanted anything to do with.
But they hit it off and decided to do a project to either prove or disprove classic Wall Street theories and axioms that had been passed down from mentor types. The big question: what worked and what didn’t work in trading?
None of the trading ideas they tested worked. Nothing was consistently effective.
Well, if you don’t have anything that works, who does? That was their next question. When they started looking around at trading winners, the first trader that they became interested in, and wanted to learn more about, was trend following trader Salem Abraham.
In early 2002 they met Abraham and were exposed to the world of trend following (You can read more about Salem Abraham in my book, The Complete TurtleTrader). They spent a great deal of time reading through his regulatory disclosure documents (one of the insights I had learned early on too), reading articles about him, and trying to understand what it was that he was doing to make so much money.
They continued to consume as much research as possible about the systematic methods behind the many trend following pioneers—including several of the trend traders in earlier chapters of this book. Surprisingly, they said my web site, TurtleTrader.com, was also an invaluable research tool in their process.
They subscribed to multiple databases that reported individual pro trend following traders’ performance and began to perform quantitative and qualitative evaluations of those traders. Not unlike the journey I took, they set out to talk to as many great trend following traders as possible. They flew all over the world, on their dime, to further their education (And for those who think today that only sending a letter or an e-mail is enough to gain an audience with trading legends—wise up.)
What they found was that most traditional trend following traders had never even looked at individual stocks—they generally traded stock indexes on futures markets. This was the pivot point to the start of a multi-year research project to determine the viability of using systematic trend following on stocks.
The most traditional trend following traders never even look at individual stocks.
What does their research have to you with your trading? It’s their process. Their process is how you need to approach it too. They were never hung up on being right; rather they were interested in not staying wrong. Wilcox, for example, has a constant process of asking, “Am I wrong?” while he sees everyone else asking, “Am I right?” If you don’t ask the correct probing question with genuine curiosity, like a scientist, you cannot arrive at the correct answer. Right?
Anything successful in life is a process of trial and error. You try something, you look at the results, and you eliminate what doesn’t work. The scientific method doesn’t allow you to prove anything. All you can do is disprove theories, and then, with a preponderance of evidence still left, you can accept and keep the remainder as long as you can’t disprove it. Wouldn’t it be nice to see Joe Kernen come on CNBC and say that some day?
Follow the Leader
Lumpy returns are good for you. Write that down.
In this “business,” most people fail. Even most professional money managers fail to outperform the market, so if you find yourself doing what makes most people comfortable, then you have to accept the results that most people get, and that is failure. You want to do something counterintuitive. What Crittenden and Wilcox found is that the small minority of stocks that generate all of the market’s returns have only one thing in common: a propensity to keep hitting new all-time highs for a long time.
So, mathematically speaking, you absolutely have to do the opposite of what the majority does, otherwise you simply can’t get ahead; it is not possible. Most people automatically gravitate toward high winning percentages. They want low drawdown, low volatility; they want all these things because those are symptoms of health—or at least they think those equal health. Unfortunately, they are more concerned with the symptoms than they are of the outcome. And most of those people are paying a premium to enjoy those things that they think signify health. You have to be doing the opposite, and that is high-payoff, low-winning-percentage trades, or said another way—lumpy returns. That is what works.
Not having any margin of safety led Crittenden and Wilcox to seek out an assortment of mentors—to try and ensure their success. Tom Basso, a very successful trend trader in the Phoenix area at the time, provided seed capital. He was a partner with their original firm from the beginning. Some readers may recall Basso’s profile from Jack Schwager’s classic book, The New Market Wizards.
Basso liked their thinking, and pointed them in the right directions. He would say, “Talk to these people, they are good. Avoid those people over there.” That might sound simple, but when someone with decades of experience points you in the right direction, you have to be in a position to understand why that type of wisdom is different. Do you just trust and not verify? Of course not, but traders, especially ones who have done well for years, are going to save you tremendous time on your trading journey. Why is Joe Torre’s expertise invaluable as a baseball manager? He has been there. He has done it. Oh, sure you can go figure it out on your own from scratch, but why not take a shortcut on the learning curve? That happens to be the reason that this book has come together as it has—to get you there faster.
Trim the Fat
A few key lessons from Basso helped Crittenden and Wilcox from the beginning. Basso was blunt, “It really is simple. You hold your winners, have discipline and cut your losers. You take what the market gives and you’ll be successful in this business.”
Crittenden added: “One. Don’t over-bet. Two. Diversify across markets. You might see a guy who has a great track record and he trades long only the S&Ps. They don’t last very long.”
If you bring a person off the street, give him a bunch of money with no instruction, and tell him to start trading, he will sell his winners, and double up on his losers. He’ll try to get a high winning percentage. His losers will be bigger than his winners. After a certain period of time his account equity will hit zero.
You don’t learn the right way at college either. “You go to a university and there are big buildings. It’s got departments, professors, and all sorts of people that work there. We had to create our own trend trading university,” said Wilcox.
There’s no class or university that teaches you how to be a successful speculator. None. They don’t exist. There is nothing available. They’re teaching something else in schools, and whatever it is, it’s not how to be a successful speculator or how to take money and make positive returns.
Let’s face it, schools teach you how to fit into the existing system. You need to ask the big question, “What is the correct system for me?” Most just accept the status quo, get their degree, and fit inside the box doing whatever they are told to do. At the end of a career, with that backwards thinking, you clean out your cube and go home. After all, The Office has been wildly popular because it is all too real.
Crittenden and Wilcox always take the approach of looking at the system and asking, “Is it right or is it wrong?” Most people don’t do this. When a teacher is lecturing and a student raises his hand to point out a contradiction, generally the teacher tells the student to pipe down and learn the material as written. Many teachers don’t discuss or theorize. They pontificate. They are, after all, cogs in a system—a system that doesn’t lend itself much to heretics.
You Have to Know Your Strategy
Wilcox put forward the counterintuitive notion when addressing the super-hyped investment of the day—gold. “Technically, buying gold is a strategy. It’s not just a trading instrument. If you listen to TV commercials on gold they will tell you to buy gold. You buy it, and you’ve just undertaken some s
trategy. Now, understand that strategy doesn’t necessarily have an exit point, which is no small issue. Many hear buy gold, and they’re assuming that there’s a strategy built in to protect on the downside. Just buying gold should actually lead you to think, then what?”
Unfortunately, the way humans make decisions is to focus on returns alone. They never focus on the risk component of what they are doing.
For example, without understanding the sell component when you buy something like gold, you can’t understand the risk component because you have not defined it. If I say I’m going to buy at X price and sell it at Y price and I’m going to allocate X dollars to it, well, I can determine that X dollars, this-minus-this is going to lead to this amount of loss if it goes down and bites me. You can box the risk in and you can understand it. However, just buying gold, with no exit in place, doesn’t box anything in. Is there a lot of swimming naked in gold markets today? You bet.
You want to make a point of never focusing daily on the return component of your trading. Good trend following will keep you in that frame of mind at all times. You don’t make a decision to allocate capital or make an investment without knowing your exit strategy first.
You can only control where you get out of a position once you put it on. You cannot control what’s going to happen. You can only control how you react.
No one controls future events. None of your analysis is going to be able to control a future event. Why focus your time and energy trying to predict an outcome that you have no control of? No one else knows either, so don’t worry that the suits on TV know something you don’t.
The Little Book of Trading Page 11