The Little Book of Trading

by Michael W Covel

  Further, taking too much risk because you get paid more in the short term is a recipe for long-term disaster. If you are overdoing your risk, it will come back to take your money and send you back to the poorhouse. The short term, however, may be a decade, you just don’t know. It might be one week, but regardless of the time component, you don’t want to be in a position to lose all of your money after one year, five years, or ten years of work. Or do you?

  Bottom line, you are up against the natural bias in the way human beings make decisions, which is to reward outcomes. If a guy is an A student, he’s obviously smart, right? At least that is the assumption. If a money manager has a good track record and a five-star fund rating, he’s good, right? Not necessarily. How could you possibly know if he’s good or not? You have to evaluate the process by how that outcome was generated. If you don’t do that, you have nothing and know nothing.

  Sear that thought into your trend following memory bank.

  Chapter Ten

  Make It Work Across All Markets

  Michael Clarke

  Most people first ponder trading and think, “How could I ever trade soybeans, gold, wheat, Apple, Japanese yen, and Swiss francs successfully?” Those markets, to the beginner’s eye, seemingly have nothing in common. But if you take a step back and analyze the price data, you can see that they do, in fact, have an important common denominator.

  Blur your eyes and imagine a chart, a price chart, hanging on the wall. Now imagine you don’t know the name of the chart. It’s just a chart. Don’t they all look the same if you take the name away? Is there really a difference? So do you really care about the economics behind oil? Or do you just want to make money from a trend delivering, for example, a 25 percent return? What if the 25 percent return came from soybeans or the Brazilian real—why do you care where your 25 percent return came from?

  That’s why you want to know Michael Clarke and his wisdom.

  Clarke has traded hundreds of millions of dollars for clients over nearly 20 years. He has traded client money to produce profit margins that no investor would complain about. What is a great example of his success in action? He started shorting crude oil in the summer of 2008 when it hovered around $140. He stayed with that trade down, going short, to $80 before getting out—collecting the bulk of the downtrend. Was he an expert in oil? No, and neither were any of the other trend followers trading oil. Were they experts in OPEC policy or whether or not tensions were flaring in the Middle East? Nope. No expertise in any of that.

  Clarke didn’t start out as a trend following trader.

  When Clarke first began programming while attending college in 1967, he was already thinking in terms of numbers, “I wanted to list all the possible combinations of numbers one through five, and so I wrote a little program to do that.” He wrote a program with a little loop, inside a loop, inside a loop, and figured out that loops inside each other were the basis of programming success. Clarke had his Aha! moment.

  He thought, “Geez! This is really cool! It’s really fun and challenging. It makes you think.” This realization hooked Clarke into the game of programming—a precursor thought process that would come in handy in trading arenas soon enough.

  Not surprisingly, his first career was as a software developer. He says, “I loved the challenge of developing integrated software solutions for different kinds of businesses, especially manufacturers. It’s a complex process to provide systems to handle functions like acquiring raw materials, putting them together, selling them, and collecting the funds for those sales. One needs to be adept at both the overall concept of how everything fits together as well as the details of implementation.”1

  As we all try to do at one time or another, Clarke tried the corporate grind. There was a programming competition during college and he won first place. The prize was consideration for a job working for Procter & Gamble in Cincinnati—no small deal to those familiar with P&G and its legacy in Cincinnati. He only had to get through the perfunctory interview. His foot was already in the door, but at the time he was a little “wild”—that would equate to a motorcycle and long hair.

  He went to the interview and didn’t exactly dress up. Procter & Gamble is very “white shirt and tie.” Clarke had his interview, but they wanted nothing to do with him. He heard back, “Nobody’s going to like you looking like that.”

  Time to try something else.

  No More Suit and Tie

  Wall Street soon called, as that was where the real money was. However, Clarke was not a great salesperson and the 1987 stock crash, followed by the mini-crash in 1989, left him searching.

  He had to find something new, and fast.

  One problem: He could not convince anyone that he knew what he was doing.

  He began looking into trading systems. He originally bought the System Writer Plus package to test technical buying and selling ideas (a precursor to TradeStation) and found it inadequate for what he wanted to do. Consequently, Clarke bit the bullet and developed his own system-testing platform. He developed the ability to test his mechanical trading system ideas from scratch!

  Clarke had read many books on trading, but the first book he found that went into the details of trend trading systems was Bruce Babcock’s The Business One Irwin Guide to Trading Systems. It was instrumental in his initial trading. Babcock described a system that went across the board making money in all markets. It was a great robust system that could be quantified and systematized. And it worked. That revelation hit Clarke in the solar plexus—the idea that a book had a way to apply some simple rules and make money. “Wow!” he thought.

  What’s the Magic Sauce?

  Why do trend following systems work? There is no great answer, and Clarke would concur. All he knows is that trend following trading systems have worked for a very long time.

  But many don’t get that. They say, “What’s copper doing?” “What do you think copper is going to do tomorrow?” “Is copper in a bull market?” “Do you know what's happening?” People want a story.

  Trend followers don’t have a clue, and Clarke is no different. That said, he will tell skeptics an opinion if they want one. But it all goes back to the fact that the models succeed. He stands by his trend following models, “There is no sense in taking a 50/50 shot in predicting anything. Just follow the models.”

  “Here are my opinions but . . .” Those opinions just don’t substitute for trading system models.

  Using a System

  If Clarke’s trend trading model says “sell this market,” he sells. He doesn’t argue with his trading system.

  Never, ever argue with your trading system.

  Everything Clarke does is programmed into his software. Of course, there is plenty of work that goes into the research and building of a trend trading system that you are comfortable with, but after it is built, and your rules are programmed in, you just follow what it says. This is not fundamental (no crop reports, no Fed watches, no OPEC news, no unemployment reports) at all. You could program fundamentals into a model, but that is not the road Clarke has taken. It’s not the road you want to be driving down either.

  After Clarke built something that worked for him, he said to himself, “This is a pretty good system. I can compete with the professionals.”

  This is the short and sweet version of how Clarke became a professional trend trader. It’s not sexy or entertaining, but his story has built an empire of money.

  To this day, the sole reason he is still in the trading game is for the joy he extracts from it. Don’t underestimate passion in the success equation. How does success translate for him? For one, he has always worked out of his suburban home in Hinsdale, Illinois, about 25 miles from downtown Chicago. Can you be anywhere and trade? Yes, you can. Does that mean Indonesia? Yes. Singapore? Yes. Anywhere? Yes.

  What system lessons can you take from Clarke that can help your account grow?

  You want to look for trend following models that remain robust over long time periods a
nd you want to be willing to include models that have flat to negative performance for periods of up to two years. The principles that allow a good model to work successfully may fall out of favor and stop working for a period of time, but if the model has validity, the long-term principles will reassert themselves over time. Don’t jump the gun in throwing away your models. Clarke emphasizes, “We don’t want to throw an otherwise excellent model away simply because it had one or two rough stretches. If it meets our overall criteria and blends well with other models, we’ll use it.”2

  You can go through long periods of no movement in the markets with trend following strategies and then all of a sudden, boom! You will get a huge run-up, as markets all start trending at the same time. It’s like being in the desert for 11 months with no rain. All of the sudden it begins pouring and flowers grow. You are happy and flying high again.

  There is no secret. You can describe this way of being, this way of trading, in one word—patience.

  In the 25 years Clarke has been trading he has gone through the emotional rollercoasters. He has thought that his trading career was toast on many occasions. He would say to himself, “Now, this is it. We’re never going to make money again. I’ve been lucky for 25 years, and now it’s perhaps soon over!”

  How do you deal with the ups and downs? Strict trading rules are the only magic salve to possibly save you from the dreaded emotional mistakes that can blow up your account.

  These days, Clarke doesn’t worry about his trend model. He knows his systems will pull through. He doesn’t sleep well at night in general, but it’s not because of trading. The no-sleep worrying from the stress of trading ended for him well over a decade ago.

  Follow the Leader

  Clarke is all about going back in time to test a trading model. You want to have a sound philosophy when developing your trading model and test it using a large pool of markets. Clarke used approximately 105 markets, with data as far back as 1945. In order for a model to be accepted, you want it to trade all markets using the same rules and parameters. Your results should yield good performance across 90-plus percent of all markets tested. Also, no model should be accepted unless it shows stability of performance during tests involved with shifting parameters and altering rules. This is the definition of robust.

  Source: www.clarkecap.com.

  While it’s common knowledge today to those who already understand or trade trend following methods, Clarke didn’t trade European or any foreign markets when he started. He traded only domestic U.S. markets, as he had only developed his trend trading models on those markets.

  One day he decided to add foreign markets. He put them into his system and they worked fine. No tweaking was necessary. He saw for the first time the eye opening universality with his trend trading models. It was yet another Aha! moment.

  However, building a trading approach that is flexible can be debated.

  I once sat down with a bright trader. She told me, “I just met with [name] trend follower, who you know is very successful. All they kept telling me was how much they’re tweaking their models and constantly improving them.”

  My response, “I don’t believe it. They tell stories for people who don’t understand trend following. That’s the story they’re creating to make you feel comfortable.”

  Clarke agreed, “You’re exactly right. You can almost pick up on what some people want to hear. Do they want to hear that you tweak the models or do they want to hear that you have them? Some people want to hear that you’re constantly adjusting to the market. But the fact of the matter is that there is no constant tweaking. The markets are ever evolving, but certain criteria are forever constant. Changing markets is what we make money off of. It’s human nature in a way for some people. If you don’t really have their story, they can’t relate. You basically give them the answer you think they want to hear. It’s like the poker players, they can look at you and figure out what you want to hear.”

  People ask, “Well, how are you keeping track with the changes in the markets?” Clarke was clear. “It’s dynamically built in. Our models are all adaptive and dynamic.”

  If you’ve done your trend trading homework properly, you don’t have to adapt your trend following nonstop to whatever is perceived as world change.

  Fundamental Folly

  I was once at a hedge fund conference with MBA students and allocators (people who give institutional money to firms like Clarke’s). One of the prominent speakers, one with a hedge fund, asked rhetorically, “How many of you think rates will be higher or lower in the next period?”

  Having received my MBA too, and having learned nothing during that time about trend following trading, the speaker’s question immediately bored me. I started to think, “Well, I assume he has some skill from the fundamental side that allows him to decide when to buy and sell . . .” However, he went through his presentation with assorted economic indicators, and there was no there, there. I felt like I was back in a graduate level economics class, wondering whether there was a connection between these ratios and statistics to actually making money.

  I could not connect the dots. I didn’t know how, after listening to his presentation, this man bought or sold anything. I just knew that he had outlined his fundamental predictions. He was obviously a bright man, or I thought he was.

  Clarke saw it, “They know how to leverage [and go “long”] and they know how to borrow cheap and [trade] at six to one leverage [and that’s it].”

  The leveraged long strategies Clarke refers to work for a while, until they bust out like clockwork. They are the root of every big name blowup over the last 20 years.

  Stories Don’t Make You Money

  These days, millions are watching CNBC and any number of other “make you money get out of debt” shows. In the old days, it was one pragmatic show: Wall $treet Week. Today, the new money shows are a circus. Further, there are brokers and fundamental research everywhere now, all promising you tomorrow’s headlines today. The pushing of fundamentally driven stories at a breakneck pace is the new normal. And the demand is there. People want to understand so badly, and stories help to rationalize. It’s comfort food for the financial soul.

  For example, many buy stocks that they use. You go to Wal-Mart, where you buy toilet paper and sponges. Wal-Mart is tangible for you. You see the store congested with people, so you think it must be making large profits. So you buy stock in Wal-Mart, assuming the stock can only go up, based on your observations. It seems logical to conclude. Or if you’re going to Starbucks for vanilla lattes and you like them and you see other people there taking coffee shots, then why not buy Starbucks stock? People operate with that mentality.

  The idea that you’re doing something mathematical (like trend following) and that it can work is not digestible for many. Most people do not understand statistics and probabilities, and don’t want to. It’s too cold, and it doesn’t allow them to talk up a fun story at the next dinner party. Try telling someone, “I’m doing this mathematically and grinding it out with a bunch of small losses because I really have no idea what the market will do next.” No one finds that exciting!

  People want to be able to tell their buddy at the gym, the guy on the golf course, their wife, their girlfriend, or anyone with a pulse—the story: “I knew Starbucks was going to be big before it ever was.”

  Clarke, on the other hand, turns on his computer and pushes a button every morning that shoots his trades out for the day, at least if there are any for that day. He sits there and watches. Some times when he loses he puts his helmet on, goes to his desk, and sits there for a few months until his trend trading system wins again. It is a never-ending cycle, but a damn profitable one.

  Motivation and Drive

  Who likes saying “yes sir!” to a hovering boss every day? Like most entrepreneurs, Clarke didn’t exactly mesh well working for the man. He never had a boss he liked.

  In fact, he sees much of his success today, and the career choices he has made
, as attributable to being a loner. If he were better looking, or more popular, he is quite certain he would have chosen another life route.

  “Gee, if I had another life I would come back really handsome, well-built, an athlete, attract a lot of girls . . .”

  But if it comes down to being less on the intellectual side, the choice isn’t easy for him. He isn’t saying he would want the same upbringing he had, but having some bad things in your childhood can develop motivational fuel. That kind of motivation can be a very effective driver to success.

  Can you relate to that? It is that kind of thinking that set Clarke’s drive and determination on course to be a winning trend following trader.

  When Clarke was initially establishing his trend trading routine, he would work long hours and love it. He would get up at 3 a.m. with ideas flowing. I did the same thing with my business. I was often so naturally wired that I could not sleep. I was ready to get to the next day already.

  If Clarke were handsome and popular rather than a loner, would he have had the time to focus, to think, and to translate over and over trend trading processes in his head? Would he have had the time to search for a workable trading methodology? Who knows! Everyone is different. Everyone has different drives.

  However, you have to have it in your gut to win. If you don’t have it or if you won’t work to get it, go hang out at the bar and commiserate with the other patrons who all imagine themselves one step away from success—of course only after they down just one more whiskey shot.

  Sheep Need Not Apply

  People in markets always move in a sheep-like mass. They move like lemmings. That will never change. Maybe the devices used, and their views, will change, but people are people. So if you want to make it, if you want to pull something off that is different, you’ve got to think outside the box. You’ve got to look at things with a critical eye. You’ve got to say, “What's different?” “What can I do?” “How can I figure this out?”