The Little Book of Trading

by Michael W Covel

  Having various combinations of skills has been essential to Clarke’s success. The ability to program his own systems was top in his mind. Giving his ideas to someone else to program would never have worked for him. He had to actually do it himself. That was his confidence. Does every trend follower do it that way? No, but Clarke did.

  You’ve got to come at trend trading from a different angle, not just an average angle, and it ultimately traces back to an entrepreneurial mindset. I recently told friends that the best trading book I had read in years had nothing to do with trading: Linchpin, by Seth Godin.

  Michael Clarke lived Godin’s book long before it was written.

  1“Clarke Capital Management,” The Barclay Group, 4th quarter, 1999.

  2“Clarke Capital Management,” The Barclay Group, 4th quarter, 1999.

  Chapter Eleven

  Stay in the Moment of Right Now

  Charles Faulkner

  Perhaps you have heard the expression about living in the moment of now. What do I mean? The past is gone and the future is unknowable, but we have right now. That does not mean we cannot consider our past experiences or mistakes as useful references. Nor does that mean we cannot prepare and plan for the future. It does mean that making decisions based upon what is actually happening in the moment of right now is how great trend following traders organize their lives and produce their fortunes.

  While not primarily a trader, Charles Faulkner brings a tremendously useful insight to the table. In all my years I can think of no one who does a better job of bringing traders and investors to a better understanding of themselves. Understanding yourself as a trader is the needed introduction to the journey of success in trend following profits.

  Faulkner sees the world from a very wide and novel perspective, and you should too.

  Case in point: A crucial lesson to understand is that when entering the market game, losses are part of the game. No matter the amount of experience you have, there will always be losses. That said, you want to make sure your losses are ones that you can handle—knowing that they are emotionally going to affect you.

  People in sports understand this. Professional game players understand that to build your skill, you need to take losses and learn from them. You hope to play against people better than you because that is what makes you better.

  Studying traders is very useful because everything in their world is extremely focused due to the intensity of their profession. What might take months or years to unfold in an ordinary life can unfold very quickly for traders. For example, for many people the biggest purchase they make is a house or a car. And for many successful trend traders that kind of money can go through their hands within an hour, or even minutes.

  This means, when trading, you don’t want to view money in terms of dollars as if you were going to buy a new car, but rather use the dollars to keep score. Putting yourself into that mental framework is critical. Releasing your mind from how you value money in terms of shopping, and instead focusing on it as a score during the game, is a huge first step.

  Critically observe how the world works. If you’re looking down from 35,000 feet and saying, “Okay, I looked out the window, I know what’s going on,” you’re missing it. You have to think about it critically for yourself.

  Take Advice

  We don’t like to take advice, but we often do. However, taking advice is putting somebody else in charge. Emotionally, it is taking a one-down position to them. What do they know that you don’t?

  Financially, it is entrusting your financial wellbeing to somebody else. Intellectually, it is making yourself less stupid and less responsible because you are turning your money over to somebody else.

  In a sense, taking advice from someone who knows a field is a completely normal thing. We learn to drive from our parents, a relative, or a driving instructor. We learn sports from coaches who give the wider perspective. They give us the beginnings of our abilities, and then we move on to others who can help take our skills further.

  In that sense, taking financial advice makes perfect sense. You know you don’t know. And knowing you don’t know, you say, “Well, who knows?”

  But this is where it gets curious. In the world of professional baseball or other big league sports, you can see a person’s performance in black and white. Further, because of the physical reality of it, you see they have talent, and statistical proof, and to go to them is to go to someone who knows their craft.

  That same assumption gets applied to financial advice too, but, unfortunately, there is a real chance that the person who made money last season did so by chance. Many of them do not actually have any skills—they were lucky.

  This becomes a conundrum. If you don’t know, how are you supposed to pick somebody who knows? Most people say, “This person made money last year, I should listen to him.” And again, in a non-money world, this would make sense. If somebody was good at cooking or somebody was good at producing films, you’d say, “Well, this person would be a good bet for next year.” Wolfgang Puck is a good bet. Spielberg is a good bet, and so on.

  This is the challenge. In other words, how do you vet the person who promises to make money? How do you decide if this person is someone you want to take advice from? If it was somebody who knew how to repair cars, you would watch him repair a few cars and say, “I can trust this person’s skill.”

  We look for people who have knowledge of a subject, but the mystery of money, the mystery of finance, is who knows? Who has real knowledge of this? Is it that they can run an actuary table? Or do they have the ability to compound interest? Does that mean they know? This is an especially difficult question given the emotional potency of money, since people tend to look right at the end result. With a game like chess, how you play is very important—the people who truly understand will win more games and for longer—with less fluke-like wins. You would not just take advice from one person who wins a few chess games—you want to learn from someone who understands the process.

  When it comes to finding someone who gives financial advice, you want to be looking not only at their results, but how did they get there? Do they have a good process? Does that process allow for mistakes? Does it allow them to get better and better?

  That is how you need to psychologically think about winning as a trend following trader.

  Responsibility

  Money is responsibility. It is a currency for life. For people who do not want to be responsible with money, it is like saying, “I'm not going to be responsible for my time, and how I use it.” That type of person is living in a reactive mode. Merely reacting to stimuli is not charting out a course for a fulfilling life. It is no different from a wild animal responding only to events just to sustain its basic needs (read: fight or flight). That is not a happy or particularly satisfying existence for human beings.

  You need to define your edge, a place in your life, where you can be proactive and begin to directly participate in the choices you make, whether it is with your time, your money, or other meaningful things in your life.

  That’s hard. The whole media cultural milieu now is one where you ought to be gratifying yourself immediately. Very few are discussing, or reflecting, or seemingly thinking about how you can save, invest, or increase your assets in wise or smart ways.

  The actual messages in media can run against each other. No wonder it’s more difficult now for people to become financially independent. The thinking isn’t in society. It used to be the province of rationalism and traditional religion to educate people to take a longer view and make better decisions, but that now falls to financial planners (and worse, to 24/7 financial media).

  For example, think about people who watch 17 hours of television a day. You might be one of them! What’s shown on television will be your memories. You will not have memories of being with your kids, walking in the woods, sitting in front of a screen and trading correctly, or planning with your spouse for the future.

  Digital images from t
he media—reality TV if you will—will be the only memories you end up with. As sad as it sounds, many decided to join Wall Street after seeing the movie Wall Street because they thought Oliver Stone’s Gordon Gecko was a good guy. More did it because of Gordon Gecko than Warren Buffett or Jim Rogers or some person of actual achievement. We’re tremendously influenced by the potency of media.

  Why do we go in these directions? Even if it’s anticipating the future, you feel gratified now. In sports one of the issues that separates amateurs from serious professionals is that they feel no gratification from just playing and losing. The gratification for professionals comes when they lose, go back and practice, and then play another day knowing they will win this next time around.

  So a big difference that has happened in our society is not only instant gratification, it is also the degree of gratification pushed by media stimulus. It is overpowering for most. People are given repeat messages about what they must want, or they must respond to the latest cell phone advertisement, or the next hybrid car innovation. That is all a business designed to herd the masses to some desired end.

  It is sort of like the old story: There is a guy, and he is drinking liquor and smoking cigarettes because early in his life he had seen the ads with the whiskey and the girl and the cigarettes and he’s wondering now, “Where are the girls?” as he gets older. You can look at all these different offers being made across the spectrum, and each one of them says that you ought to be gratified now, and so consequently people think they ought to be.

  Even though some investors may have made a plan, when they see and hear these messages many times a day they can’t help but respond to the nonstop offers. Look at Jim Cramer. His show is filled with movement, sound, and all kinds of stimulating input. That messaging captivates many.

  Faulkner sees the insanity: “Cramer’s show is vivid, immediate, sensory, full of sound, and movement. We’re designed to respond to that. We can’t help but respond to that. Even though, of course, Barron’s magazine has pointed out that if you actually followed Cramer’s recommendations, you wouldn’t be doing very well at all. But people don’t seem to mind because they get to feel this closeness with somebody who is active and doing stuff. They see Cramer as intelligent and he seems to know what he is talking about. He is saying these things with a great deal of authority. How can someone with so much vigor be so wrong? My god, he has got to be right!”

  You need to develop your capacity to be your own person. You need to be the one who makes decisions based on your circumstances. There needs to be a point at which you can look at TV talking heads and go, “That’s just a point of view.”

  That’s the mindset you need as a foundation.

  Human Nature

  You don’t need to academically research the concept of “hunting and gathering.” Anyone who has ever been to a modern grocery store realizes that clever advertisers and marketing strategies crowd the isles together to get us to hunt and gather for our foods. It’s well known that Fortune 500 companies now hire anthropologists to try and give us more satisfaction than we actually need as human beings. This is what we are up against.

  Efficiency, and who we are as human beings, do not really fit together. We are not designed for efficiency. We are designed to satisfy a tendency to take the best decision that we can, grab hold of it, and enforce it in the present moment. And even if that holds us back later, we do not really mind. In fact, we often try to make a bad process work for as long as possible, that is until it finally breaks and we actually give up, forcing us to try something more promising.

  That is quite different from how our modern technologies have developed along a more efficient, automated, and reliable frontier. Whereas we can be distracted by an interesting looking person or by a certain odor—inconsequential random acts that distract us—computers and rigid trading strategies like trend following are not persuaded by emotional stimuli. It is more of a challenge than people realize: How do you stay focused on what really matters?

  Think about it. We do not stick with our money decisions just because we made them, but rather, we stick with them because they are us. For example, many traders as long as they have not actually sold a losing stock can pretend that it is not a loss. Yet, of course, that is a reality-unreality strategy. A loss is a loss regardless of how you rationalize it.

  But it goes deeper than that.

  The dog disappears in the morning but is outside the kitchen door by evening. If your kid says he is going to run away, he is back by dinner. And when you lose your car keys (buried on the kitchen table), for some reason they show up a little later on the kitchen table right where you lost them.

  As creatures, we’re actually designed to think that what we lose is going to come back, and if you think back to most of human history, that was probably true. People didn’t often get past the village gate in medieval times.

  If a piece of gold or currency is lying on the ground, fundamental traders would say that it can’t be real because somebody would have picked it up already.

  So the idea of cutting your losses quickly and letting your gains run is in fact going against human biology. That is why so many trend traders are called contrarians. It is not that they are just contrary, although many of them are. It’s that they have to be optimistic in a situation where most people would be pessimistic. Trend followers take losses quickly and say, “Hey! I got out. It didn’t cost me much. I’m feeling pretty good.”

  Of course you could look at it like many inexperienced investors might: “That cost me something. I want revenge on the market. I will never forget that loss.”

  People are irrationally pained by the notion of loss. They are pained even more by these wide differences of perspective about loss.

  These different points of view have a lot to do with your previous experiences, the kind of life that you have led, your mentors, and so on. For example, for some people real estate looks real, and it does have the word right in it—real. And as an uncle of Faulkner’s said to him when he was young, “Buy land, they’re not making any more of it.” Those early messages make investing and trading as adults, seem very wise, even if they are not actually smart rules for making money.

  I don’t think there is anyone alive who would unilaterally accept real estate as a sound buy-and-hold investment with no downside. We all know better now.

  Old School Is Not New School

  Early on Faulkner traded commodities and currencies making a tidy sum of profit. He called his mother and father one day to tell them about his success and mentioned the dollar profit. His mother quickly said, “You take that money and put it in the bank right now.”

  In his parents’ world, that was a much safer place. You might think, “Banks? I wouldn't put it in a bank. It wouldn’t be safe there.”

  That was Faulkner’s thought too.

  Let’s face it. There have been a number of massive changes in the way people view the world. Before the Depression era people did not travel very much. Most people stayed in one place their entire lives, but now over 50 percent of the country is mobile to new areas every five years. That is a massive change in lifestyle for modern man.

  Further, our grandparents had direct experiences. If you think about it, a majority of people’s experiences are now virtual and or remote. Meaning if you are looking at a stock price, it’s remote from you, it’s abstract, and it’s not like you’re actually trading the physical shares. Who has stock certificates today? These changes have affected our current ideas, images, and beliefs.

  Many feel these changes are positive with no unintended consequences. Faulkner sees it very differently.

  He argues against the idea that there has been a democratization of the stock market. There have been investments made on behalf of people without their knowledge. Very often people don’t know what they are invested in through their pension funds and mutual funds. In terms of pension funds, many of these operations enrich the fund managers more than they enrich the
pensioners. It is a huge problem with mutual funds too. Mutual funds deliver no returns for a decade and still make billions for their owners. The system is backwards.

  Find the Essence

  If you look around today, everything is about money. You cannot return to nature without paying for the space to pitch your tent. You cannot hunt for food without paying for the license to hunt (or fish). Money is our lifeblood, a stream running through our culture. It’s fundamental. A basic competence at making money is not a luxury.

  If you divide investing and trading into different categories: real estate, stocks, commodities, futures, ETFs, alternative assets, and so on, how are you going to evaluate them? Are you going to go into the fundamental details? Like a Jim Rogers or Warren Buffet? Are you going to tear the company balance sheet apart and digest arcane balance sheet details? Find out who’s the CEO? What’s the price-earnings ratio?

  That’s the old way.

  You can go in another direction. You can abstract up and say, “What do all these things have in common?” Meaning, what do markets all have in common? Trend followers see price as the big differentiator, the element they have in common. It is a distinct way of thinking.

  When you move into the world of trend followers there are no stories (a common theme across all chapters). Trend followers do not care about the company CEO’s marriage or family life before buying a stock. They are not interested in outside factors. Just give them the price data.

  This does not sit well with some newcomers and critics. They say, “Okay, I don’t know the causative story, so I’m not going to indulge my mind in that.” They just put the horse blinders onto this new way of trend thinking.