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The Little Book of Trading

Page 14

by Michael W Covel


  Years ago Faulkner saw Ed Seykota at a conference (he appears again) trying to win over converts. Seykota told attendees, “This market has the property of going up.” Faulkner thought, “Wow, is this guy being careful with his language. He’s not introducing any story, even in his own head.” Whereas, everyone else wanted to know “why”—“why is it going up?” Faulkner saw Seykota’s subtleness and depth, which was a great lesson.

  Successful trend following trading is about developing a belief deep in your belly that you are part of a larger system. The world is not your world. You exist in a flowing river, and figuring out how you can navigate that flow is the much bigger question to answer versus how do you control it—because you can’t.

  There is no mastering the uncontrollable, but you don’t have to control anything, except your downside, to make serious money.

  Follow the Leader

  Faulkner paints a great picture of “now”: Trend followers exist in the moment of now. Like a Mobius loop, the last principle circles back to the first one: “No one can predict the future.” Nor can anyone get hints or messages from there because there’s no there, there. When the “not yet now” happens, it’s not the future, it’s now. That is, until it’s yesterday—an unreliable collection of memories only experienced . . . now. With only now, there’s no room for stories, reasons, historical precedence, or other ideas requiring a past and future as if they are actual places instead of mental ideas we created. All of our would-bes, could-bes, should-bes, and should-of-beens are found in these imagined pasts and hoped for futures. In fact, some emotions require a disappointing past (regret) or an unfulfilled future (greed). When you realize there is only now, these would-a, could-a, should-as and their accompanying emotions become easier to set aside, making it possible to see what actually is . . . now. “There is only now” also focuses the mind. This moment is all there is. Our imperfect understanding of it is all we get. Act now . . . or not . . . in the next moment (of now), it’s all there is, and different from the previous now in unpredictable ways, and our imperfect understanding of it is all we get.

  In this world, clarity and simplicity are very highly valued, in thought and in action. This might seem quite Zen-like or mystical, but it’s not. It was first recognized by the western psychologist Mihaly Csikszentmihalyi as “flow”—being so totally in an activity that one forgets oneself. It often happens when we fall in love with something or someone, or when we’re playing a favorite sport or a musical instrument. It can also happen in so-called mindless activities, like washing the car, and suddenly your mind fills with new ideas.

  What’s finally so fascinating about this is whether you believe it or not, there is only now.

  Chapter Twelve

  Sing the Whipsaw Song

  You may have noticed a recurring name in the chapters of The Little Book of Trading. I had no plans to mention Ed Seykota in five chapters of this book—it just happened. During my research process, the traders kept bringing up Seykota’s name, over and over again.

  For those unfamiliar, Seykota was originally profiled in the classic book Market Wizards, and is considered one of the legendary trend following traders of our time. He has influenced a tremendous number of traders—far more than are mentioned in this book.

  My path first crossed with Seykota in 2001. He invited me to the U. S. Virgin Islands. The time spent with Seykota, and the ensuing phone conversations and e-mails over the years, have become some of my most influential trend following trading lessons. I would not be writing this book and passing along wisdom without Seykota’s generosity and early mentoring.

  While it was a pleasant surprise to see Seykota woven throughout the lives of other great traders, in this very small world of ours it should have not been terribly unexpected. When you decide you want the chance at making the big money, when you decide that you really are serious, there are only so many living original sources around who are willing to share. Seykota is one.

  And unlike this book, which is filled with words, albeit words that I consider very important to your future financial success, Seykota perhaps does an even better job of getting the trend following point across in his video on YouTube. It’s actually a music video of trend following—the only one that exists so far. It is a video that could only come out of the mind of Ed Seykota. To give you a feel for the song before you see the video, Seykota allowed his lyrics to be republished here. It is called The Whipsaw Song.

  What does whipsaw mean? It is a condition where a market price heads in one direction, but then is followed quickly by a movement in the opposite direction. The term derives from the push and pull action used by lumberjacks to cut wood with a type of saw that has the same name.

  The Whipsaw Song is to the tune of The Crawdad Song, a traditional bluegrass tune in the key of A.

  Chorus:

  You get a whip and I get a saw, honey

  You get a whip and I get a saw, babe

  You get a whip and I get a saw

  One good trend pays for ’em all.

  Honey, trader, ba-by mine.

  Banjo (Ride Your Winners):

  What do we do when we catch a trend, honey . . . etc.

  We ride that trend right to the end.

  Mandolin (Cut Your Losses):

  What do we do when we show a loss, honey . . . etc.

  We give that dag-gone loss a toss.

  Fiddle (Manage Your Risk):

  How do we know when our risk is right, honey . . . etc.

  We make a lot of money and we sleep at night.

  Guitar (Use Stops):

  What do we do when the price breaks through, honey . . . etc.

  Our stops are in so there’s nothing to do.

  Bass (Stick to the System):

  What do we do when a drawdown comes, honey

  What do we do when it gets real big, babe

  What do we do when it’s even bigger . . .

  We stick to the plan and pull the trigger.

  Banjo (File the News):

  What do we do with a hot news flash, honey . . . etc.

  We stash that flash right in the trash.

  Now go watch the video at www.seykota.com.

  Step Up or Step Down

  Now what? You have a choice to make. You can either go down the path of becoming a trend following trader, becoming the next Larry Hite or Kevin Bruce, or you can invest your money with a trend following trader. That’s it. The choices are clear. You either do or not do. It’s very black or white.

  Of course, you can always buy and hold some top mutual fund and hope that strategy will give you enough money to retire on by the time you get there or before another buy-and-hope market collapse of minus 50 percent. Forget that. The case has been laid out here for the benefits of trend following trading. The strategies of winners have been shown to give you confidence. Now it’s up to you to decide what you want to be when you grow up.

  I enjoyed researching and writing The Little Book of Trading. It has been a much different experience and challenge as compared to my prior books. My other books (see www.trendfollowing.com) were perhaps less accessible for the average reader. I hope The Little Book of Trading fills the void for those searching for something different. Good luck and feel free to contact me at www.covel.com.

  Appendix A

  Getting Technical

  What is Capitalism Distribution?1

  The stock market yields a minority of very large winners, a majority of below average returns, and a larger than expected number of dramatic losers. This phenomenon is Capitalism Distribution, and it can be observed in virtually any market, on any continent, across any decade. Capitalism is brutal, lumpy, and winner-take-all.

  In Chapter 10, we met Eric Crittenden and Cole Wilcox. The database they use to find winning stocks covers all common stocks that traded on the NYSE, AMEX, and NASDAQ since 1983, including delisted stocks. Stock and index returns were calculated on a total return basis (dividends reinvested). Dynamic point-in-time
liquidity filters were used to limit the universe to the approximately 8,000 (due to index reconstitution, delisting, mergers, etc.) stocks that would have qualified for membership in the Russell 3000 at some point in their lifetime. The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98 percent of the investable U.S. equity market. (See Exhibit A.1.)

  Exhibit A.1 Total Lifetime Returns for Russell 3000 Stocks, 1983–2006

  Source: Adapted from Table 1 in “The Capitalism Distribution: Observations of Individual Common Stock Returns, 1983–2006,” a research paper by Eric Crittenden and Cole Wilcox. Used with permission.

  An investor who owned 95 percent of all stocks, but who missed the 5 percent best performing each year, would have lost money from 1991 to 2008. Alternatively, an investor who owned 90 percent of all stocks and managed to avoid the 10 percent worst performing would have doubled the market’s compounded annual return (see Exhibit A.2). Clearly, a small minority of very strong and very weak stocks have a disproportionate impact on results.

  Exhibit A.2 Compounded Annual Return, 1991–2008

  Money management is crucial to investment success. A positive average return (mathematical expectancy) is not enough. Consider a simple coin flip analogy. Heads you win 200 percent, tails you lose 100 percent (not unlike an investment in a single stock). This equates to a 2:1 win/loss ratio and a 50 percent win rate, which yields an average return of +50 percent per coin flip. However, to achieve this +50 percent average return, you’d have to bet everything on each coin flip. In doing so, you’d go broke, with certainty, the first time you experience a loss. How can you have a positive average return and go broke?

  If you start with $100 and enjoy a 200 percent return you’ll have $300. If you then suffer a −100 percent loss you’ll have $0. But your average return will be +50 percent (200% − 100%)/2 = +50%.

  How much should you bet per coin flip? In the case of this coin flip analogy, risking 25 percent on each flip results in the highest compounded return over time. Risking more than this yields lower returns, higher volatility, and deeper drawdowns in equity. Risking more than 50 percent (over-betting) results in losses, despite having a favorable bet with a positive average return. Some refer to this phenomenon as volatility gremlins or variance drain. Take a look at Exhibit A.3.

  Exhibit A.3 Watch Your Losses—10:1 Win/Loss Ratio

  Compounding is more sensitive to losses than to gains. Even if the amount won on a coin flip is 10 times greater than the amount lost, there is no benefit to risking more than 50 percent per flip. As you can see from Exhibit A.4, that would be over-betting.

  Exhibit A.4 Compound Return Using 10:1 Win/Loss Ratio

  Readers interested in this concept should refer to the works of Ralph Vince, Ed Thorp, David Druz, and Ed Seykota.

  1Adapted from “The Capitalism Distribution: Observations of Individual Common Stock Returns, 1983–2006,” a research paper by Eric Crittenden and Cole Wilcox. Used with permission.

  Appendix B

  Fund Performance Data

  The traders and funds I’ve talked about in this book are a big deal, and they’re making it big by sticking to trend following. But maybe you need more proof. Consider these performance numbers. They show that trend following excels in the long run. Even if you thought every word of this book was complete bull, try explaining these performance numbers to me.

  Note: All tables show composite monthly and annual rates of return (%) net of all fees.

  Chadwick Investment Group

  Drury Capital

  Mulvaney Capital Management

  Sunrise Capital Partners

  Tactical Investment Management Corporation

  Winton Capital Management

  Glossary of Key Terms

  Bollinger Bands A technical analysis tool consisting of three bands drawn around a market price. The middle band measures the intermediate-term trend, usually a moving average, and serves as a 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. Developed by trader John Bollinger.

  channel breakout Another term used to describe Bollinger Bands, or close approximations of Bollinger Bands.

  Commodity Futures Trading Commission (CFTC) The U.S. federal regulatory agency for the futures industry, first established in 1974.

  commodity trading advisor (CTA) An individual or organization that is paid to directly or indirectly advise others on the buying and selling of futures contracts. Must be registered with the CFTC and NFA.

  compound interest Interest that accrues on initial principal. It also accrues on accumulated interest of principal.

  disclosure document The document that CTAs must supply when soliciting customers. It typically contains disclosure statements, performance records, information on business background and trading methodology, and advisory agreement papers.

  drawdown The peak-to-trough measurement in both time and money of an account’s losing period. See also peak-to-trough.

  efficient market hypothesis (EMH) The efficient market hypothesis states that all available information is known to investors and or traders, hence their decisions are deemed rational. Trend followers believe just the opposite.

  exchange traded fund (ETF) A fund traded on stock exchanges not unlike a stock (i.e., they have a symbol like stocks). ETFs can consist of stocks, bonds, futures, currencies, and so on. ETFs can employ many different types of strategies. Many ETFs attempt to emulate futures contracts.

  hedger A hedger is a person who typically takes a position in one market in an attempt to offset exposure in some opposite position.

  fat tail In the normal distribution of portfolio returns, the far ends of the bell curve are called tails. The term is used to describe a deviation from a statistical normal distribution. Trend following trading routinely wins by capturing extreme and unforeseen events—the fat tails (otherwise known as the 100-year floods).

  fundamental analysis A form of market analysis that attempts to divine market direction through study of all factors perceived to affect supply and demand. These could include analysis of the Federal Reserve, crop reports, OPEC, P/E ratios, and so on.

  futures (or futures contract) An agreement to buy or sell a particular financial instrument at a predetermined price. Futures contracts detail the quality and quantity of the underlying market. They are standardized and traded on futures exchanges (such as CME Group).

  managed account An arrangement by which the owner of an account gives written power of attorney to a CTA to buy and sell without prior approval of the account owner. Also called discretionary account.

  mechanical trading A trading approach in which buy and sell signals are automated through computing technology. Trend following is regularly made mechanical.

  money manager An individual or organization that allocates assets to CTAs and manages the allocations on behalf of investors. Generally registered as a CTA and CPO with the CFTC or as a registered investment adviser with the Securities and Exchange Commission.

  moving average An analysis tool that averages a market price over a set time period.

  peak-to-trough A drawdown measurement made from an account’s all-time equity high to a low. The measurement typically is made on a month-end basis.

  rate of return The percentage of money gained or lost on an investment relative to the amount of money invested.

  speculator Speculators accept risk in futures markets, aiming to profit from price changes that hedgers are protecting against. Trend followers are speculators.

  standard deviation A statistical measure used to measure market volatility. Does not accurately quantify trend following since it penalizes upside volatility.

  technical analysis An approach to market analysis that examines patterns of price change, rates of change, and changes in volume of trading and open interest. This a
pproach does not involve the use of fundamental market factors. Trend following is a form of technical analysis.

  track record The entire performance history of a trader (i.e., CTA).

  trading system A system that generates buy and sell signals for a trading strategy. Most successful trading systems are trend following based.

  trend The general direction, either upward or downward, in which prices may move.

  whipsaw A condition where a market price heads in one direction but then is followed quickly by a movement in the opposite direction.

  Author Disclaimer

  Michael W. Covel serves as president of Trend Following™, a privately owned research firm. His trend following books include The Little Book of Trading (2011), Trend Commandments (2011), The Complete TurtleTrader (2009, 2007), and Trend Following (2009, 2007, 2005, 2004). For more information about systemic trend following trading systems, please see www.trendfollowing.com and www.covel.com.

  Data from various sources were used in the preparation of this book. The information is believed to be reliable, accurate, and appropriate, but is not guaranteed in any way. Performance track records included are on file with the United States government and can be obtained via the Freedom of Information Act. This book also contains the names of some companies and individuals used as examples of the strategies described, but none can be deemed recommendations to the book’s readers. Strategies discussed in this text may be inappropriate for some investors, and you are urged to speak with a financial professional and carefully review any pertinent disclosures before implementing any investing or trading strategy. This book has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation to buy or sell, any security or instrument, or to participate in any particular trading strategy.

 

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