Pod Insights Michael Covel's Trend Following Ep. 1330: Trend Following Trading Systems with Michael Covel on Trend Following Radio About this episode Please enjoy my monologue Trend Following Trading Systems with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive. --- I’m MICHAEL COVEL, the host of TREND FOLLOWING RADIO, and I’m proud to have delivered 10+ million podcast listens since 2012. Investments, economics, psychology, politics, decision-making, human behavior, entrepreneurship and trend following are all passionately explored and debated on my show. To start? I’d like to give you a great piece of advice you can use in your life and trading journey… cut your losses! You will find much more about that philosophy here: https://www.trendfollowing.com/trend/ You can watch a free video here: https://www.trendfollowing.com/video/ Can’t get enough of this episode? You can choose from my thousand plus episodes here: https://www.trendfollowing.com/podcast My social media platforms: Twitter: @covel Facebook: @trendfollowing LinkedIn: @covel Instagram: @mikecovel Hope you enjoy my never-ending podcast conversation!
Transcript 0:00 Speaker 00 People text me all the time. Is trend following for the market right now, today? Now, of course, they never tell me which market they're talking about. I assume US stocks. But this perspective, this understanding, this thinking, that trend following is not timeless, then you don't yet understand trend following. What I share with people, what I teach people, not only will it be useful for you, it'll be useful for your kids, your grandkids, your great-grandkids. There are not trading strategies like trend following.
0:42 Speaker 00 This is the basics and the sense of, we deal with reality here. Supply and demand, the trend, greed and fear, the zero-sum game. It's not changing, ladies and gentlemen. That doesn't mean you're going to make money with trend following every day. If you think you're going to make money with any trading strategy every day, you've already got a problem that you probably can't solve. But if you want timeless, if you want to know how the world really works, and you want a chance at the big money, trend following is your direction. Today, I want to share Chapter 10
1:24 Speaker 00 of my book, Trend Following, my bestseller. Chapter 10, affectionately titled, Trading Systems. Perhaps you have heard this, perhaps you have not heard this. It's a good reminder. It's good foundational. It's timeless. Again, what you are about to listen to will be valid tomorrow, next week, next year, and 100 years from now. So, sit back and enjoy. And if you have any questions, reach me, [email protected] . I will see you again next week.
2:22 Speaker 01 Chapter 10. Trading Systems.
2:26 Speaker 01 If you don't risk anything, you risk even more. Erica Jong. No matter what kind of math you use, you wind up measuring volatility with your gut. Ed Secoda.
2:40 Speaker 01 To manage human fallibilities, trend following has a process to counteract behavioral risk. Psychologist Daniel Crosby lays bare in his Laws of Wealth, where that success foundation starts. Consistency, clarity, courageousness, conviction. Building on those four Cs, trend following reduces to rules that guide daily decision making. These rules comprise what are commonly called trading systems. There is no limit to the number of different types of trading systems. But most trend following systems are similar as they seek to capture trends in big liquid markets. Unlike so many holy grails, the never-ending fundamental predictions of this or that,
3:26 Speaker 01 trading systems are quantified. Dunn Capital, for example, has said their trading system has a programmed risk of a 1% probability of suffering a monthly loss of 20% or more. That's what I mean by quantifying. That's what serious people do.
3:44 Speaker 01 Risk, Reward, and Uncertainty.
3:48 Speaker 01 Trend following is a precarious balance between risk and reward. If you want the big rewards, take big risks. If you want average rewards and an average life, take average risks. Charles Sanford's commencement address nails it. "From an early age, we are all conditioned by our families, our schools, and virtually every other shaping force in our society to avoid risk. To take risks is inadvisable. To play it safe is the counsel we are accustomed both to receiving and to passing on. In the conventional wisdom, risk is asymmetrical. It has only one side, the bad side. In my experience, and all I presume to offer you today is observations drawn on my own
4:31 Speaker 01 experience, which is hardly the wisdom of the ages, in my experience, this conventional view of risk is shortsighted and often simply mistaken."
4:41 Speaker 01 My first observation is that successful people understand that risk, properly conceived, is often highly productive rather than something to avoid. They appreciate that risk is an advantage to be used rather than a pitfall to be skirted. Such people understand that taking calculated risks is quite different from being rash. This view of risk is not only unorthodox, it is paradoxical. The first of several paradoxes which I'm going to present to you today. This one might be encapsulated as follows. Playing it safe is dangerous. Far more often than you would realize, the real risk in life turns out to be the refusal to take a risk.
5:23 Speaker 01 One of Major League Baseball's best pitchers, all of 24 years of age, died in a 2016 boating accident. Jose Fernandez was almost guaranteed to make hundreds of millions of dollars, gone in an instant, perhaps due to a very bad risk choice. There is no getting away from that reality, there will be failure. Therefore, get over yourself and accept that life is a big league game of chance. And if life is a game of chance, assessing odds in the face of risk is goal number one. Money under a mattress is no good. The house you purchase could burn down, or the real estate market might tank.
6:07 Speaker 01 Investing only in your startup is zero diversification. If your corporate job fails, you lose your employment and nest egg. Buy index mutual funds, pray that buy and hold will always work for you, that's dicey. There is no way to know what will happen next. To proceed in the face of risk, begin by accepting markets do not reward stupidity or ignorance in the long run. They reward brains, guts, and determination to find opportunity where others have overlooked, and to press on where others fall short. Every business opportunity is ultimately involved in assessing risk. Putting capital to work in the hopes of making it grow is the goal.
6:50 Speaker 01 The right decisions lead to success, and the wrong ones lead to bankruptcy. Bear Stearns, Lehman Brothers, AIG, IndyMac, and so on.
6:59 Speaker 01 The key issues in a solid business plan. What is the market opportunity in the market niche? What is the solution to the market need? How big is the opportunity? How do you make money? How do you reach the market and sell? What is the competition? How are you better? How will you execute and manage the business? What are the risks? Why will you succeed? Those questions must be answered by everyone, regardless of venture or discipline. It is paramount to answer to assess the risk of a business venture, a relationship, and it is just as important to answer honestly if you are going to trade.
7:39 Speaker 01 Wise minds know the amount of risk taken in life is in direct proportion to how much you want to achieve. If you want to live boldly, you take bold moves. If your goals are meager, they can be reached easily with less risk of failure, but with greater risk of dissatisfaction. One of the saddest figures burns with desire to live big, but to avoid risk, embraces fear and lives lost. He is worse off than the man who tries and fails, or the man who never had desire. Yet there is hope. If you study risk, you will find there are two kinds: blind risk and calculated risk. The first one, blind risk, is suspect.
8:22 Speaker 01 Blind risk is the calling card of laziness, the irrational hope, something for nothing, the cold twist of fate. Blind risk is the pointless gamble, the emotional decision, and the sucker play. The man who embraces blind risk demonstrates all the wisdom and intelligence of a drunk. However, calculated risk builds fortunes, nations, and empires. Calculated risk and bold vision go hand in hand. To use your mind, to see the possibilities, to work things out logically and then move forward in strength and confidence is what places humans above animals. Calculated risk lies at the heart of every great achievement and achiever since the dawn of time.
9:07 Speaker 01 Yet, when it comes to trading, most focus only on how to enter the market. They say, "I've got a way to beat the markets because this trading system I have is right eighty percent of the time. It's only wrong twenty percent of the time." They need to take a step back. Okay, what does eighty percent right mean? If eighty percent you don't win much, but twenty percent of the time you lose a lot, losses can far outweigh gains even though you're right eighty percent of the time. The magnitude of wins and losses is the game. Lotteries, for example, reach jackpots of hundreds of millions of dollars or more all the time. And as the jackpot gets bigger, more buy tickets in the buying-feeding frenzy.
9:52 Speaker 01 But as they buy more, the odds of winning do not increase. The ticket buyers still have a better chance of being struck by lightning. For example, the odds of winning the California Super Lotto jackpot are one in eighteen million. If one purchases fifty Lotto tickets each week, he will win the jackpot about once every five thousand years. If a car gets twenty-five miles per gallon and a gallon of gas is bought for every Lotto ticket bought, there will be enough gas for about seven-hundred-fifty round trips to the moon before the jackpot is won. If you know the odds are against you, don't play. Likewise, if your trading system says you have a one in thirty thousand chance of winning,
10:37 Speaker 01 or roughly the same chance as being struck by lightning, you don't bet everything. You must have a mathematical expectation, an edge, or you won't win in the long run. For example, consider a coin-flipping game. Imagine an unbiased coin toss game. Suppose also you bet that the next flip will be heads and the payoff will be even money when you win. You receive a dollar profit in addition to the return of the wager. The mathematical expectation is 0.5 times 1 plus 0.5 times negative 1 equals 0. The mathematical expectation of any bet in any game is computed by multiplying each possible gain or loss by the probability of gain or loss.
11:23 Speaker 01 Then you add the two numbers. In this example, you can expect to gain nothing from playing this game. This is known as fair game, one in which a player has no advantage or disadvantage. Now suppose the payoff was changed to 3 to 2. A gain of $1.50 in addition to a dollar bet. The expectation would change to 0.5 times 1.5 plus 0.5 times negative 1 equals positive 0.25. Playing this game 100 times would give a positive expectation of 0.25. This is the exact type of edge cultivated and honed inside trend-following strategy. You might ask, if everyone knows about expectation,
12:08 Speaker 01 how can I ever find my edge for success in the face of competition? Good question. Consider a scene from the movie A Beautiful Mind, the film biography of mathematician John Nash. Nash and some of his mathematician buddies are in a bar when a sexy blonde and four brunettes walk in. After they admire the new arrivals, Nash and his friends decide to compete for the blonde. However, Nash has reservations. Correctly observing, if everyone goes for the same woman, they will just end up blocking each other out. Worse, they will offend the rest of the women not chosen. The only way for everyone to succeed is to ignore the blonde and hit on the brunettes.
12:51 Speaker 01 This scene dramatizes the Nash equilibrium, his most important contribution to game theory. Nash proved in any competitive situation, war, chess, even picking up a date at a bar, if the participants are rational and they know that opponents are rational, there is only one optimal strategy. That theory won Nash a Nobel Prize in Economics and transformed the way we think about competition in both games and the real world. Building off Nash's work, Ed Sikota lays out a basic risk definition. Risk is the possibility of loss. That is, if you own a stock and there is a possibility of a price decline, you are at risk.
13:34 Speaker 01 The stock is not the risk, nor is loss the risk. The possibility of loss is risk. As long as you own the stock, you are at risk. The only way to control risk is to exit. In the matter of trading stocks for profit, risk is unavoidable, and the best you can do is to manage the risk. Risk management is to direct and control the possibility of your loss. The activities of a risk manager are to measure risk and to increase and decrease risk by buying and selling. In general, good risk management combines several elements. One, clarifying trading and risk management systems until they can translate to computer code.
14:17 Speaker 01 Two, include diversification and instrument selection in the backtesting process. Three, backtesting and stress testing to determine trading parameter sensitivity and optimal values. Four, clear agreement among all parties regarding volatility and return expectations. Five, maintenance of supportive relationships between investors and managers. Six, above all, stick to the system. Seven, see number six above.
14:49 Speaker 01 Five questions.
14:52 Speaker 01 Answer the following five questions and you will have the core components of a trend-following trading system and be on your way to having your edge. One, how does the system know what to buy or sell? Two, how does the system know how much to buy or sell? Three, how does the system buy or sell short? Four, how does the system get out of a losing position? Five, how does the system get out of a winning position? These five questions are seminal to trend-following, but no less important is attitude. Don't forget, what do you want? Why are you trading? What are your strengths and weaknesses? Do you have any emotional issues?
15:36 Speaker 01 How disciplined are you? Are you easily convinced? How confident are you in yourself? How confident are you in your system? How much risk can you handle? When I discussed trading with Ed Secota and Charles Faulkner, they both said the first step any person should take before trading is to complete a personal inventory. What is my nature and how well am I suited to trading? How much money do I want to make? What level of effort am I willing to make to reach my goals? What, if any, is my investing/trading experience? What resources can I bring to bear? What are my strengths and weaknesses?
16:18 Speaker 01 Answering these questions is mandatory for when you're in the middle of the zero-sum game and adrenaline and sweat are flowing heavy. You can't afford to blink when chaos hits.
16:31 Speaker 01 What do you buy or sell? Will you trade stocks, currencies, futures, commodities? What markets will you choose? While some people might focus on limited, market-specific portfolios, such as currencies or bonds, others pursue a more widely diversified portfolio of markets. For example, the AHL Diversified Program, the largest trend-following fund in the world, now run by Man Financial, trades a diversified portfolio of over 100 core markets on 36 exchanges. They trade stock indices, bonds, currencies, short-term interest rates, and commodities. For example, energies, metals, and agriculturals.
17:14 Speaker 01 Table 10.1, AHL Portfolio. Currencies: 24.3%. Bonds: 19.8%. Energies: 19.2%. Stocks: 15.1%. Interest rates: 8.5%. Metals: 8.2%. Agricultural: 4.9%.
17:38 Speaker 01 AHL does not have fundamental expertise. No trend-following trader keeps fundamental experts on staff. They do not have an in-depth understanding of the companies that comprise whatever stock index. Their expertise is to take these different markets and make them the same through price analysis. When you look at trend-following performance, losses are offset by winners. No one ever knows which market will be the big trend that pays for the losses, hence the need for diversification. AHL is even more precise about diversification. The cornerstone of the AHL investment philosophy is that financial markets experience persistent anomalies
18:21 Speaker 01 or inefficiencies in the form of price trends. Trends are a manifestation of serial correlation in financial markets, the phenomenon whereby past price movements inform about future price behavior. Serial correlation can be explained by factors as obvious as crowd behavior, as well as more subtle factors, such as varying levels of information among different market participants. Although they vary in their intensity, duration, and frequency, price trends are universally recurrent across all sectors and markets. Trends are an attractive focus for active trading styles applied across a diverse range of global markets. You can see AHL's words perform in practice by how another trend-following trader described diversification.
19:07 Speaker 01 Portfolio diversification is often said to lose its importance after you have seven to 10 different instruments in your portfolio. We found this simply not to be the case. Pre-June 2007, we traded with 18 major markets in the program, and we were in seven to eight of them most of the time. In short, our exposure was seven to eight markets at any one time, while signals in 18 were possible. After evaluating the program, we discovered that most of our losses, at the time, were coming from one or two sectors that hit their maximum loss at roughly the same time. A breakout in the 10-year notes was most likely followed by a breakout in the 5-year notes. Trading several highly correlated markets had led to exaggerated losses
19:53 Speaker 01 because these markets triggered a larger drawdown as they were stopped out together. He increased his portfolio to over forty markets with the goal of being in fifteen-plus markets most of the time. And he still left his core trading system, entry and exits, the same. The turnaround in results was dramatic, all from changing the portfolio diversification. Paul Mulvaney, for example, made over forty percent in October 2008 alone. His performance was generated from these markets. Currency: eight point nine one percent. Interest rates: two point seven eight percent. Stocks: fourteen point five nine percent. Metals: nine point eight three percent.
20:37 Speaker 01 Energy: three point four three percent. Crops: seven point eight four percent. Livestock: four point five one percent. Yes, that is one great outlier month. All months and sectors will not always be positive, clearly. But Mulvaney's performance during one of the worst months ever is a wake-up call to trend-following possibilities. After all, author and film star Ben Stein famously said, "If you made money in October 2008, you were doing something wrong." Now, fast-forward eight years. On June 23rd, 2016, fifty-one point nine percent of the United Kingdom voted to exit the European Union.
21:22 Speaker 01 Most prognosticators were surprised, if not shocked. Mulvaney's performance was seventeen percent on June 24th. His one-day Brexit performance, his greatest one-day return in the history of his firm, is a fantastic illustration of being on the right side of surprise. Long-time trend-following trader Robert Rotella adds, "Qualitative examination of price movements suggests that markets were trending in the direction of the Brexit exit in the prior months. This is supported by systematic analysis over the same period." There is never one perfect portfolio composition that will capture the next trend. Many trade different portfolios for untold different reasons.
22:05 Speaker 01 Generally speaking, trend followers trade the same markets. However, although larger trend-following funds might avoid smaller markets, such as pork bellies or orange juice, other trend-following traders might trade currency or bond-only portfolios. Salem Abraham, for example, once made a killing off cattle. Whatever markets chosen to trade remain open to opportunity when it arrives. Author Tom Friedman makes the strong argument for sound strategy in a complex world. If you can't see the world and you can't see the interactions that are shaping the world, you cannot strategize about the world. And if you are going to deal with a system as complex and brutal as globalization and prosper within it,
22:50 Speaker 01 you need a strategy for how to choose prosperity for your country or company. Friedman knows all too well the real power brokers in today's frighteningly interconnected world are traders, not politicians.
23:05 Speaker 01 How much do you buy or sell?
23:08 Speaker 01 The question many avoid at all costs is the question of money management, also called risk management, position sizing, or bet sizing. It is a critical component to trend-following success. As Gibbons Burke observes, "Money management is like sex. Everyone does it, one way or another, but not many like to talk about it, and some do it better than others." When any trader makes a decision to buy or sell short, they must also decide at that time how many shares or contracts to buy or sell. The order form on every brokerage page has a blank spot where the size of the order is specified. The essence of risk management is making a logical decision about how much to buy or sell when you fill in this blank.
23:53 Speaker 01 This decision determines the risk of the trade. Accept too much risk, and you increase the odds that you will go bust. Take too little risk, and you will not be rewarded in sufficient quantity to beat the transaction costs and the overhead of your efforts. Good money management practice is about finding the sweet spot between these undesirable extremes.
24:16 Speaker 01 I've only got a certain amount of money. How much do I trade? If you have a hundred thousand dollars and you want to trade Microsoft, well, how much of your hundred thousand dollars will you trade on Microsoft on your first trade? Will you trade all one hundred thousand dollars? What if you're wrong? What if you're wrong in a big way and you lose your entire one hundred thousand dollars on one bet? Trend following by design makes small bet sizes initially. So if you start at one hundred thousand dollars and you're going to risk 2%, that equals two thousand dollars. You might say to yourself, "I've got a hundred thousand dollars. Why am I only risking two thousand dollars? What's the deal? I've got a hundred thousand dollars. Two thousand dollars is nothing."
25:01 Speaker 01 That's not the point. You can't predict where the trend will go. You don't know up or down. One trader's view on the initial risk decision. There are traders who are unwilling to risk more than 1%, but I would find it surprising to hear of any trader who risks more than 5% of assets per trade. Bear in mind, risking too little doesn't give the market the opportunity to allow your profitable trade to occur. Think about money management as getting physically fit. Let's say you're a male athlete and you want peak performance. You weigh 185 pounds, 84 kilograms, and you're six foot one, 185 centimeters. Well, guess what?
25:43 Speaker 01 You can't lift weights six times a day for 12 hours a day for 30 straight days without hurting yourself during those 30 days. There's an optimum amount of lifting you can do in a day that gets you ahead without setting you back. You want to be at that optimal point, just as you want to get to an optimal point with money management. Ed Secoda describes that optimal point with a concept of heat. Placing a trade with a predetermined stop-loss point can be compared to placing a bet. The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin.
26:23 Speaker 01 A bold trader placing large bets feels pressure or heat from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference. Bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances they give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2% on each of five instruments has a total heat of 10%, as does a portfolio risking 5% on each of two instruments. A student of Ed Sikoda adds,
27:06 Speaker 01 "There has to be some governor so I don't end up with a whole lot of risk. The size of the bet is small, around 2%." Sikoda calls his risk-adjusted equity "core equity", and the risk tolerance percentage "heat". Heat can be turned up or down to suit the trader's pain tolerance. As the heat gets higher, so do the gains, but only up to a point. Past that point, more heat starts to reduce the gain. Traders must be able to select a heat level where they are comfortable. Do you trade the same with $100,000 as you would $200,000? What if your $100,000 goes to $75,000?
27:47 Speaker 01 Tom Basso knows many traders usually begin trading small, say with one contract, and as they get more confident, they might increase to 10 contracts. Eventually, they attain a comfort level of 100 or 1,000 contracts where they may stay. Basso counsels against this. He stresses the goal is to keep things on constant leverage. His method of calculating the number of contracts to trade keeps him trading the same way even as equity increases or decreases. One of the reasons traders don't trade proportionally as capital increases is fear. Although it might feel comfortable when the math dictates you trade a certain number of shares or contracts at fifty thousand dollars,
28:30 Speaker 01 when the math dictates trade a certain amount at five hundred thousand dollars, you might become risk averse. So instead of trading the optimal amount at whatever capital you have, some trade less. This can be avoided by creating an abstract money world. Don't think about what money can buy. Look at numbers like when playing Monopoly or Risk. Dunn Capital speaks to "the money as a way to keep score" perspective. Part of Dunn's approach is adjusting trading positions to the amount of equity under management. He says if his portfolio suffers a major drawdown, he adjusts positions to the new equity level. Unfortunately, he says, not enough traders follow this rather simple strategy.
29:14 Speaker 01 If you start with a hundred thousand dollars and you lose twenty-five thousand dollars, you obviously now have seventy-five thousand dollars. You must make your trading decisions off seventy-five thousand dollars, not one hundred thousand dollars. You don't have one hundred thousand dollars anymore. However, Paul Mulvaney felt I was missing a critical aspect in money management. Trend following is implicitly about dynamic rebalancing, which is why successful traders appear fearless. Many hedge fund methodologies make risk management a separate endeavor. In Trend Following, it is part of the internal logic of the investment process.
29:55 Speaker 01 When do you buy or sell?
29:59 Speaker 01 When do I buy? When do I sell? These are the questions that keep investors and traders up at night. Yet there is no reason why the buy and sell process should be a melodrama. Obsessing about when to buy or sell keeps your limited time focused on things you can't control. For example, Apple has been trading between 100 and 120 for six months. All of a sudden, Apple jumps or breaks out to a price level of 130. That type of upward movement from a range is an entry trigger for trend-following strategy. They think, "I might not know that Apple is going to continue upward, but it's been going sideways for a while, and all of a sudden, the price has jumped to 130.
30:43 Speaker 01 I'm not in this game to try and find bargains or cheap places to buy. I'm in this game to follow trends, and the trend is up." One trend trader outlined the simplicity. As our systems are designed to send a buy or sell signal only when a clear trend develops, by definition, we never get in at the beginning of a trend or get out at the top. If your goal is to ride a trend that starts at 50 and goes up to 100, it does not make a difference whether you got in at 52 or 60 or 70. Even if you got in at 70 and the trend went up to 100, you still made a lot. Now, if you got in at 52, and how you think you might predict the bottom, I will never know,
31:27 Speaker 01 you made more money than if you got in at 70. There are plenty of traders out there who think, "Oh, I couldn't get in at 52, so I won't get in at all, even if I have the chance to get in at 70." Richard Dennis smacks that thinking. "Anytime the market goes up a reasonable amount, say a strong day's work, after you've put on a position, it's probably worth adding to that position. I wouldn't want to wait for a retracement. That is everyone's favorite technique, to buy something strong that retraces. I don't see any justification in the statistics for that. When beans are at $8 and go to $9,
32:07 Speaker 01 if the choice is to buy them at $9 or buy them if they retraced $8.80, I'd rather buy them at $9. They may never retraced to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement." Even if people are somewhat familiar with Dennis's approach to trend trading, they still love the entry obsession, a misdirection of energy and focus. Sakota deadpanned, "The entry is a big concern before it happens, a small concern thereafter."
32:41 Speaker 01 He is saying after you are in the trade, entry price isn't important. You have no idea how high the market is going to go or not. You should be concerned about protecting your downside in case the market goes against you, as opposed to creating drama associated with the perfect entry. After all, trend-following trades can last extended timeframes. Positions held for two to four months are not unusual, and some have been held for more than one year, says a spokesman. Historically, only thirty to forty percent of trades have been profitable. The words of the great baseball player Ted Williams immediately come to mind. Hitting a baseball, I've said it a thousand times, is the single most difficult thing to do in sport.
33:26 Speaker 01 If Joe Montana or Dan Marino completed three of every ten passes they attempted, they would be ex-professional quarterbacks. If Larry Bird or Magic Johnson made three of every ten shots they took, coaches would take the basketball away from them. How is it possible to make money with only forty percent winners? Trend-following firm Campbell & Company is clear. Say, for example, on the sixty percent, you lose one percent of your capital, but on the forty percent-winning trades, you make two percent. Over longer periods of time, say a year or more, this would net twenty percent on a broadly diversified program.
34:08 Speaker 01 Trend-following rules to enter and exit are driven by what is commonly called "technical indicators." The technical indicator for trend-following strategy is price action, that is breakout, moving average, etc. However, many remain preoccupied with the hundreds upon hundreds of other indicators that promise prediction. They debate nonstop which is better, always assuming there must be something better, and they always yell at me that I didn't provide them the secret. Technical indicators, however, are small components of the overall trading system. They are some of the tools needed in the trading toolkit, but not the kit itself. A technical indicator accounts for maybe 10% of the overall trading success.
34:53 Speaker 01 When some trader opines, "I tried indicator X and found it was worthless," or, "I tried indicator Y and found it useful," that makes no sense. These statements imply an indicator is the actual trading system. By itself, a technical indicator is meaningless. That means the suits that come on CNBC every week to talk "technicals" are meaningless? Yes. When do you get out of a loser? The time to think most clearly about why and when to exit is before getting in. In any trading system, the most important thing is to preserve your capital.
35:34 Speaker 01 A preset sell strategy gives you opportunity to not only preserve capital, but also redeploy into more opportune markets. When do trend traders get out of a losing position? Fast. This is fundamental to trend following. The logic of cutting losses and then cutting them even more has been around far longer than trend following. As Bernard Baruch notes, "If a speculator is correct half of the time, he is hitting a good average. Even being right three or four times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong." For example, you enter G-O-O-G with a 2% stop-loss.
36:18 Speaker 01 This means if you lose 2%, you exit. Period. Get out. Don't debate it. Look back at the British pound trade in my Chapter 2 Dunn profile. That chart, see Figure 2.3 in the supplemental PDF, shows the constant starts and stops. Dunn keeps receiving entry signals and then exit signals. The trend is up, and then it is down. He enters, and then exits. Dunn knows he can't predict the direction of the British pound. He only knows he has received an entry signal, so he gets on board. Then he receives an exit right after that, so he gets out. Then another entry signal, then another exit. Dunn did say he rides the bucking bronco.
37:02 Speaker 01 Traders call these back-and-forth swings whip saws. Whip saws are quick ups and downs that go nowhere. Your trade is jerked or whip sawed back and forth, causing small losses due to lack of sustained trends. Sakota says the only way to avoid whip saws is to stop trading. See his Whip Saw Song on YouTube. Whip saws are part of the game. Don't want to live with them? Don't trade. An old pro trader sent in a great story about his days at Trend Following Incubator Commodities Corporation that makes the point. Back in the early 90s, Commodities Corporation, CC, brought a few Japanese traders in for some in-house training.
37:46 Speaker 01 Of course, the ultimate and true goal was to capture some big Japanese money. I was still in their good graces, and CC asked me to have lunch with a couple of these gentlemen. They were new to the program, and I hoped to give them some insight into how I handled the process of trading. I told them they had to come up with a method or system that fitted who they were. Then I told them I thought it was great to find a mentor, and I was available anytime they had questions or issues, and that is still me today. I then began to discuss how important risk management was, and that I was willing at that time to risk only 1% per bet in dealing with public money. I am more aggressive today, but that was then. I told them that losses were part of the process in finding winners.
38:31 Speaker 01 I will never forget, as long as I live, the youngest trader looked me square in the eye, and with a very puzzled look asked, "You have losses?" I knew right then these birds had a very long way to go, and I often wondered what happened to them. Guaranteed, that young trader moved into another profession. When do you get out of a winner? You have seen the headline hype. Use Japanese candlesticks to spot reversals. Or determine support and resistance. Or learn proper profit taking. Stop. You can't spot reversals until they happen.
39:11 Speaker 01 There is no way to define the concept of support and resistance as 100 people could have 100 different definitions. These directions all try to do the impossible. Predict. Tom Basso slams profit objectives. A new trader approaches an old trend follower and asks, what's your objective on this trade? The old trend follower replies that his objective is for the position to go to the moon. Exiting a winning position can be a challenge because you have to be comfortable with letting a trend run as far as it can, crest, and then begin to decline before considering an exit with profits. Say you were up 100% in paper profits. If you cash in, those paper profits become real.
39:56 Speaker 01 But you have made a big mistake because you limited yourself in how much you could make. If you are long several positions and there are huge open profits on the table and the trend is still up, that is not the time to get out of a winner. Profit targets cap profits. For example, you enter at 100 and before you ever enter, you establish you will exit if the price reaches a 25% gain or 125. The idea of a profit target sounds wise at first blush. However, if you are riding a trend, you have to let it go as far as it can go. You need to fully exploit the move.
40:36 Speaker 01 You don't want to exit at 125 and watch the trend go to 225. Although profit targets keep you from getting to 225, they also play a damaging role in the overall trend following portfolio.
40:51 Speaker 01 Trend following needs those home runs to pay for its whipsaw losses. If you are artificially creating a profit target for no other reason than comfort, you are limiting potential for big trends. This in turn, limits the ability to cover the small losses you've incurred. If you had used profit targets, there is no way you would have been around to win the huge profits from the events described in Chapter 4. Trend following profits come from the meat or middle of a trend. See Figure 10.1 in the supplemental PDF.
41:27 Speaker 01 Your Trading System
41:30 Speaker 01 When you mechanize a trend following trading system, you take all discretionary judgments and build them into rules. For example, if you are uncomfortable with a high level of risk, you make a rule that sets a tolerable risk level. If you trade a currency-only portfolio, you make rules for that contingency from the outset. The logic is to hardwire all scenarios you could possibly see in advance across your portfolio. If a market rises 100% in short order, you have rules that dictate the action to take. If a market loses 10%, follow the rules. You must have an unambiguous plan established in advance. It also helps to constantly be aware of the downside.
42:15 Speaker 01 Larry Hight gives that legendary stoic perspective. "We approach markets backwards. The first thing we ask is not what we can make, but how much can we lose? We play a defensive game."
42:30 Speaker 01 Frequently Asked Questions
42:33 Speaker 01 Fact 1: Starting Capital Ed Cakota was once asked how much money someone should have before starting to trade. He responded, "Good money management is equity invariant. I'd ask a trader who thinks he needs a certain amount before he can trade exactly what amount he would need to stop trading." There is no dollar amount too little or too big that allows you to sit back and assume your starting capital alone is the secret. Numerous factors related to starting capital exist, not least of which is the personal discipline and ability to stick with it. Anyone who promises a certain amount of starting capital needed to win is full of it. However, what if you have unlimited resources?
43:16 Speaker 01 Rich can be a benefit or strike against you. Yaromir Jagr, the famous hockey player and trend trader William Eckhart, have polar views on starting capital. Jagr is the riverboat gambler. He doesn't play the stock market, but romps through it. Last year, published reports estimated he took a hit (loss) of anywhere from $8 million to $20 million in the dot-com market. He doesn't just have a girlfriend who is pretty and bright, he has a girlfriend who was former Miss Slovakia and a second-year law student. Jagr might be a great hockey player, but his approach is straight to the poorhouse. Backed by the millions he made playing hockey, Jagr is the trader Eckhart avoided.
44:00 Speaker 01 I know of a few multimillionaires who started trading with inherited wealth. In each case, they lost it all because they didn't feel the pain when they were losing. In those formative first years of trading, they felt they could afford to lose. You're much better off going into the market on a shoestring, feeling that you can't afford to lose. I'd rather bet on somebody starting out with a few thousand dollars than on somebody who came in with millions. Consider net worth examples of trend-following traders that started as one-man shops. Bruce Covner is worth over $5.3 billion. John W. Henry is worth $2.1 billion. He used his trend-following gains to buy the Boston Red Sox for $700 million.
44:45 Speaker 01 Bill Dunn made $80 million in 2008, when the rest of the world was blowing up. Michael Marcus turned an initial $30,000 into $80 million. He also taught Bruce Covner. Marcus was a student of Ed Secotis. David Harding is worth over $1,387 billion. Kenneth Troopin made $120 million in 2008 as buy-and-hold collapsed. Earlier in his career, he led John W. Henry's firm. That is inspirational. A small fraction of those huge fortunes is motivating, if you still have a pulse. Fact two: Trend-following for stocks.
45:26 Speaker 01 One of the great myths about trend-following is it does not work on stocks. This is 100% false. Trends in stocks are no different than trends in currencies, commodities, or futures. Jerry Parker's Trend-following Firm, for example, has adapted its system to stock trading, and he is not alone, for example, David Harding. He notes his system works well with stocks, particularly stocks and outlier moves that are in single industries. Bruce Terry, a disciple of Richard Doncian, dismisses out of hand the "not-for-stocks" meme. Originally, in the 1950s, technical models came out of studying stocks. Commodity trading advisors, CTA, applied these to futures.
46:12 Speaker 01 In the late 1970s and early 1980s, stocks were quiet and futures markets took off. That is how the CTA market started. It has come full circle. People are beginning to apply these models to stocks once again. From my "Leave No Stone Unturned" research, I reminded of the opening line I found in the "Managed Accounts Reports" article from 1979. "Trading stocks and commodity futures by means of trend-following techniques is an art with a long history."
46:43 Speaker 01 Fact three: Computers and Curve-Fitting. Larry Height knows a computer can't get up on the wrong side of the bed in the morning, which is why computers handle his decision-making and implementation of his trading rules. If your boyfriend or girlfriend breaks up with you, you'll feel one way. If you get engaged, you'll feel another way. Height would much rather have one smart guy working on a lone Macintosh than a team of well-paid timekeepers with an army of supercomputers. At the same time, however, Height is adamant the real key to using computers successfully is the thinking that goes into the computer code. When someone asked him why go the computer route when people's power is so important, he replied, "Because it works.
47:28 Speaker 01 It's countable and replicable. I'm a great fan of the scientific method. And the other things are not scientific. If I give you the algorithms, you should be able to get the same results I did. That, to me, means a great deal." However, technology can over-optimize or curve-fit a trading system to produce something that looks great on paper alone. Barbara Dixon, a Doncian student, notes: "When designing a system, I believe it's important to construct a set of rules that fit more like a mitten than like a glove. On the one hand, markets move in trends. But on the other hand, past results are not necessarily indicative of future performance.
48:09 Speaker 01 If you design a set of rules that fit the curve of your test data too perfectly, you run an enormous risk that it will fizzle under different future conditions." A robust trading system, one that is not curve-fit, must ideally trade all markets at all times in all conditions. Trend-following parameters or rules must work across a range of values. System parameters that work over a range of values are considered robust. If the parameters of a system are slightly changed and the performance adjusts drastically, beware. For example, if a system works great at 20 but does not work at 19 or 21, that system is not robust.
48:53 Speaker 01 On the other hand, if a system parameter is 50 and it also works at 40 or 60, the system is much more robust and reliable. Trend trader David Drews has long championed robustness in trading systems. He dismisses trades of short-term traders who fight for quick-hitting arbitrage-style profits as pure noise. Traders who focus on short-term trading often miss the longer-term trends, those trends where long-term trend-following often bags its biggest opportunities. To wait like that, you need complete faith in your trading system. However, you are in serious trouble if all you think you need to succeed at trading is the latest hardware and software.
49:38 Speaker 01 As Barbara Dixon warns: "Contemporary databases, software, and hardware allow system developers to test thousands of ideas almost instantaneously. I caution these people about the perils of curve-fitting. I urge them to remember one of their primary goals is to achieve discipline, which will enable them to earn profits. With so many great tools, it's easy to change or modify a system and to develop indicators rather than rules, but is it always wise?" It is easy to get caught up in the computer program hype. Advertisements run nonstop everywhere, promising instant riches. Fancy charting software will make you feel like master of the universe. But that is false security.
50:23 Speaker 01 When describing his early trading successes, John W. Henry made it clear it was philosophy, not technology. In those days, there were no personal computers beyond the Apple. There were few, if any, flexible software packages available. These machines, far from being the ubiquitous tool seen everywhere in the world of finance and the world at large today, were the provinces of computer nerds. I set out to design a system for trading commodities. But things changed quickly and radically as soon as I started trading. My trading program, however, did not change at all. As I said, it hasn't changed even to this day. One of Henry's longtime associates elaborated.
51:05 Speaker 01 Originally, all of our testing was done mechanically with pencil and graph that turned into Lotus spreadsheets, which was still used extensively in a lot of our day-to-day work. With the advent of some of these new modeling systems like SystemWriter, DayTrader, and some of the other things, we've been able to model some of our systems on these products. Mostly just to backtest what we already knew, the trend-following works. Tom Basso clarifies. You'll find that the more you're computerized, the more markets you'll be able to handle. Computers leverage your time if you know how to use them. And Richard Donchon makes clear that time needed to execute successfully as a trend-following trader. If you trade on a definite trend-following, loss-limiting method,
51:51 Speaker 01 you can trade without taking a great deal of time from your regular business day. Because action is taken only when certain evidence is registered, you can spend a minute or two per market in the evening checking up on whether action-taking evidence is apparent, and then, in one telephone call in the morning, place or change any orders in accord with what is indicated. Furthermore, a definite method, which at all times includes precise criteria for closing out one's losing trades promptly, avoids emotionally unnerving indecision.
52:23 Speaker 01 The minute or two Doncian refers to takes preparation time. After you test your system and are satisfied with the results enough to begin trading, the work is still not done. System results must be periodically compared to actual results to ensure that testing closely reflects real time. It is also helpful to keep a journal to record how well you stick to executing your system. One trend trader trained at commodities corporation told me, "Early in my trading career, I found myself hung up on the 'need to be right', rather than the 'desire to make money'. I learned early that being right, of having a high percentage of winners, had very little to do with my overall trading success.
53:05 Speaker 01 Those who have a need to be right with a high percentage of winners will find themselves passing on their best trading opportunities, assuming they use some degree of discretion in their trading selections. One of my trading buddies enjoys a trading success rate annually of around 15% winners with 50% losers and 35% break-even trades. In 2005, he made over 300% on his initial beginning-of-year trading capital of a seven-figure account. This is a risk-reward numbers game, and most who think it is something else usually face a forced awareness at some point in their trading careers. To further emphasize my point,
53:46 Speaker 01 everyone has seen ads on the internet for systems being promoted at 90% accuracy. I bet three-quarters of these systems are based on a set of past criteria that have very little to do with their future performance. Let's say you do 100 trades in a calendar year. The average winning trade makes a net $100, so you make a net $9,000 in the winners. Now, the bad news is the 10 losing trades are for $1,000, so you lose a total of $1,000 for the year in a system that had 90% winners. Now, I realize this is a stretch from reality, but mathematically, this is what happens once a trader commits capital to the so-called 'sure thing' trading systems.
54:29 Speaker 01 Trend-following legend Kent Tropin was even more specific. In order for a system to be successful, it has to be what I call robust. Robust means I can test that system in a market I designed it around. Say I'm using it in the Treasury bonds, and then if I switch that market and try that system in the Euro, it still works. And if I change its parameters, it still works. And if I switch it over to corn, something totally different than Treasury bonds, it still works. And if I look at some data that was out of sample from what I designed it around, it still works. Then I have something that might be interesting and have a chance of living in the future. Because the nature of data is it changes a little all the time.
55:12 Speaker 01 And so the key to success in systems trading is to have what I call a loose-fitting suit. I can't have a suit that's so tight and perfectly proportioned to me that if I gain two pounds, it won't fit the data anymore.
55:25 Speaker 01 Andrew Lowe of MIT brings it back to simplicity. The first rule of thumb, being that no matter how complex and subtle a strategy is, and no matter how sophisticated it might be, it has to be possible to describe that strategy in relatively simple and intuitive terms to a sophisticated investor. In other words, regardless of how subtle and impressive and sophisticated the strategy is, I've never come across anything that couldn't be described in relatively straightforward terms as to what the value added of that strategy was.
55:59 Speaker 01 Fact four: Day trading limits.
56:03 Speaker 01 When you trade with higher frequency, the profit you earn per trade decreases while transaction costs stay the same. This is not a winning strategy. However, many traders believe that short-term trading is less risky. Short-term trading by definition is not less risky, as evidenced by the catastrophic blowouts of Viktor Niederhafer and Long-Term Capital Management, LTCM. Do some short-term traders excel? Yes. However, think about the likes of whom you might be competing with when you are trading short-term, such as Jim Simons and Toby Krabbel. Professional short-term traders, the HFT guys, have hundreds of staffers working as a team 24/7.
56:46 Speaker 01 They are playing for keeps and looking to eat your lunch in the zero-sum world. You don't stand a chance, Mr. Day Trading Dreamer. But day trading flaws are invisible to many. Sumner Redstone, billionaire CEO of Viacom, talked of constantly watching Viacom's stock price hour after hour, day after day. Although Redstone is a brilliant entrepreneur and has built one of the great media companies, his obsession with share price is pointless. Redstone might see his company as undervalued, but staring at the screen will not boost it.
57:23 Speaker 01 Fact Five: Wrong Way to View a Trade. Leo Malamed is chairman emeritus to the CME, episode number 265 on my podcast. He is recognized as the founding father of financial futures. He was named to the top 10 most important Chicagoans in business of the 20th century. Yet with his tremendous resume and success, he is clearly not a trend-following trader. The Hunt silver debacle also provided the setting for my worst trade. My company partner George Fawcett and I had become bullish on silver beginning in June 1978, when it was trading around $5 an ounce level. We were right in the market and silver prices moved higher.
58:06 Speaker 01 In September 1979, silver reached the high price of $15 an ounce, and the profit we were each carrying was substantial. George and I had never before made that kind of money. It was truly a killing. How much higher would silver go? Wasn't it time to take the profit? Large profits, as I learned, were even more difficult to handle than large losses. I had a very good friend with special expertise in the precious metals markets. Since he knew I was long silver, I ventured to ask him his opinion. "Well, Leo," he responded, "you have done very well with your silver position, and I really can't predict how much higher silver will go. But I'll tell you this: At $15, it is very expensive.
58:51 Speaker 01 On the basis of historical values, silver just doesn't warrant much higher prices." I never doubted that he gave me his honest and best opinion. I transmitted this information to George, and we decided that if nothing happened by the end of the week, we would liquidate our positions and take our profits. That's exactly what we did. This was in late October 1979. So why was this my worst trade when in fact it was the biggest profit I had ever made up to that time? Because, within thirty days after we got out of our position, the Hunt Silver Corner took hold. It did not stop going higher until it hit fifty dollars an ounce in January nineteen eighty. George and I had been long silver for nearly two years,
59:35 Speaker 01 and had we stayed with our position for just another thirty days, we would have been forced to take a huge profit. We both vowed never to calculate how many millions we left on the table. I can see why his nineteen seventy-nine silver trade was his worst trade. He described no predefined entry criteria. He never gives a reason why he and his partner were bullish on silver in nineteen seventy-eight, nor does he explain why he entered the silver market, other than it was at such a low price, five dollars. When the price of silver started to increase, he attempted to find out how high it would go, which is impossible. However, because he had no clearly defined exit rationale, he was uncertain when to get out.
1:00:19 Speaker 01 Without an exit strategy, Malamed fell back on conventional trading wisdom that buying higher highs is wrong. He attempted to use fundamentals to justify that silver would not continue to increase, and then set a profit target to get out. By having a profit target instead of an exit plan, Malamed lost out on millions of dollars of profit. Now, he has had a fantastic career, but his trade example contrasts sharply with trend following. Rob Romaine brings it back to preparation. "The value of a disciplined trading system's approach is that it allows you to design your strategy during non-stressful times. Then, when the markets are tough,
1:01:02 Speaker 01 you need only to execute your plan rather than being forced to face difficult decisions under pressure when you are most likely to make mistakes." Let me state emphatically the big picture point. If you are sitting in front of 20 monitors pretending to be master of the universe, like Bobby Axelrod in Billions, and imagining you can watch all those screens simultaneously and react cat quick to thousands of pieces of real-time data, give me a break. You can't, even though this guy, seen in the picture in the supplemental PDF, would argue vociferously for his supernatural monitor scanning skills.
1:01:45 Speaker 01 Summary food for thought. Money is how you keep score. Ewan Kirk. Have we changed things on the basis of what happened? The answer is no. We did not lose the faith. We are always grounded in research and coming up with new ideas. If a model is losing money but is within the statistical expectation, you can't just chop and change everything because you have a period of poorer performance. Paul Tudor Jones. I teach an undergrad class at the University of Virginia and I tell my students, "I'm going to save you from going to business school. Here, you're getting a hundred grand class and I'm going to give it to you in two thoughts, okay?
1:02:28 Speaker 01 You don't need to go to business school, you've only got to remember two things. The first is, you always want to be with whatever the predominant trend is. You don't ever want to be a contrarian investor." Larry Tenterelli. My biggest winners over time have come from two signals: crossing over 200 SMA and new 52-week highs. That's it. Josh Hawes and Paul King. The Four Ways to Make Money Trading. Making money when price moves, making money when price does not move, arbitrage, market making/scalping/high-frequency trading. Seth Godin. If someone needs direction, don't give them a globe. It'll merely waste their time.
1:03:12 Speaker 01 But if someone needs to understand the way things are, don't give them a map. They don't need directions, they need to see the big picture. Leo Tolstoy. The two most powerful warriors are patience and time.
1:03:33 Speaker 00 I see a time when those awake will understand how to make money in up, down, and surprise markets. Whether new trader or experienced, college student or financial advisor, protecting against a crash or just trying to make a lot of money, trend following offers everyone an answer in uncertain times. To get started immediately, send me an email, [email protected] . I will send you the right trend following steps to take along with my free video. But if you want to buy and hold, trust the government and trust Wall Street, this is absolutely not for you.
Previous Ep. 1329: More Trend Following Masters with Michael Covel on Trend Following Radio Next Ep. 1331: Moritz Seibert Interview with Michael Covel on Trend Following Radio Page updated November 7, 2026 · transcript and summary are machine-generated
