Trend Following Strategy for Big Winnings is the subtitle of Michael Covel’s latest book (link on Amazon), an addition to the “Little Book of…” series (“Trading” in this instance).

I find it quite surprising for an author to come out with two books roughly at the same time but this book is fairly different from the recent Trend Commandments.

Similarly, this is an easy, short read – good for one sitting on the beach or by the pool, as the cliche has it.
And once again, one should not expect an actual specific strategy per se, in the form of a ready-to-be-traded system, delivered in the book – for this, a better place would probably be the Trading Blox forums or even this humble blog (start with the State of Trend Following report, which uses and points to several basic Trend Following systems provided by Trading Blox). Unless you prefer to purchase the author’s course…

No, this book is mostly about inspiration from successful (Trend Following) stories. Whereas Trend Commandments is all about “principles over personalities”, this latest Covel instalment revolves around some famous Trend Following personalities. And successful stories are one of the best ways to get inspiration and motivation, in my opinion. I actually felt this was one aspect missing from Trend Commandments, especially compared with the original Trend Following book (which contains a variety of philosophy, trading aspects, successful stories, performance charts, trader insights, etc.).

It seems that Covel decided to split out several concepts in two different books). In this Little Book, each of the twelve chapters cover Trend Following personalities, with their story and insights on trend trading.

Below are the personalities/firms covered (a large share of them being part of the Trend Following Wizards report) with chosen quote(s) from each chapter.

Sunrise Capital (Gary Davis, Jack Forrest, Rick Slaughter)

Trend Following can be simple, but sticking with it is the hard part.

Make sure you never miss a potential big trend. You always want to put some kind of trade when your system says enter as your price trigger hits. If you are wrong, you have stops to protect your capital, to protect your downside. After all, you never know which move is going to be the mother of all moves.

David Druz

Trend traders are trying to capture risk premium from the hedgers. […]
Hedgers hope to minimize their exposure to unwanted risk. Speculators (i.e. trend followers assume risk for hedgers. […]
Hedgers are net losers in futures markets over the long run, and Druz’s trend trading approach is based on capturing this risk premium.

The more robust a system, the more volatile it tends to be!
There are whole families of trend trading ideas that seem to work forever on any market. The down side is they are very volatile because they are not curve-fit

Paul Mulvaney

How you compute the amount you are willing to risk for every trade, and how you exit your big winners, that’s what counts.

Mulvaney’s trend trading is profitable on 54 to 55 percent of days, but only on 25 percent of trades. Obviously those 25 percent of trades are more profitable than the 75 percent of trades that are losers.

Kevin Bruce

There is great truth in the idea that if you take care of the downside, the upside will take care of itself.

Larry Hite

Hite has two basic rules about trading and life:
1) If you don’t bet, you can’t win.
2) If you lose all your chips, you can’t bet

David Harding

Don’t get caught up constantly trying to lower your risks. Think of yourself as running a risk targeting business where you go find risk. No risk, no reward!

I think the efficient market hypothesis is quite useful too. One prediction it makes is that it is difficult to beat the markets. It’s just saying that the markets know better than you do. So the assumption that the markets know better than you do is quite a sensible and useful assumption. It certainly would lead you to approach [beating the markets] with humility and modesty.

Determination is the same as having wings. If at first you don’t succeed, try, try, and try again. Madonna always says, ‘I’m like a cockroach.’

Bernard Drury

I made the decision that I would give up the use of my experience as a sector specialist in favour of adopting a systematic approach in which the most important benefits are the application of very extensive research, consistency of method, and diversification. For example, if we are curious about a trading rule, we run a simulation across a portfolio of about 70 instruments and 15 years of data. If we run a simulation on three or four systems together, then we get an even more robust result. This type of research provides some benefits that are difficult for a discretionary or fundamental trader to have.

Justin Vandergrift

While entry and exit is an overwhelming focus for new traders, it is only a small part of the recipe for winning in the trend follower’s cookbook. Money management is far more imperative to your success than worrying about a perfect entry.

Vandergrift, like many of the trend following traders, found through intense research that the only systems that really worked over time were long term trend following in nature. However, his real Aha! moment came when he put money management into his trading system equation. […] If you have a portfolio of markets, […] you want t risk an equal amount on every trade.

Eric Crittenden and Cole Wilcox

Wilcox, for example, has a constant process of asking, “Am I wrong?” while he sees everyone else asking, “Am I right?” If you don’t ask the correct probing question with genuine curiosity, like a scientist, you cannot arrive at the correct answer.
The scientific method doesn’t allow you to prove anything. All you can do is disprove theories, and then, with a preponderance of evidence still left, you can accept and keep the remainder as long as you can’t disprove it.

A few key lessons from Basso helped Crittendedn and Wilcox from the beginning. Basso was blunt, “It really is simple. You hold your winners, have discipline and cut your losers. You take what the market gives and you’ll be successful in this business”. Crittenden added: “One. Don’t over-bet. Two. Diversify across markets.”

Michael Clarke

You want to look for trend following models that remain robust over long time periods and you want to include models that have flat to negative performance for periods of up to two years. The principles that allow a good model to work successfully may fall out of favour and stop working for a period of time, but if the model has validity, the long-term principles will reassert themselves over time. Don’t jump the gun in throwing away your models.

In order for a model to be accepted, you want it to trade all markets using the same rules and parameters. Your results should yield good performance across 90-plus percent of all markets tested. Also, no model should be accepted unless it shows stability of performance during tests involved with shifting parameters and altering rules. This is the definition of robust.

Charles Faulkner

Stay in the moment of right Now.

The idea of cutting your losses quickly and letting your gains run is in fact going against human biology.

Successful trend following trading is about developing a belief deep in your belly that you are part of a larger system.

Ed Seykota

The Whipsaw song:

• Ride your Winners
• Cut your Losses
• Manage your Risk
• Use Stops
• Stick to the System
• File the News

 
Interesting and an easy read, a good book to round off the Summer…

nebulous intricacies

In the last post we looked at the Turtle Trading system and saw that its performance went from outstanding for a long period of time to flat for 20 years. This opens a can of worms:

Does Trend Following work, is it dead, do markets change, does trend following rules need to adapt to these changes?

Let’s look at the different points of view.

The EMH Crowd

The EMH crowd does not believe in anything else than the Random Walk and by definition discards any profit-generating mechanical strategy.

As much as the Efficient Market Hypothesis (EMH) is a cornerstone of most modern financial theory, it has proven to be wrong partly because of some of its assumptions (not all actors in the market are rational, market prices are not fully random and normally distributed, etc.).

One great book that discredits the EMH approach and their descendant theories (CAPM, etc.) is by Mandelbrot: The (mis)behavior of the markets. It lays the arguments against the EMH in an approachable (ie not too much maths) way.

Trend Following is dead/does not work

Curtis Faith declared that “every few years trend following traders experience a period of losses and inevitably some expert will announce the end of trend following.”

Mike Covel also has a similar quote in his Trend Following book: “every 5 years some famous trader blows up and everyone declares trend following to be dead. Then 5 years later some famous trader blows up and everyone declares trend following to be dead, etc. ”

One of the main proponents of the argument against Trend Following is infamous trader Vic Niederhoffer (who “blew up” twice). He has been highly vocal about it, declaring Trend Following as one of the top Stock Market con.
Here is another link from his website to read more about it.

Arguments like this, despite the empirical evidence against it – in the form of Trend Following Wizards success, can be taken as a motivation for healthy skepticism and push you to strengthen your statistical research.

Are markets changing? (and must Trend Following change too?)

The self-professed “Trend Following poster boy” (a.k.a. Michael Covel) authoratively declares that this is a specious argument.

Occasionally, someone trying to promote something or start a debate will argue that trend following rules must always change due to changing market conditions. This is nonsense. It is a specious argument.

This is at best ambiguous. Covel likes to cite Bill Dunn who:

proffered that his basic system rules have not changed since 1974

Now, that is seducing: it seems to sell you the idea that you can develop a system, implement it and trade it for life. However this is not strictly true. As mentioned in this interview:

Dunn annually adjusts the parameters of trading signals and each markets weighting. In February – just as the grains were about to take off – he dumped the entire grain sector. But Dunn has no regrets.

Dunn is also known to have collaborated with Robert Pardo, a strong proponent of Walk-Forward testing (see below: a constant system adjustment).

To clarify: although Trend Following principles will never change, the rules/parameters of a Trend Following system might need to be adjusted to changing market conditions.

How can a Trend Following strategy adapt to the ever-changing markets?

In an Active Trader article, Anthony Garner attempts to discuss:

Do markets change? Is it necessary to undertake continued research and development and adapt a trend-following system to maintain its profitability over the years?

The article is only available for the magazine subscribers, but the result of the equity curve can be found on the Trading Blox forum. By “tuning up” the Turtle system, Garner manages to obtain interesting stats (MAR=2.26, CAGR=35.28%). The main change to the system is the use of a longer-term timeframe.

Practically

I know I would not be happy trading the original Turtle System in the last 20 years and get a 0% return. If you started trading this system “back then”, when and how would you think it is time to switch to a revised system?

Let’s look at options:

1. Walk-Forward

Walk-Forward testing‘s principle is to keep running (in simulation) a “pool” of systems using different rules/parameters. At regular interval, you evaluate what systems are best (performance, robustness, etc.) and trade those until the next re-evaluation. The potential risk with this approach is that you might end up like a dog chasing your tail.

However, this approach would have you switched from the original Turtle system to the new one a while ago.

2. Alternative Walk-Forward

Markets exhibit some degree of inefficiency – and Trend Following is a strategy designed to profit from these inefficiencies. I am still refining my theoritical understanding and explanation of it, but I believe Trend Following’s performance is mostly the result of fat-tailed distributions (distribution kurtosis) and possibly autocorrelation.

If one can associate the evolution of these characteristics to the performance of Trend Following systems it might be possible to adapt the system rules/parameters to the values and evolution of the price distribution characteristics. This is a topic I’d like to investigate further.

3. Mixing Systems

Finally, and this seems to be a strategy adopted by many professionals: mix different systems and different timeframes. Here the rationale is that we cannot predict what systems are going to under/over perform and mixing several ones together will smooth out the equity curve.

What this book is not

If you are looking for the Holy Grail of trading systems and/or a complete “turn-key” trading system: look elsewhere as this is not what this book is set to achieve. It will not reveal any trading secrets; however reading this book will make you realise that this is not what is important…

Trend Following: essentials of a trading philosophy

It looks like Michael Covel appreciated the concept of Market Wizards from Jack Schwager and drew inspiration from it. In a clever mix, Covel managed to overlay and enrich all the foundations of trend following with great trend follower insights.

The book covers the principles of the trend following trading philosophy and its multiple aspects: discipline, drawdowns, risk and money management, behavioral biases, prediction vs. reaction, etc. It makes for a very interesting read – both instructive and interactive.

Even with an automated trading system, you have to be in agreement with the strategy philosophy. This book helps you understand the philosophy of trend following in greater detail – you can then decide whether it suits you. Additionally it can help you strengthen your belief during the inevitable low points such as drawdowns while trading a trend following system.

Inside Trend Wizard minds: 10 years of research

The world of trend followers is relatively discreet: barely anybody has heard of Ed Seykota or Bill Dunn – but John Meriwether opening up his third hedge fund (after blowing up his previous 2 – including LTCM!) makes it to the first page of Bloomberg and the FT.

Michael Covel has spent 10 years researching and interviewing for this book. This allowed him to get in the head of the greatest trend following traders. This results in extensive quotes/pearls of wisdon from Ed Seykota, Dave Harding, Bill Dunn, John W Henry, all the greatest Trend Following Wizards. It really gives you great insights on the way they think and how they apply their market philosophy to trend following. And this is information that is not readily available anywhere else.

New Edition addition

I have read both earlier and newest (post-2008) editions and I think the later version is worth it. Many references to the major events of 2008 help to put the text in the present context and add some relevancy (especially with trend followers outstanding performance during these times).

Additonally there is a new appendix covering in detail Trend Following for Stocks, which is of interest.

Controversies

One of the main message of Trend Following (the trading philosophy and the book) is that we cannot predict. It forces society to admit that we are no as sophisticated as we think. It also points to the fact that chance might have much more to do with success of so-called “experts” rather than their “expert prediction abilities”.
One such “expert trader” Victor Niederhoffer slams the book:

I get the same sort of value from these books [Trend Following] as I do from studying the Keech cult, supernatural operators such as Uri Geller and horosope readers

You can tell that Covel takes some pleasure describing the latest blow-up from Niederhoffer’s fund in 2007 in his “Big Events” chapter.
Some people have also raised the question as to why Michael Covel primarily seems to be marketing his books and courses rather than trading for himself. Whether this is a valid point or not, this does not remove any quality from the book.

You can check and follow Michael Covel on his trend following blog to make your opinion.

In closing

I find this book very inspiring and motivating.
If you are new to trend following, this is a must-read: it will introduce you to all the basic concepts.
If you already believe in trend following, this is a must-read: it will reinforce your beliefs and motivation.
If you do not believe in trend following: this is a must-read: it is not too late to change your mind and this is the best book for it!

I have read Trend Following about 3 times now; this is a book that lives on my trading bookshelf – I know that every time I need a boost for motivation, a re-read will provide me just that.

As Larry Hite says:

The way I see it, you have two choices – you can do what I did and work for 30-plus years, cobbling together scraps of information, seeking to create a money-making strategy, or you can spend a few days reading Covel’s book and skip that three-decade learning curve.