Praise for Trend Following
“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 Trend Following and
skip that three‐decade learning curve.”
—Larry Hite, profiled in Market Wizards
“Michael Covel’s Trend Following: Essential.”
—Ed Seykota, profiled in Market Wizards
“Trend Following by Michael Covel? I’m long this book.”
—Bob Spear, Mechanica“
[Trend Following] did a superb job of covering the philosophy and thinking behind
trend following (basically, why it works). You might call it the Market Wizards of
Trend Following.”
—Van K. Tharp, PhD, profiled in Market Wizards
“[Trend Following] documents a great deal of what has made trend following man-
agers a successful part of the money management landscape (how they manage
risk and investment psychology). It serves as a strong educational justification on
why investors should consider using trend following managers as a part of an over-
all portfolio strategy.”
—Tom Basso, profiled in The New Market Wizards
“I am very pleased to see Michael Covel’s updated version of Trend Following; one
of my favorite trading books out of the hundreds that I have read. He has doubled the size of this edition and expounded on the process used by legendary trend fol-
lowing traders. The traders in this book made millions by getting on the right side
of trends and managing risk in diversified markets. This book should be studied by
any serious trader or investor.”
—Steve Burns, NewTraderU.com
“Trend Following: Definitely required reading for the aspiring trader.”
—David S. Druz, Tactical Investment Management
“A mandatory reference for anyone serious about alternative investments.”
—Jon Sundt, Altergris
“Michael Covel does an excellent job of educating his readers about the little‐-
known opportunities available to them through one of the proven best hedge fund
strategies. This book is like gold to any smart investor.”
—Christian Baha, Superfund
“Covel has created a very rare thing—a well‐documented and thoroughly re-
searched book on trend following that is also well written and easy to read. This is
one book that traders at all levels will find of real value.”
—John Mauldin, Mauldin Economics
“I think that Michael’s Trend Following is an outstanding read from which all in-
vestors can learn to trade markets better by limiting their risks and maximizing
their profits through a more disciplined approach to investments.”
—Marc Faber
Managing Director, Marc Faber Limited
Editor, “Gloom, Boom & Doom Report”
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Trend Following
Fifth Edition
How to Make a Fortune in Bull, Bear, and Black Swan Markets
Michael W. Covel
Cover design: Wiley
Copyright © 2017 by Michael W. Covel. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
The fourth edition of Trend Following was published by FT Press in 2009.
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Library of Congress Cataloging‐in‐Publication Data:
Names: Covel, Michael W., author.
Title: Trend following : how to make a fortune in bull, bear and black swan
markets / Michael W. Covel.
Description: Fifth edition. | Hoboken : Wiley, 2017. | Series: Wiley trading | Re-
vised edition of the author’s Trend following. | Includes bibliographical refer-
ences and index.
Identifiers: LCCN 2016056666 (print) | LCCN 2016057575 (ebook) | ISBN
9781119371878 (hardback) | ISBN 9781119371915 (ePDF) | ISBN 9781119371908
(ePub) |
Subjects: LCSH: Investments. | Stocks. | BISAC: BUSINESS & ECONOMICS /
Commodities.
Classification: LCC HG4521 .C82 2017 (print) | LCC HG4521 (ebook) | DDC
332.6—dc23
LC record available at https://lccn.loc.gov/2016056666
“Get on the motorbike. Relax.” Cảm ơn Anh.
He was impregnably armored by his good intentions and his ignorance.
—Graham Greene, The Quiet American
Yesterday don’t matter if it’s gone.
—The Rolling Stones, “Ruby Tuesday”
Contents
1.Foreword
2.Preface
3.Section I Trend Following Principles
•1 Trend Following
•Speculation
•Winning versus Losing
•Investor versus Trader
•Fundamental versus Technical
•Discretionary versus Systematic
•Hiding in Plain Sight
•Change Is Life
•Follow the Trend to the End When It Bends
•Surf the Waves
•Summary Food for Thought
•2 Great Trend Followers
•David Harding
•Summary Food for Thought
•Bill Dunn
•Summary Food for Thought
John W. Henry
•Summary Food for Thought
•Ed Seykota
•Summary Food for Thought
•Keith Campbell
•Summary Food for Thought
•Jerry Parker
•Salem Abraham
•Summary Food for Thought
•Richard Dennis
•Summary Food for Thought
•Richard Donchian
•Summary Food for Thought
•Jesse Livermore and Dickson Watts
•Summary Food for Thought
•Note
•3 Performance Proof
•Absolute Returns
•Volatility versus Risk
•Drawdowns
•Correlation
•Zero Sum
•George Soros
•Berkshire Hathaway
•Summary Food for Thought
•4 Big Events, Crashes, and Panics
•Event 1: Great Recession
•Event 2: Dot-com Bubble
•Event 3: Long-Term Capital Management
•Event 4: Asian Contagion
Event 5: Barings Bank
•Event 6: Metallgesellschaft
•Event 7: Black Monday
•5 Thinking Outside the Box
•Baseball
•Billy Beane
•Bill James
•Stats Take Over
•Summary Food for Thought
•Note
•6 Human Behavior
•Prospect Theory
•Emotional Intelligence
•Neuro-Linguistic Programming
•Trading Tribe
•Curiosity, Not PhDs
•Commitment
•Summary Food for Thought
•7 Decision Making
•Occam’s Razor
•Fast and Frugal Decision Making
•Innovator’s Dilemma
•Process versus Outcome versus Gut
•Summary Food for Thought
•8 The Scientific Method
•Critical Thinking
•Linear versus Nonlinear
•Compounding
•Summary Food for Thought
•9 Holy Grails
Buy and Hope
•Warren Buffett
•Losers Average Losers
•Avoiding Stupidity
•Summary Food for Thought
•10 Trading Systems
•Risk, Reward, and Uncertainty
•Five Questions
•Your Trading System
•Frequently Asked Questions
•Summary Food for Thought
•11 The Game
•Acceptance
•Don’t Blame Me
•Decrease Leverage, Decrease Return
•Fortune Favors the Bold
4.Section II Trend Following Interviews
•12 Ed Seykota
•13 Martin Lueck
•14 Jean-Philippe Bouchaud
•15 Ewan Kirk
•16 Alex Greyserman
•17 Campbell Harvey
•18 Lasse Heje Pedersen
5.Section III Trend Following Research
•19 A Multicentennial View of Trend Following
•The Tale of Trend Following: A Historical Study
•Return Characteristics over the Centuries
•Risk Characteristics over the Centuries
•Portfolio Benefits over the Centuries
•Summary
•Appendix: Included Markets and Relevant Assumptions
•20 Two Centuries of Trend Following
•Introduction
•Trend Following on Futures since 1960
•Extending the Time Series: A Case-by-Case Approach
•Trend over Two Centuries
•Conclusions
•Notes
•21 Trend Following
•Overview
•Introduction to Different Trend Following Models
•Diversification between Different Trend Following Models
•Aspect’s Approach to Trend Following
•Aspect’s Model Compared to Other Trend Following Models
•Conclusion
•Chart Disclaimer
•Note
•22 Evaluating Trading Strategies
•Testing in Other Fields of Science
•Revaluating the Candidate Strategy
•Two Views of Multiple Testing
•False Discoveries and Missed Discoveries
•Haircutting Sharpe Ratios
•An Example with Standard and Poor’s Capital IQ
•In Sample and Out of Sample
•Trading Strategies and Financial Products
•Limitations and Conclusions
•Note
•23 Black Box Trend Following—Lifting the Veil
Synopsis
•The Strategies
•Performance Results and Graphs
•Sector Performance
•Performance of Long versus Short Trades
•Stability of Parameters
•Are CTAs a Diversifier or a Hedge to the SP500?
•Summary
•Note
•24 Risk Management
•Risk
•Risk Management
•Optimal Betting
•Hunches and Systems
•Simulations
•Pyramiding and Martingale
•Optimizing—Using Simulation
•Optimizing—Using Calculus
•Optimizing—Using the Kelly Formula
•Some Graphic Relationships Between Luck, Payoff, and
Optimal Bet Fraction
•Nonbalanced Distributions and High Payoffs
•Almost-Certain-Death Strategies
•Diversification
•The Uncle Point
•Measuring Portfolio Volatility: Sharpe, VaR, Lake Ratio, and
Stress Testing
•Stress Testing
•Portfolio Selection
•Position Sizing
•Psychological Considerations
•Risk Management—Summary
•25 How to GRAB a Bargain Trading Futures . . . Maybe
•Introduction
•How to GRAB a Bargain Trading Futures
•Following Trends Is Hard Work
•Figuring Out How the Pros Do It
•A Computer Model of the Pros
•A Terrible Discovery
•Solving the Mystery—Why Does the GRAB System Lose?
•Often It Is Out of Sync with the Market
•Worse Still, It Misses the Best Moves!
•Maybe Being Profitable Means Being Uncomfortable?
•GRAB Trading System Details
•Buys on Break of Support, Sells on Break of Resistance
•Testing Reveals Some Behavior I Do Not Expect
•Difference between Parameter Values Defines Character of
GRAB System
•GRAB Trading System Code
•Indicator Setup
•Position Entry
•Position Exit
•Position Sizing
•Note
•26 Why Tactical Macro Investing Still Makes Sense
•Introduction
•Managed Futures
•Defining Managed Futures and CTAs
•Where Institutional Investors Position Managed Futures
and CTAs
Skewness and Kurtosis
•Data
•Basic Statistics
•Stocks, Bonds, Plus Hedge Funds or Managed Futures
•Hedge Funds Plus Managed Futures
•Stocks, Bonds, Hedge Funds, and Managed Futures
•Conclusion
•Appendix A
•Appendix B
•Appendix C
•Review of Skewness and Kurtosis
•Note
•27 Carry and Trend in Lots of Places
•Carry and Trend: Definitions, Data, and Empirical Study
•Carry and Trend in Interest Rate Futures
•Trend and Carry across Asset Classes
•Carry and Trend across Rate Regimes
•Conclusions
•Note
•28 The Great Hypocrisy
6.Epilogue
7.Afterword
8.Trend Following Podcast Episodes
9.Bibliography
10.Acknowledgments
11.About the Author
12.Index
13.EULA
List of Tables
1.Chapter 2
•Table 2.1
•Table 2.2
•Table 2.3
•Table 2.4
•Table 2.5
2.Chapter 3
•Table 3.1(a)
•Table 3.1(b)
•Table 3.2
•Table 3.3(a)
•Table 3.3(b)
•Table 3.4
•Table 3.5
•Table 3.6
3.Chapter 4
•Table 4.1
•Table 4.2
•Table 4.3
•Table 4.4
•Table 4.5
•Table 4.6
•Table 4.7
•Table 4.8
•Table 4.9
•Table 4.10
•Table 4.11
4.Chapter 5
Table 5.1
5.Chapter 8
•Table 8.1
6.Chapter 9
•Table 9.1
7.Chapter 10
•Table 10.1
8.Chapter 19
•Table 19.1
•Table 19.2
•Table 19.3
•Table 19.4
9.Chapter 20
•Table 20.1
•Table 20.2
•Table 20.3
•Table 20.4
•Table 20.5
•Table 20.6
•Table 20.7
•Table 20.8
•Table 20.9
10.Chapter 26
•Table 26.1
•Table 26.2
•Table 26.3
•Table 26.4
•Table A-1
•Table A-2
•Table A-3
•Table B-1
•Table B-2
•Table B-3
11.Chapter 27
•Table 27.1
•Table 27.2
•Table 27.3
•Table 27.4
•Table 27.5
List of Illustrations
1.Chapter 2
•Figure 2.1: Dunn Capital Management: Composite Performance
1974–2016
•Figure 2.2: Dunn Capital’s Japanese Yen Trade
•Figure 2.3: Dunn Capital’s British Pound Trade
•Figure 2.4: Henry South African Rand Trade
•Figure 2.5: Henry Japanese Yen Trade
•Figure 2.6: Hypothetical $1,000 Growth Chart for Campbell & Com-
pany
2.Chapter 3
•Figure 3.1: Drawdown Chart
3.Chapter 4
•Figure 4.1: U.S. Dollar Short Trade
•Figure 4.2: : Long Gold Trade
•Figure 4.3: :Long Five-Year Notes Trade
•Figure 4.4: Crude Oil Short Trade
•Figure 4.5: Nikkei 225 Short Trade
Figure 4.6: British Pound Short Trade
•Figure 4.7: Long December 2008 Euribor Trade
•Figure 4.8: :Long December 2008 EuroSwiss Trade
•Figure 4.9: Short December 2008 Lean Hogs Trade
•Figure 4.10: Short January 2009 Lumber Trade
•Figure 4.11: Short January 2009 Robusta Coffee Trade
•Figure 4.12: Long December 2008 U.S. Dollar Trade
•Figure 4.13: Abraham Trading Compared to the S&P
•Figure 4.14: Trend Followers and the S&P Chart, January 2002–
December 2002
•Figure 4.15: Trend Followers and the Dollar Chart, January 2002–
December 2002
•Figure 4.16: Trend Followers and the Yen Chart, January 2002–
December 2002
•Figure 4.17: Trend Followers and the Euro Chart, January 2002–
December 2002
•Figure 4.18: :Trend Followers and the T-Bond Chart, January 2002–
December 2002
•Figure 4.19: Trend Followers and the FTSE Chart, January 2002–
December 2002
•Figure 4.20: :Trend Followers and the Euro-Bund, January 2002–
December 2002
•Figure 4.21: Trend Followers and the DAX, January 2002–December
2002
•Figure 4.22: Enron Stock Chart
•Figure 4.23: Natural Gas Stock Chart
•Figure 4.24: Trend Followers and 10-Year T-Note, May 1998–
December 1998
•Figure 4.25: Trend Followers and U.S. T-Bond, May 1998–
December 1998
•Figure 4.26: Trend Followers and German Bund, May 1998–
December 1998
•Figure 4.27: Trend Followers and S&P, May 1998–December 1998
•Figure 4.28: Trend Followers and Swiss Franc, May 1998–
December 1998
•Figure 4.29: Trend Followers and Eurodollar, May 1998–December
1998
•Figure 4.30: Trend Followers and Yen, May 1998–December 1998
•Figure 4.31: Trend Followers and Dollar Index, May 1998–December
1998
•Figure 4.32: Nikkei 225 September 1994–June 1995
•Figure 4.33: Crude Oil Futures, February 1993–February 1994
4.Chapter 7
•Figure 7.1: Process versus Outcome²⁵
5.Chapter 9
•Figure 9.1: Weekly Chart Nikkei 225, 1985–2003
6.Chapter 10
•Figure 10.1: Trend Following Entry/Exit Example: The Middle Meat
7.Chapter 19
•Figure 19.1 A standard price index for tulip bulb prices
•Figure 19.2 A historical plot of the S&P 500 Index and S&P 500
Total Return Index from 1800 to 2013 in log scale
•Figure 19.3 The number of included markets in the representative
trend following program from 1300 to 2013
•Figure 19.4 Cumulative (log) performance of the representative
trend following portfolio from 1300 to 2013
•Figure 19.5 The GFD Long-Term Government Bond Yield Index
from 1300 to 2013
•Figure 19.6 A composite annual inflation rate for the United States
and the United Kingdom from 1720 to 2013
Figure 19.7 The Dow Jones Industrial index during the 1929 Wall
Street Crash (Black Monday)
•Figure 19.8 Cumulative performance for the representative trend fol-
lowing system pre and post the 1929 Wall Street Crash (Black Mon-
day). The data period is October 1928 to October 1930.
•Figure 19.9 Average monthly returns for the representative trend fol-
lowing system during down periods in equity and bond portfolios
•Figure 19.10 Average monthly returns for trend following when the
equity index is down. Conditional performance is plotted for both
with and without a long bias to the equity sector.
•Figure 19.11 The “CTA Smile”: Quintile analysis of trend following
for 1913–1962 and 1963–2013. Returns are sorted by quintiles of eq-
uity performance from 1 (worst) to 5 (best).
•Figure 19.12 The “CTA Smile”: Quintile analysis of trend following
for 1913–1937, 1938–1962, 1963–1987, and 1988–2013. Returns are
sorted by quintiles of equity performance from 1 (worst) to 5 (best).
•Figure 19.13 The maximum and average of the largest five relative
drawdowns as a percentage for trend following relative to the buy-
and-hold portfolio. The maximum drawdown of trend following is
75 percent of the magnitude of the maximum drawdown for the
buy-and-hold portfolio.
•Figure 19.14 The relative size of the longest duration and average
duration of the longest five drawdowns for trend following relative
to the buy-and-hold portfolio. The longest drawdown duration is
less than 10 percent of the length of the longest drawdown length
for the buy-and-hold drawdown.
•Figure 19.15 Sharpe ratios for individual asset classes including eq-
uity and combinations of the three asset classes from 1695 to 2013
8.Chapter 20
•Figure 20.1 Fictitious P&L, as Described in Equation 2.2, of a
Month Trend-Following Strategy on a Diversified Pool of Futures
•Figure 20.2 Global Debt of the U.S. Government (a) in Billions of
U.S. Dollars and (b) as a Fraction of GDP
•Figure 20.3 Trend on Spot and on Futures Prices
•Figure 20.4 Aggregate Performance of the Trend on All Sectors
•Figure 20.5 Fit of the Scatter Plot of Δ(t) = p(t + 1) – p(t) as a Func-
tion of sn(t), for n = 5 Months, and for Futures Data Only
•Figure 20.6 Recent Performance of the Trend
•Figure 20.7 Ten-Year Cumulated Performance of the Trend (Arbi-
trary Units)
•Figure 20.8 Performance of a Three-Day Trend on Futures Con-
tracts since 1970
9.Chapter 21
•Figure 21.1 Simulated Performance of Trend Following Models: Jan-
uary 1999 to June 2016
•Figure 21.2 Simulated Risk-Adjusted Performance of Trend Fol-
lowing Models: January 1999
•Figure 21.3 Simulated Correlations between Trend Following Mod-
els: Jan 1999 to Jun 2016
•Figure 21.4 Simulated Performance of Trend Following Models and
Average across all 13: Jan 1999 to Jun 2016
•Figure 21.5 Simulated Average Information Ratios from Combining
Different Trend Following Models: January 1999 to June 2016
•Figure 21.6 Aspect’s Trend Following Model Simulated Perfor-
mance Improvements: January 1999 to June 2016
•Figure 21.7 Simulated Performance of Trend Following Models ver-
sus Aspect’s Trend Following Model: January 1999 to June 2016
•Figure 21.8 :Simulated Performance of Trend Following Models ver-
sus Aspect’s Trend Following Model: January 1999 to June 2016
•Figure 21.9 Simulated Impact on Aspect’s Model Information Ratio
Figure 19.7 The Dow Jones Industrial index during the 1929 Wall Street Crash (Black Monday)
Figure 19.8 Cumulative performance for the representative trend following system pre and post the 1929 Wall Street Crash (Black Monday). The data period is October 1928 to October 1930.
Figure 19.9 Average monthly returns for the representative trend following system during down periods in equity and bond portfolios
Figure 19.10 Average monthly returns for trend following when the equity index is down. Conditional performance is plotted for both with and without a long bias to the equity sector.
Figure 19.11 The CTA Smile: Quintile analysis of trend following for 1913–1962 and 1963–2013. Returns are sorted by quintiles of equity performance from 1 (worst) to 5 (best).
Figure 19.12 The CTA Smile: Quintile analysis of trend following for 1913–1937, 1938–1962, 1963–1987, and 1988–2013. Returns are sorted by quintiles of equity performance from 1 (worst) to 5 (best).
Figure 19.13 The maximum and average of the largest five relative drawdowns as a percentage for trend following relative to the buy-and-hold portfolio. The maximum drawdown of trend following is 75 percent of the magnitude of the maximum drawdown for the buy-and-hold portfolio.
Figure 19.14 The relative size of the longest duration and average duration of the longest five drawdowns for trend following relative to the buy-and-hold portfolio. The longest drawdown duration is less than 10 percent of the length of the longest drawdown length for the buy-and-hold drawdown.
Figure 19.15 Sharpe ratios for individual asset classes including equity and combinations of the three asset classes from 1695 to 2013
Chapter 20
Figure 20.1 Fictitious P&L, as Described in Equation 2.2, of a
Five-Month Trend-Following Strategy on a Diversified Pool of Futures
Figure 20.2 Global Debt of the U.S. Government (a) in Billions of U.S. Dollars and (b) as a Fraction of GDP
Figure 20.3 Trend on Spot and on Futures Prices
Figure 20.4 Aggregate Performance of the Trend on All Sectors
Figure 20.5 Fit of the Scatter Plot of Δ(t) = p(t + 1) – p(t) as a Function of sn(t), for n = 5 Months, and for Futures Data Only
Figure 20.6 Recent Performance of the Trend
Figure 20.7 Ten-Year Cumulated Performance of the Trend (Arbitrary Units)
Figure 20.8 Performance of a Three-Day Trend on Futures Contracts since 1970
Chapter 21
Figure 21.1 Simulated Performance of Trend Following Models: January 1999 to June 2016
Figure 21.2 Simulated Risk-Adjusted Performance of Trend Following Models: January 1999
Figure 21.3 Simulated Correlations between Trend Following Models: Jan 1999 to Jun 2016
Figure 21.4 Simulated Performance of Trend Following Models and Average across all 13: Jan 1999 to Jun 2016
Figure 21.5 Simulated Average Information Ratios from Combining Different Trend Following Models: January 1999 to June 2016
Figure 21.6 Aspect’s Trend Following Model Simulated Performance Improvements: January 1999 to June 2016
Figure 21.7 Simulated Performance of Trend Following Models versus Aspect’s Trend Following Model: January 1999 to June 2016
Figure 21.8 :Simulated Performance of Trend Following Models versus Aspect’s Trend Following Model: January 1999 to June 2016
Figure 21.9 Simulated Impact on Aspect’s Model Information Ratio from Adding Other Trend Following Models: Jan 1999 to Jun 2016
10.Chapter 22
•Figure 22.1 A Candidate Trading Strategy
•Figure 22.2 Two Hundred Randomly Generated Trading Strategies
•Figure 22.3 Panel A: False Trading Strategies, True Trading Strate-
gies. Panel B: False Trading Strategies, True Trading Strategies.
11.Chapter 24
•Figure 24.1 A Luck-Payoff matrix, showing six outcomes For now,
however, we return to our basic coin example, since it has enough
dimensions to illustrate many concepts of risk management. We
consider more complicated examples later.
•Figure 24.2 Simulation of fixed-bet and fixed-fraction betting sys-
tems
•Figure 24.3 Simulation of equity from a fixed-fraction betting system
•Figure 24.4 Expected value (ending equity) from 10 tosses, versus
bet fraction, for a constant-bet fraction system, for a 2:1 payoff
game, from the first and last columns of Figure 24.3
•Figure 24.5 The Kelly Formula
•Figure 24.6 Optimal bet fraction increases linearly with luck,
asymptotically to payoff.
•Figure 24.7 The optimal expected value increases with payoff and
luck.
•Figure 24.8 For high payoff, optimal bet fraction approaches luck.
•Figure 24.9 The Lake Ratio = Blue / Yellow
12.Chapter 25
•Figure 25.1 Trend Following System, E-Mini S&P 500 (Back-
Adjusted)
•Figure 25.2 E-Mini S&P 500 (Back-Adjusted)
•Figure 25.3 GRAB System; Parameter Values 40, 80
•Figure 25.4 GRAB System; Parameter Values 40, 80 Soybean Oil
(Back-Adjusted)
•Figure 25.5 GRAB System; Parameter Values 40, 80 Euro German
Bund (Back-Adjusted)
•Figure 25.6 Near-Box Look-Back: 20 Days. Far-Box Look-Back: 100
Days, Corn (Back-Adjusted)
•Figure 25.7 Parameters Far Apart: Near-Box Look-Back: 20 Days.
Far-Box Look-Back: 200 Days, New York Coffee (Back-Adjusted)
•Figure 25.8 Parameters Close Together: Near-Box Look-Back: 110
Days. Far-Box Look-Back: 140 Days Natural Gas (Back-Adjusted)
13.Chapter 26
•Figure 26.1 Mean return of varying allocation between traditional
and alternative portfolios, while changing the alternative portfolio’s
Managed Futures/Hedge Fund composition, for the period January
2001–December 2015
•Figure 26.2 Standard deviation of varying allocation between tradi-
tional and alternative portfolios, while changing the alternative port-
folio’s Managed Futures/Hedge Fund composition for the period
January 2001–December 2015
•Figure 26.3 Risk-adjusted return of 50/50 portfolios of stocks,
bonds, hedge funds, and managed futures for the period of January
2001–December 2015
•Figure 26.4 Skewness of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for the period June 2001–December
2015
•Figure 26.5 Kurtosis of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for the period June 2001–December
2015
•Figure 26.6 Efficient frontier for portfolios ranging from 100%
Traditional portfolio to 100% Alternatives portfolio in 10% incre-
ments for the period June 2001–December 2015
Figure A-1 Mean return of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for the period January 1990–December
2015
•Figure A-2 Standard deviation of 50/50 portfolios of stocks, bonds,
hedge funds, and managed futures for the period January 1990–
December 2015
•Figure A-3 Skewness of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for the period January 1990–December
2015
•Figure A-4 Kurtosis of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for the period January 1990–December
2015
•Figure B-1 Mean return of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for Kat’s study period of June 1994–
May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom). Note:
Our image looks different than Kat’s, primarily because he con-
strained the equity returns for the period and we did not.
•Figure B-2 Standard deviation of 50/50 portfolios of stocks, bonds,
hedge funds, and managed futures for Kat’s study period of June
1994–May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom)
•Figure B-3 Skewness of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for Kat’s study period of June 1994–
May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom)
•Figure B-4 Kurtosis of 50/50 portfolios of stocks, bonds, hedge
funds, and managed futures for Kat’s study period of June 1994–
May 2001 (top, Kat’s original graphic below;¹¹ ours is on bottom)
14.Chapter 27
•Figure 27.1 Excess Return Index and Estimated Carry for Rolling
U.S. 10-Year Note Futures
•Figure 27.2 Decomposing History of U.S. 10-Year Note Futures by
Carry and Trend
Foreword
True story: Not long after the financial crisis of 2008–09, I was dragged to a posh
Long Island country club for some terribly boring social event (those tony golf
places are not my idea of fun). On my way out the door, I was introduced to
someone—let’s just call him Trader Guy—who is described to me sotto voce as
the wealthiest person in the club. The thinking apparently was “Hey, two finance
guys! They should meet.”
We exchange small talk. Trader Guy’s diffidence makes it clear he has no interest
in chatting. We are both heading out to the valet—these places won’t let you
park your own car—and a rather memorable few moments ensued.
Trader Guy knows who I am. My book on the financial crisis had come out the
prior year; I had already been a regular in the financial media for a while. He
knows my name and, truth be told, he could not possibly have cared less. If only
to be polite to the host who introduced us, I ask what sort of trading he does.
Trader Guy actually sighs deeply—then says to me, “I trade everything, I am a
trend follower, you wouldn’t understand.”
Oh, really?
“What a coincidence” I say. “A friend of mine wrote a book on trend following.”
By now, I have exhausted what little patience Trader Guy had with me to begin
with. I actually heard his eyes roll.
“Listen, dude, it’s really cute you have a friend who wrote a book on this, but
there is only one book on the topic, every other one is crap. Your pal wasted
trees writing his. The definitive book on the subject, the only one that matters, is
called Trend Following. Everything else is a waste of your time.”
I tried, I really tried so hard not to smirk.
As best as I could with a straight face, I casually say: “Yeah, that’s the one. That’s
the book Mike—my friend Michael Covel—wrote. Trend Following.
Talk about an attitude adjustment: Trader Guy has a genuine come-to-Jesus mo-
ment, turning into a smitten schoolgirl: “OhmygodOhmygodOhmygod—you
know Mike Covel? I love that book, I love Trend Following! I was a failing trader,
about to get blown out of the business. I read that book, and it turned my whole
life around. I owe that guy my entire career!”
Ahhh! The tables have turned. Now it is my turn to have a little fun:
“I keep telling Mike he needs to punch it up, make it more colorful, add a section
on forecasting economic data, evaluating corporate management, and analyzing
geopolitics. Make it fresh and interesting.”
Long pause as Trader Guy’s jaw drops.
It takes him a few seconds before he realizes that: a) I am totally kidding; b) I
understand how irrelevant those things are to trend followers, and; c) I am bust-
ing his chops for being such a hard ass before.
Trader Guy laughs as I am now deemed worthy. We are suddenly best buds: We
chat about what we were short during the crisis (AIG, Lehman, Bear), the equity
rally off of the lows (strong), and the gold run (at risk of breaking), dollar trend-
ing. His car pulls up, we keep talking. My car comes around, and we are still talk-
ing. Mr. Diffident has morphed into Mr. Conversationalist.
All of which goes a long way towards explaining why the book in your hands,
now in its fifth edition, has become one of the most popular trading books ever
written.
What are the characteristics that make Trend Following so unique? I have my own
biases. I see the inherent and natural flaws of human psychology as an in-
vestor’s biggest flaws. Like our inability to understand risk and data and statis-
tics, our obsession to be right, and the ways our wetware constantly fool us into
believing things that objectively are not true.
Hence, my top ten reasons I like Trend Following reflect all of that:
1.It is an objective, price-based approach.
2.News headlines, pundits, analysts, and opinions are not mean-
ingful.
3.It has risk management built into it.
4.Specific views on “The Fundamentals” are not relevant.
5.It is methodical and systematic.
6.The same exact strategies apply across all asset classes.
7.It does not require any predictions.
8.Time frames are long-term in nature.
9.Economic data—Employment, GDP, Fed, etc.—are irrelevant.
10.It demands a very exacting personal discipline.
Readers may find that other aspects of trend following that resonate more for
them. It depends on your own personality. But what does not vary for any trend
follower is understanding the specific underlying philosophy, and having the
discipline to follow that approach with unwavering, religious dedication.
I have a few complaints as well. It gives you nothing to talk about at cocktail par-
ties or barbecues. It is less intellectually stimulating than say debating whether
and when the FOMC should or should not (or will or will not) raise or lower
rates next meeting. It can be boring. And, there are long stretches of time where
the trend is neutral, and you are doing nothing.
Anyone can learn the methods Covel discusses here. Putting them into action
requires commitment to the craft, and a military discipline. The Achilles heel of
so many traders is a lack of precisely those qualities. As you will learn, Trend Fol-
lowers must be willing to tough out some difficult sledding. It is an old joke but
it’s true: If it was easy, everyone would be rich!
But it is not easy. Anyone who has lived with a major drawdown understands
how your own body responds. Physical and emotional tolls are not insignificant.
You lose sleep, you have a low-grade headache for days or weeks at a time, and
some people respond with physical nausea. The biggest issue comes in the hit
to self-confidence. Riding out the loss of capital leads traders to question them-
selves and to doubt their methodology. They wonder if maybe it really is different
this time. Market structures have changed, the Fed is doing something unprece-
dented, high-frequency trading is new, or perhaps it is ETFs, they think some-
thing is different this time around. “Perhaps if I just tweak the approach a little
here this once . . .” are famous last words.
To those who master the techniques described herein, there are profits to be
had. But it is not for everyone, and if you are unable or unwilling to ride out the
losses, accept drawdowns in capital, be bored through periods of tedium and
inactivity, to have the discipline to follow your strategy, to you I say, “Move
along. Trend following is not for everyone.”
For those who want to learn the craft of trading, have the personality and disci-
pline, and are willing to do the heavy lifting, read on . . . you won’t regret it.
—Barry L. Ritholtz
Chairman, Chief Investment Officer, Ritholtz Wealth Management
Columnist for Bloomberg View and Washington Post
Host of Masters in Business radio podcast for Bloomberg
Preface
Men wanted for hazardous journey. Small wages. Bitter cold. Long months of
complete darkness. Constant danger. Safe return doubtful. Honor and recognition in
case of success.1
Want to take the financial journey to a new investing philosophy that might very
well affect the rest of your moneymaking life? I can’t guarantee the yellow brick
road, but I can promise the red pill will leave you wide awake.
In late 2016 The Wall Street Journal reported that Steve Edmundson, the investment
chief for the Nevada Public Employees’ Retirement System, has no coworkers,
rarely takes meetings, and eats leftovers at his desk. His daily trading strategy: Do
as little as possible, usually nothing. The Nevada system’s $35 billion in stocks and
bonds are all in low-cost funds that mimic indexes. He may make one change to
the portfolio a year.2
Not exactly a life changing revelation, I know, but that do-nothing, sit-on-
your-hands investing premise doesn’t stop with one-man shows. Dimensional
Fund Advisors LP (DFA), the sixth-largest mutual fund manager, is drawing in
nearly $2 billion in net assets per month at a time when investors are fleeing other
firms. DFA is built on the bedrock belief that active management practiced by tradi-
tional stock pickers is futile, if not an absurdity. DFA’s founders are pioneers of
index funds.3
Now we are getting somewhere, because just about everyone has money tied up in
an index fund—which in 2017 is not exactly pioneering. But the much larger issue
at hand, unknown to most, is that there is an academic theory that allows anyone to
confidently index.
The efficient market theory (EMT) states asset prices fully reflect all available infor-
mation. This means it is impossible for average investors—or superstars, for that
matter—to beat the market consistently on a risk-adjusted basis, since market
prices should only react to new information or changes in discount rates. EMT, set
in motion with Louis Bachelier’s PhD thesis published in 1900, and developed by
University of Chicago professor Eugene Fama, argues stocks always trade at fair
value, making it impossible for investors to either purchase undervalued stocks or
sell stocks for inflated prices.4
Let me drop the nuclear warhead on that perspective.
There is a mind-numbingly large hole in this cool-sounding theory. EMT by defi-
nition leaves the epic October 2008 stock market meltdown out of the academic
equation. And for those who know about the sausage making of writing peer review
papers or engineering a PhD, much of modern finance’s foundation was bricked
together with EMT mortar. Fama was ultimately awarded the 2013 Nobel Prize in
Economic Sciences because his findings “changed market practice”—that is, the
worldwide acceptance of index funds.
Those findings are the generally accepted status quo.
Not everyone, however, is a true believer guzzling the Kool-Aid.
One of the first and loudest critics of EMT was famed mathematician Benoit Man-
delbrot. He saw EMT proponents sweep big events like 2008 under the carpet, like
kids house cleaning for the first time, calling them “acts of God.” French physicist
Jean-Philippe Bouchaud sees EMT marketing in play: “The efficient market hypoth-
esis is not only intellectually enticing, but also very reassuring for individual in-
vestors, who can buy stock shares without risking being outsmarted by more savvy
investors.”5
Bouchaud continues: “Classical economics is built on very strong assumptions
that quickly become axioms: the rationality of economic agents, the invisible hand
and market efficiency, etc. An economist once told me, to my bewilderment: ‘These
concepts are so strong that they supersede any empirical observation.’ As Robert
Nelson argued in his book, Economics as Religion, ‘the marketplace has been
deified.’ In reality, markets are not efficient, humans tend to be over-focused in the
short-term and blind in the long-term, and errors get amplified through social pres-
sure and herding, ultimately leading to collective irrationality, panic and crashes.
Free markets are wild markets.”6
David Harding, a man you might not know yet, ratchets up the polemic by describ-
ing EMT in apocalyptic terms: “Imagine if the economy as we know it was built on
a myth. Imagine if that myth was the foundation stone on which the mainstream
financial systems that control the global economy have been erected—the great
bazaars of stock markets, bond markets, fiendishly complex financial instruments,
credit default swaps, futures and options on which the fortunes of billions rest.
Imagine if the myth was the key cause of the global crash in 2008—and if its per-
petuation today threatened another catastrophic crash in the future. We don’t have
to imagine. The myth is Efficient Market Theory (EMT).”7
Harding does not have a Nobel Prize, but he does have a net worth of $1.4 billion.8
He is a flat-out financial heretic and would not be offended if you called him a
punk rocker for his antiestablishment attitude. In prior centuries he absolutely
would have been burned at the stake for his wholesale dressing down of the finan-
cial high priests. He knows to question EMT is seen as madness by academics,
banks, pension funds, and endowments.9
Interestingly, and with a bipolar flair, the Nobel committee split the 2013 Nobel
Prize among economists with radically different theories. Robert Shiller, a man fo-
cused more on behavior and who shares the Nobel Prize with Fama, sees the con-
tradictions: “I think that maybe he has a cognitive dissonance. [His] research
shows that markets are not efficient. So what do you do if you are living in the
University of Chicago? It’s like being a Catholic priest and then discovering that
God doesn’t exist or something you can’t deal with so you’ve got to somehow
rationalize it.”10
Harding goes further, explaining EMT madness in an everyman way: “This theory of
rational markets treats economics like a physical science—like Newtonian
physics—when in fact it is a human or social science. Human beings are prone to
unpredictable behavior, to over-reaction or slumbering inaction, to mania and
panic. The markets that reflect this behavior do not assume some supra-human
wisdom, they can and sometimes do reflect that volatility.”11
Further translation: Human nature isn’t rational. It blows bubbles and then pops
bubbles—and you can see this going back hundreds of years:
•Dutch Tulip Mania (1634–1637)
•The South Sea Bubble (1716–1720)
•The Mississippi Bubble (1716–1720)
•The British Railway Mania Bubble (1840s)
•The Panic of 1857
•The Florida Real Estate Bubble of the 1920s
•The stock market crash of 1929
•The 1973–1974 stock market crash
•Black Monday—the stock market crash of 1987
•Japan’s bubble economy and crash, 1989–current
•Dot–com bubble (1999–2002)
•United States bear market (2007–2009)
•Flash Crash (2010)
•Chinese stock market crash (2015–2016)
•Brexit (2016)
And on and on. . . .
But it’s beyond being not rational. Those events, the human actions driving those
booms and busts, are best described by academia’s prospect theory, cognitive
dissonance, the bandwagon effect, loss aversion, and assorted heuristics in judgment
and decision-making—to name a few of the hundreds of biases inherent in peo-
ple’s lizard brains.
No doubt, the efficient versus not-efficient debate will not be resolved in these
pages. Perhaps it will never be satisfactorily resolved in an academic mine is bigger
than yours sense, which would not be surprising given that human beings and their
egos, greed, fear, and money are knotted up so tight as to restrict brain blood flow.
And please don’t expect this work to be filled with the latest and greatest macroe-
conomic bubblegum predictions. You already know that is bullshit completely
unrelated to making money—even if you have not yet admitted that fact to yourself.
In the face of such chaos, complexity, and human frailty, my curiosity is quite sim-
ple. Answer a question: “Why does David Harding think he is right and, more
importantly, how in the hell did he get all that money trading the likes of Apple,
Tesla, gold, U.S. dollars, crude oil, NASDAQ, natural gas, lean hogs, palm oil,
wheat, and coffee without investing in an index or having a fundamental expertise
in any of those markets or the ability to predict directions?”
That is a worthy question, and the answer is a follow the big money adventure.
Trend Following
The 233,092 words in this book are the result of my near 20-year hazardous journey
for the truth about this trading called trend following. To this day it still fills a void
in a marketplace inundated with books about value investing, index investing, and
fundamental analysis, but lacking few resources to explain how David Harding
made his billion-dollar fortune with trend following.
Out of the gate let me break down the term trend following into its components.
The first part is trend. Every trader needs a trend to make money. If you think about
it, no matter what the technique, if there is not a trend after you buy, then you will
not be able to sell at higher prices. Following is the next part of the term. We use
this word because trend followers always wait for the trend to shift first, then follow
it.12
Every good trend following method should automatically limit the loss on any posi-
tion, long or short, without limiting the gain. Whenever a trend, once established,
reverses quickly, there is always a point, not far above or below the extreme
reached prior to the reversal, at which evidence of a trend in the opposite direction
is given. At that point any position held in the direction of the original trend should
be reversed—or at least closed out—at a limited loss. Profits are not limited be-
cause whenever a trend, once established, continues in a sustained fashion with-
out giving any evidence of trend reversal, the trend following principle requires a
market position be maintained as long as the trend continues.13
A big reason this conceptually works is seen in the wonky-sounding Bayesian
statistics. Named for Thomas Bayes (1701–1761), the belief is the true state of the
world is best expressed in probabilities that continually update as new unbiased
information appears, like a price trend that keeps updating and extending. New
data stays connected to prior data—think of it chain-ganged together. Random dice
rolls this is not.
Trend following thus aims to capture the majority of a connected market trend up
or down for outsized profit. It is designed for potential gains in all major asset
classes—stocks, bonds, metals, currencies, and hundreds of other commodities.
However straightforward the basics of trend following, it is a style of trading widely
misunderstood by both average and pro investors, if it is known at all. Academic
literature and real-world investors, for example, have put forth a host of strategies
that, on the surface, appear unique, but at a high level they are all related to trend following.14
That classic trend wisdom has long failed to be understood in academic circles—
that is, until very recently. Notable voices in the academic community have come
around to agree momentum exists—the source of trend following profit—but to
confuse matters they describe two forms of momentum: time series momentum
(i.e., trend following) and cross-sectional momentum (i.e., relative strength). I
don’t see a connection between the two, and I can guess carving out business and
academic niches for assorted reasons is in play, but I do know which strategy has
produced decades of real performance proof, and it’s trend following.
The desire to enlighten this state of confusion is what launched my original re-
search and ignited my passion, going all the way back to 1994. My plan was to be
as objective as possible, pulling research data from wide sources:
•Month-by-month trend following performance histories.
•Hundreds of interviews conducted with subjects from top traders to
Nobel Prize winners.
•Published interviews from dozens of trend followers over the last 50
years—details not found on Google.
•Charts of winning markets traded by trend followers.
•Charts of historical markets seen across financial disasters.
If I could have utilized only data, numbers, charts, and graphs showing extreme
trend following performance data, that would have been perfect—it is, after all,
the raw, unassailable data.
Yet without a narrative explanation few readers would appreciate the ramifications
of data mining. Robert Shiller has said “that there is a narrative basis for much of
the human thought process, that the human mind can store facts around narra-
tives, stories with a beginning and an end that have an emotional resonance. You
can still memorize numbers, but you need stories. For example, the financial
markets generate tons of numbers—dividends, prices, etc.—but they don’t mean
anything to us. We need either a story or a theory, but stories come first.”15
Foundationally, my approach to researching and writing Trend Following became
similar to the one described in the book Good to Great, in which researchers gener-
ated questions, accumulated data in an open-ended search for answers, and then
debated it all—looking for stories, then for explanations that could lead to theories.
However, unlike Good to Great, which was about well-known public companies, to
this day the strategy of trend following is still built around an underground net-
work of relatively unknown traders who, except for the occasional misguided arti-
cle, the mainstream press virtually ignores—and that has not changed in my 20
years. What I attempted with my first edition of Trend Following and with this new-
est edition is to lift the veil on this enormously successful strategy—how trend fol-
lowers trade and what can be learned that anyone can apply to their portfolio for
profit.
Throughout this effort I avoided institutionalized knowledge as defined by Wall
Street banks, brokers and typical long only hedge funds. I did not start with JPMor-
gan Chase or Goldman Sachs. Instead I asked questions across all types of
sources and then, objectively, doggedly, and very slowly—and even through some
Deep Throat help—answers that made intuitive sense were revealed.
If there was one factor that motivated me to work in this manner, it was childlike
curiosity—where you rip the toy open to the find the motor and locate the essence.
For example, one of my earliest curiosities was about who profited when a famed
British bank collapsed, making the front cover of Time magazine. My research
alone unearthed a connection between this bank and a wildly successful trend fol-
lower now worth billions. This trader’s trend-trading track record had me won-
dering, “How did he discover trend following in the first place?”
I also wanted to know who won when a two-billion-dollar hedge fund collapsed and almost sank the entire global economy. Why did the biggest banks on Wall Street,
the so-called smart guys in charge of your retirement, invest $100 billion in this
fund when there was so much obvious risk? Further, when I contrasted typical Wall
Street losses during October 2008 to what trend following made during the same
time in the great zero-sum game, it was hard to grasp why few market players were
aware of the strategy. Other questions appeared:
•How does trend following win in the zero-sum game of trading?
•Why has it been the most profitable style of trading?
•What is the philosophical framework of trend following success?
•What are the timeless principles?
•What is the trend following view of human behavior?
•Why is it enduring?
Many trend followers are still reclusive and extremely low key. One who has beaten
the markets for over 40 years works out of a quiet office in a Florida coastal town.
For Wall Street this approach is tantamount to sacrilege. It goes against all the cus-
toms, rituals, trappings, and myths embedded in so-called success. It is my hope
my narratives, backed by data, will correct misconceptions of winning as a harried,
intense workaholic posted 24/7 in front of 12 monitors while downing Red Bull.
One of my sources who helped break apart this puzzle was Charles Faulkner. He
observed elite traders are almost “floating above the world, seeing it from a dif-
ferent perspective than the rest of other market participants.” His insights go
straight to the core:
•It doesn’t matter what you think; it’s what the market does that matters.
•What matters can be measured, so keep refining your measurements.
•You don’t need to know when something will happen to know that it
will happen.
•Successful trading is a probabilistic business, so plan accordingly.
•There is an edge to be gained in every aspect of your trading system.
•Everyone is fallible, even you, so your system must take this into ac-
count.
•Trading means losing as well as winning, something you must live with
for success.
To adequately explain the genesis of this new edition, I need time travel. You see,
my public trend following persona started in October 1996 with the launch of a
simple four-page website. Armed with a political science degree from George
Mason University, no connection to Wall Street or any fund and with zero aca-
demic respect or PhD credentials, it seemed perfectly appropriate to create the first
trend following website.
And I did.
Loaded with original content, that rudimentary-looking site, turtletrader.com,
generated millions of views, millions of dollars, and— unbeknownst to me at the
time—respect among legions of beginner and professional traders alike.
Six years into that website, I decided it was time for a book—or maybe the book de-
cided it was time for me. Larry Harris, the finance chair at the University of South-
ern California, randomly e-mailed me. He wanted me to review his new book be-
cause I was driving more interest in his whitepaper, The Winners and Losers of the
Zero-Sum Game, than anyone else.
Without skipping a beat I said sure to a review of his book, but asked for an intro-
duction to his publisher, since I was writing a book, too. He obliged and connected
me even though my book at that moment was conceptual.
After two years of starts and stops, Trend Following was finally ready. And when the
first edition hit the streets in April 2004, I had no idea whether it would sell 10 or
10,000 copies. But immediately the book made an under-the-radar splash, landing
in Amazon’s top 100—of all books. In fact, that first edition was so expected to fail
by my first publisher you could only get it online—initially no bookstore. It went on to sell over 100,000 copies with translations into German, Korean, Japa-
nese, Chinese, Arabic, French, Portuguese, Russian, Thai, and Turkish. Its success
led to four more books and the opportunity to direct a documentary film over the
course of 2007 to 2009.
I never expected an obscure trading book first written 13 years ago would lead me
to conversations with five Nobel Prize winners or face-to-face learning from trading
legends Boone Pickens, David Harding, Ed Seykota, and literally hundreds more.
This journey also led me to the world’s top behavioral economists and psychol-
ogists from Daniel Kahneman and Robert Cialdini to Steven Pinker. And it opened
the door to my podcast, which has run since 2012 and now has over five millions
listens. My podcast has further featured guests ranging from Tim Ferriss to paleon-
tologist Jack Horner of Jurassic Park fame—all connected philosophically to trend
following thinking (at least in my mind).
Yet this wild ride has been far more than one-on-one conversations. The serendip-
ity of Trend Following has led me around the world before live audiences in Chica-
go, New York City, Beijing, Hong Kong, Kuala Lumpur, Macau, Shanghai, Singa-
pore, Tokyo, Paris, Vienna, and São Paulo. A speaking gig in front of 1,500 native
German speakers at the Hofburg Palace, the former imperial palace in Vienna, Aus-
tria—that happened.
And it kept going. Audiences with China Asset Management to Singapore’s Sover-
eign Wealth Fund GIC to regular investor audiences with well over a thousand peo-
ple—every-one from new investor to pro who wanted to learn more about trend fol-
lowing, all allowed me to come into their world.
But I recall my first public presentation in support of Trend Following—fall 2004
at Legg Mason’s headquarters in Baltimore, where their chief market strategist had
invited me to lunch. Afterward, I was escorted up a flight of stairs to a nondescript
door. Upon entering the room, I found it filled with young bankers listening to a
speaker. Michael Mauboussin, then Legg Mason’s chief investment strategist, mo-
tioned for me to sit. I instantly recognized the speaker as Bill Miller, then the fund
manager of Legg Mason Value Trust. At the time Miller had beaten the S&P 500
index for 14 straight years—and was easily one of Wall Street’s most successful
and famed players.
Miller then introduced me to the audience. Until that moment I had no idea I was
up next. For the next hour, Miller from one side of the room, and Mauboussin
from the other side, alternately peppered me with questions about trend following,
risk management, and the TurtleTraders.
After the presentation I thanked Miller for the opportunity to make my case, but
wanted to know how he learned about Trend Following. He said, “I surf Amazon for
all types of books. I came across yours, bought it, liked it, and told all my people at
Legg Mason they should read it.”
At that moment I knew Trend Following might be catching on a little—at least in
some very rarified circles. Forget sales—which were very good—I knew that if
Trend Following’s message had struck a chord with Miller, who was not trading as a
trend follower, I might be on to something life changing.
However, now it is time to bring this living work forward to 2017 and a whole new
audience and generation for I have barely dented the broad consciousness of glob-
al investors. Roughly $80 trillion of investable assets sit squarely at the mercy of
EMT inside buy and hold and/or passive index funds with only a quarter of 1 per-
cent of assets in trend following strategies. Almost everyone’s savings and retire-
ment monies are literally a slave to wobbly economic theory that leaves the masses
unprepared for the next smack down.
That slavery is why I have yet again opened up the chest cavity on Trend Following.
Not outpatient surgery to correct typos, but open-heart surgery to add thousands
of details—big picture to minutia that bulk up the original to a new and improved Schwarzenegger-on-steroids edition. For starters, Trend Following is now divided into
three sections:
1.Trend Following’s original chapters and principles, updated and ex-
tended.
2.Trend following interviews (new): Seven interviews from pros illu-
minate trend following’s big picture with the requisite finer details.
3.Trend following research (new): Research contributions that add to
the trend following conversation for average investors, professionals
and scholars.
This is my most radical and extended volume. Content changes and additions are
everywhere. It’s now three books in one. I have added material in a way where you
can take small steps or go for the deep dive—starting on almost any page. The
tone is different, too. Toned down in some areas, toned up in others. Some of my
younger blank and vinegar was expunged and reformulated to a new mature ver-
sion, while staying true to the heart and soul of my origins. Last, some might com-
plain there is too much information, too much content, and I am throwing the
kitchen sink at the subject. If so, I will be happy with that criticism. Guilty as
charged.
Now, if you’re looking for guru secrets or easy money riches—please head on back
to that OxyContin bender. There is no such thing. If you’re in the mood for out-
landish predictions, stories about the ultimate gut trader, or what it’s like to work
inside a Wall Street bank, or if you want to complain life is unfair and beg for the
government to save you with a bailout—no one can help you on your path to irrel-
evance. Or, worse yet, if you maintain faith in EMT, steadfastly refusing to consider
overwhelming contradictory evidence, maybe you can burn me in effigy along with
Bouchaud and Harding. If you fit any of these problematic profiles, there is a good
chance my words, and my politically incorrect perspective, will give you an
aneurysm. Turn me off now.
In the alternative, if you want outside-of-the-box different, the truth of how out-sized
returns are made without any fundamental predictions or forecasts, this is it. And if
you want the honest data-driven proof, I expect my digging will give everyone the
necessary confidence to break their comfort addiction to the box they already know
and go take a swing at making a fortune in bull, bear, and black swan markets.—
Michael W. Covel
Author note: The following quotations appear in the hardcover side
margins.
Nearly every time I strayed from the herd, I’ve made a lot of money. Wandering
away from the action is the way to find the new action.
Jim Rogers
Q: Do you pencil it in first?
A: No, you just start drawing.
Q: But don’t you make mistakes?
A: There is no such thing as a mistake. A mistake is an opportunity to do something
else. You have to leave it and let nature take it course.
Ralph Steadman, British artist best known for his work with American author
Hunter S. Thompson, talking to Anthony Bourdain.
The efficient market theory is about two questions: Can the market be beat and is
the market price the right price? First, evidence says the market can be beat. Second, debating the right or wrong price is futile. There is only the market price and it’s the
most real, objective piece of data in finance. Don’t make the market a morality tale.
Michael Covel
When it is a question of money, everyone is of the same religion.
Voltaire
Proponents of the theory [EMT] have never seemed interested in discordant evidence.
Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not
limited to theologians.
Warren Buffett The Warren Buffett Portfolio 1999
Education rears disciples, imitators, and routinists, not pioneers of new ideas and cre-
ative geniuses. The schools are not nurseries of progress and improvement, but
conservatories of tradition and unvarying modes of thought.
Ludwig von Mises
You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is
double the worst that you have ever seen.
Cliff Asness
Fish see the bait, but not the hook; men see the profit, but not the peril.
Chinese proverb
If you can’t explain it simply, you don’t understand it well enough.
Anonymous
To be aware how fruitful the playful mood can be is to be immune to the propa-
ganda of the alienated, which extols resentment as a fuel of achievement.
Eric Hoffer
The credit bubble pushed the price of most financial assets far from fundamental
value. The central bankers were rigging the market with their asymmetric approach
to market volatility, where Alan Greenspan put a floor under the stock market but
did not cap it with a ceiling. That ensured that the cost of waiting until after the
event to clean up was unacceptably high.16
Question: Some researchers argue that a market timing strategy based on buy/sell
signals generated by a 50- or 200-day moving average offers a more appealing
combination of risk and return than a buy and hold approach. What is your view?
Eugene Fama: An ancient tale with no empirical support.17
I have noticed that everyone who ever told me that the markets are efficient is poor.
Larry Hite
The essence of trend following has been effective beyond my wildest dreams, and for
me it has been more risky to diversify away from it than to embrace it whole-
heartedly.
David Harding
Most big startup breakouts are where people aren’t paying attention.
Bill Gurley18
If you’re chasing the masses, you’re almost certainly heading the wrong direction.
The masses are ignoring you. It’s the weird who are choosing to pay attention, to
seek out what they care about.
Seth Godin
It is necessary for you to learn from others’ mistakes. You will not live long enough to
make them all yourself.
Hyman G. Rickover
The river meanders because it can’t think.
Richard Kenney
“Trend” synonyms: tendency, movement, drift, swing, shift, course, current, direction,
progression, inclination, leaning, bias, bent.
To receive my free interactive trend following presentation send a picture of your re-
ceipt to receipt@trendfollowing.com.
Notes
1. Ernest Shackleton, “Men Wanted (advertisement),” Times, London, 1913.
2. Timothy W. Martin, “What Does Nevada’s $35 Billion Fund Manager Do All
Day? Nothing,” Wall Street Journal, October 19, 2016,
www.wsj.com/articles/what-does-nevadas-35-billion-fund-manager-do-all-day-nothing- 1476887420.
3. Jason Zweig, “Making Billions with One Belief: The Markets Can’t Be Beat,”
Wall Street Journal, October 20, 2016,
www.wsj.com/articles/making-billions-with-one-belief-the-markets-cant-be-beat-1476989975.
4. “Efficient Market Hypothesis,” Wikipedia, last modified December 11, 2016,
https://en.wikipedia.org/wiki/Efficient-market_hypothesis.
5. Jean-Philippe Bouchaud and Damien Challet, “Why Have Asset Price Prop-
erties Changed So Little in 200 Years,” May 2, 2016.
6. Jean-Philippe Bouchaud, “Economics Needs a Scientific Revolution,” Capital
Fund Management, December 1, 2008.
7. David Harding, “Efficient Market Theory: When Will It Die,” Winton Capital
Management, February 2016.
8. “David Harding (financier),” Wikipedia, last modified December 11, 2016,
https://en.wikipedia.org/wiki/David_Harding.
9. Harding, “Efficient Market Theory.”
10. Katie Allen, “Nobel Prize-Winning Economists Take Disagreement to Whole
New Level,” The Guardian, December 12, 2013,
www.theguardian.com/business/2013/dec/10/nobel-prize-economists-robert-shiller-eugene-fama.
11. David Harding, “Efficient Market Theory: When Will It Die,” Winton Capital
Management (February 2016).
12. Van K. Tharp, Trade Your Way to Financial Freedom (New York: McGraw-Hill,
1999).
13. Richard D. Donchian, “Trend-Following Methods in Commodity Price Anal-
ysis,” Commodity Year Book (1957), 35.
14. Ari Levine and Lasse Heje Pedersen, “Which Trend Is Your Friend,” Financial
Analysts Journal 72, no. 3 (May/June 2016).
15. Miles Kimball, “Robert Shiller: Against the Efficient Markets Theory,” Confes-
sions of a Supply-Side Liberal (blog), April 14, 2014,
http://blog .supplysideliberal.com/post/82659078132/robert-shiller-against-the-efficient-markets.
16. John Plender, “A New Paradox Found in Markets Theory,” Financial Times,
December 9, 2012,
www.ft.com/content/8e2ae5b2-3e14-11e2-91cb-00144feabdc0.
17. Eugene F. Fama and Kenneth R. French, “Q&A: Market Timing with Moving
Averages,” Fama/French Forum,
https://famafrench.dimensional.com/questions-answers/qa-market-timing-with-moving-averages.aspx.
18. Eric Johnson, “Benchmark’s Bill Gurley Says He’s Still Worried about a Bub-
ble,” Recode, September 12, 2016,
www.recode.net/2016/9/12/12882780/bill-gurley-benchmark-bubble-venture-capital-s
Section I
Trend Following Principles
1
Trend Following
An object at rest stays at rest and an object in motion stays in motion with the same
speed and in the same direction unless acted upon by an unbalanced force.
—Newton’s First Law of Motion
Speculation is dealing with the uncertain conditions of the unknown future. Every
human action is a speculation in that it is embedded in the flux of time.
—Ludwig von Mises1
Speculation
It might sound pedantic or perhaps that I am focusing on the extraneous, I am
not: A speculator’s ability to receive a price they can count on as fact—is the
foundation of markets. Said another way, with no price, humanity is back to cave-
men beating each other with clubs. Austrian economist Ludwig von Mises puts
price discovery’s value in perspective:
It is the very essence of prices that they are the offshoot of the actions of indi-
viduals and groups of individuals acting on their own behalf. The catallactic
concept of exchange ratios and prices precludes anything that is the effect of
actions of a central authority, of people resorting to violence and threats in
the name of society or the state or of an armed pressure group. In declaring
that it is not the business of the government to determine prices, we do not
step beyond the borders of logical thinking. A government can no more deter-
mine prices than a goose can lay hen’s eggs.3
Although government can’t determine prices in the long run, in the short-term,
government will attempt to directly rig the market system via QE, ZIRP, NIRP, or
whatever acronym sure to follow.
However, speculation is all there is for making choices about those market prices.
Learning how best to speculate using prices is not only a worthy endeavor—it is a
survival-of-the-fittest concept that traces back to the earliest literature of Wall
Street.
From Young America on Wall Street (1857), quoting a French poem about a latter-
day millionaire:
Monday, I started my land operations;
Tuesday, owed millions, by all calculations;
Wednesday, my brown-stone palace began;
Thursday, I drove out a spanking new span;
Friday, I gave a magnificent ball;
Saturday, smashed—with just nothing at all.4
There is nothing wrong with that turn of events. It’s normal. It’s the expected up
and down. Luck is always in play, but so is skill. From The Theory of Stock Exchange
Theory (1874):
A man who wins by haphazard speculation, who chances to operate success-
fully until he has filled his pockets, and retires with his gains from so fasci-
nating an arena, is one in a hundred. Any one who knows anything of Stock Ex-
change speculation will confirm the statement that, to the ordinary run of men,
the game is not worth the candle. There are, however, conditions under which
speculation, in a market where ten or fifty thousand pounds can be lost in half
an hour, may, under given conditions, be systematically practiced profitably.
First, and most important perhaps of all those conditions, is the temperament
of the speculator. When it is known in a market that a great speculator is selling,
weak bulls are speedily frightened out, and when he has such an object in view
it is his game to intimidate with all the force of his prestige and the power of his
capital. Such a man must have a concrete hardness of indifference through
which nothing can penetrate to his heart. It is as necessary to the success of his
operations that he posses no more regard for the feelings or pockets of other
people than a hungry tiger would for him if he were airing himself uncon-
cernedly in a Bengal jungle. He has a purpose in view, just as a surgeon has
when the amputation of a leg has been decided upon. The speculator’s sole aim in the operation is the profit, towards which he cuts his way, regardless of the
nature of the obstacles to be overcome, just as the knife is plunged into the
flesh, severing the arteries, muscles, and sinews that surround the bone, which
it is the object to reach and saw through. For a man to tread a path in which he
must systematically not only disregard the interest of other people, but delib-
erately calculate upon the weaknesses of human nature which characterize the
crowd, in order to work upon them for his own ends, it is obvious that he must
be constituted in a quite exceptional manner, and not in a way that it is at all
desirable others should attempt to imitate. If uninitiated people who enter the
arena in which some of the professional speculators flourish, were to spend
some months in gathering information and in close observance of the modus
operandi, so far as they can get to see and hear, many of them would soon be
persuaded that they were utterly useless at such work, and would retire, thank-
ing their stars. The haphazard man, who is the antithesis of the professional
speculator, will generally be found as differently constituted as are the results of
his operations. The man who makes a study and business of speculating, in-
vestigating every detail that it seems necessary to probe until he has adapted it
to the rest of his machinery, will be found to be a hard-grained man, sailing very
close to the wind, while your persistently haphazard man is mostly a person of
flabby character, and no less flabby mind, as easily frightened off a line that he
has set himself to follow, in the innocence of a heart that expands with a delu-
sive consciousness of possessing power, as a stray rabbit. Such a class of man
is to be found by hundreds in the haunts of the stock markets, and they are al-
ways fidgeting in and out, first as little bulls, and then as little bears, disap-
pearing after a sharp panic like flies from a joint of meat that is rudely disturbed
by the shop-boy, with the important difference that whereas the flies always get
something, the speculators invariably drop their money.5
From How to Win and How to Lose (1883) arguably the first trend-based market
player arrives: “The shrewdest operator ever known on the London Stock Board
was David Ricardo (1772–1823) who amassed an enormous fortune. In advice to a
friend he sums up as the true secret of his success, the rule, every word of which is
golden. ‘Keep down your losses—never let them get away from you. Let your prof-
its take care of themselves.’”6
That precept is huge. Timeless. If you were to put Ricardo into language of modern
day computer science 134 years later you would say, optimal stopping or win-stay,
lose-shift or A/B testing. More clarification from 1883 keeps the focus on taking a
loss: “Speculation is looked upon as being so much more risky than other avoca-
tions cause its results are more sudden and startling, though not one whit more
disastrous. Statistics show that ninety-five out of one hundred men fail in mercan-
tile life. The proportion is not greater among speculators: quicker action is ob-
tained whether it be favorable or unfavorable, and it does not take five or ten years’
time to find that you are playing a losing game.”7
No one is saying that attitude comes naturally. From The Art of Investing (1888):
“Then, in theory, it is so easy to win by speculation! To buy at a low figure and sell
at a higher, or to sell at a high figure and afterward buy at a lower, seems such a
simple operation! It almost looks as if you could go into Wall Street and pick up
money from the sidewalks.”8
Intense study, practice, is the rock solid foundation. From Gold Bricks of Specu-
lation (1904):
Speculation is inherent in the human constitution, and men have a legal and
moral right to speculate, provided they do so reasonably, intelligently and at
their own risks. Reasonable speculation is such speculation as cannot seriously
or permanently affect the resources or position of the persons indulging in it.
Intelligent speculation is such speculation as is indulged in only after a thor-
ough investigation and study of the subject of the speculation. The professional
speculator is in the market not for the purpose of either depressing or raising prices. He is as ready to make money on a rise as on a fall in prices. In either
case he will try to ascertain what the probable tendency of the market is before
he embarks in any undertaking. No speculator or clique of speculators in their
senses would undertake to try to depress prices in the face of a rising market.9
From Investments and Speculation (1911) it’s easy to see free-market capitalism and
less government as optimal:
Call it what you will, speculation will always be with us. Prudes may frown upon
it, superficial thinkers may confuse it with the commonest forms of gambling,
and sociologists may dream of the day when envy, ambition and covetousness
will be a thing of the past and the human race can exist in peace without these
human traits, but their agitations and outcries can no more check speculation
than human ingenuity can devise a scheme to control the tides. What the blood
is to the human body, speculation is to business. It is absolutely a necessary
part of it. The only difference, if there is at all a difference, is in the form it as-
sumes. What would business be without incentive? In fact incentive is all there
is at the bottom of speculation. Men are willing to take risks to acquire wealth.
They are willing to stake their capital upon opportunities, which appeal to their
judgment. From the pioneer who heedlessly plunges into a trackless waste to
find a new home with greater opportunities for the acquisition of wealth, to the
modern capitalist, who, to control the trade in a given commodity, plans gigan-
tic trusts, is a long line of speculators, as speculation is behind all their ambi-
tions. The inventor who is, apparently, of all men the least of speculators, takes
greatest speculative chances, for he uses up time and energy to shape his ideas
into some form where they can be of practical use and should he fail has wasted
them utterly and lost all. Illustration after illustration could be given to demon-
strate how speculation in a greater of less degree enters into the material welfare
of each individual. Without speculation no business could progress. It is the dy-
namic power behind every incentive to activity and progress. It is the desire for
gain, which prompts the inception of every venture. If it is all that, then it can be
readily seen how necessary speculation is. In fact, speculation in its highest
form has shaped the course of history and often changed the map of the world.
Intelligent speculation is no crime. It is not gambling. It is merely pitting human
shrewdness against the uncertainties of the future. For that matter, life itself is a
speculation in which ministers, prudes and agitators hope to avoid sickness
and accident and live their allotted span of life. Between speculation and gam-
bling there is as much difference as there is between night and day. Speculation
commands the exercise of the greatest measure of acumen, where gambling
trusts everything to luck and the turn of a card. Experience has demonstrated far
too convincingly that wherever speculation has been leashed by the iron bonds
of the law, the effect has been almost an immediate stoppage in the material
progress of the country.10
And finally from Psychology of the Stock Market (1912), one year before the Federal
Reserve System was established, the behavioral school comes into focus:
The psychological aspects of speculation may be considered from two points of
view, equally important. One question is: “What effect do varying mental atti-
tudes of the public have upon the course of prices?” “How is the character of
the market influenced by psychological conditions?” A second consideration is:
“How does the mental attitude of the individual trader affect his chances of suc-
cess?” To what extent, and how, can he overcome the obstacles placed in his
pathway by his own hopes and fears, his timidities and his obstinacies?11
This wisdom is clean, clear, and instantly true for those awake. These days, how-
ever, speculation is often positioned as a pejorative among the intelligentsia. While
I enjoy Oliver Stone’s outsider status, his film Wall Street: Money Never Sleeps
(2010) paints speculation quite differently, as his film’s main character Gordon
Gecko profanes, “The mother of all evil is speculation.”12
Stone is not alone in making an enemy out of speculation. New age guru Deepak
Chopra makes the sweeping generalization that “Wall Street is broken for sure be-
cause it succumbed to greed and corruption and pure speculation with no values.”
Wall Street, the phrase, can mean anything. If Chopra is talking big bank bailouts it
is easy to agree with him, but pure speculation practiced honestly is far from value-
less. Politicians, too, love the sport of ripping speculators, an enduring ritual. Unit-
ed States socialist Bernie Sanders was predictable: “I’m not much into specu-
lation.” The character Bobby Axelrod of Billions counters Sanders: “What have I
done wrong? Really? Except make money. Succeed. All these rules and regulations?
Arbitrary. Chalked up by politicians for their own ends.”
Axelrod is of course a fictional, fast and loose day trader built on inside infor-
mation, but his words, words uttered by many an honest man over the millennia,
expose in raw form the hatred inferior minds have toward speculation and rein-
force it as a worthy endeavor—at least for those disconnected from The Matrix.
Winning versus Losing
It is typical the general public equates winning in the markets with abusing the
financial market system—you know the horror stories so I won’t overwhelm you.
However, there are players with the utmost integrity who achieve spectacular re-
turns year after year. Examine their beliefs and self-perceptions and you will under-
stand what keeps them honest. But before you examine their perspectives, take a
moment to consider your own.
For example, at the end of the 1990s or let’s say summer 2007 or even fall 2016 for
that matter, when investors were feeling more secure financially on paper, the you-
know-what hit the fan or was about to, and by the time it was over, they had lost
significant money. They became angry with analysts, experts, brokers, and money
managers whose advice they had guzzled down. Now they know they will not meet
their investment goals or come close to the mythological retirement. They’ve reli-
giously held on to their remaining investments hoping they will eventually turn
around, but 401(k) decisions are paralyzing. They still believe indexing or buying
and holding is the way to go—after all, they’ve been sold that meme for decades.
But now as a final act of desperation, they give up—they rationalize winning as
only dumb luck.
Still others lost even more in October 2008, but, win or lose, they enjoy the thrill in
the hopes of the one trade that makes them rich. Investing gurus, stock tips, and
all of that is their entertainment. Plus they love to boast about their investments—
ego needs attention, after all. Yes, they are depressed and angry when they lose, but
when they win it feels terrific—it’s the heroin-junkie high. Since their main goal is
to invest for quick profits, they will keep doing what they’ve always done. After all,
there was one time a few years ago when a tip made a nice profit they still dream
about.
Stop.
There is a much better way to think: Your approach becomes objective, moving as
close as you can to rational. You have enough confidence in your own decision
making that you never seek out investment recommendations. You’re content to
wait patiently for the right opportunity. And you’re never too proud to buy a stock
making new highs, even all-time highs. For you, investing opportunities are market
breakouts. Conversely, when wrong, you exit immediately, no questions asked. You
view loss as an opportunity to learn, move on, and save money to play another day.
Obsessing on the past is pointless. You approach trading as a business, making
note of what you buy or sell and why in the same matter-of-fact way you balance
your checkbook. By not personalizing your trading decisions, your emotional inde-
cision has the chance to decrease.
The first perspective is that of a market loser; the latter a winner. Don’t be in a
hurry to choose your approach until you know what the choice entails. And look,
don’t be shy about it. You have to want the money. You have to want to get ahead
and be rich—the critics’ condemnation, the player hating, the rank jealousy be
damned. Speculation is not only honorable—it is life. Profit-seeking speculation is
the absolute driving force of markets and without it there is only disintegration.14
Investor versus Trader
Wide swaths of the population think as investors in search of a bargain. However,
if you were to learn the most consistent market winners call themselves traders,
you would want to know why. Simply put, they don’t invest—they trade.
Investors put their money, or capital, into a market, such as stocks or real estate,
with the assumption that value will always increase over time: “I am long and never
wrong!” As value increases, their investment and psychological reinforcement also
increase. But investors have no plan when their value drops. They hold on to their
investment, hoping the value will go back up. Investors succeed in bull markets
and lose in bear markets—like clockwork.
This is because investors have zero plan to respond when losses mount. They al-
ways choose to hang tight and continue to lose. And if mainstream press contin-
ually positions investing as good or safe and trading as bad or risky, average in-
vestors will be reluctant to align themselves with trading. Better to trust the mutual
fund, and government systems, and fall asleep.
A trader, on the other hand, has a defined plan or strategy to put capital to work to
achieve profit. Traders don’t care what they buy or what they sell as long as they
end up with more money than their starting capital. They are not investing in any-
thing. They are trading. It is a critical distinction.
Trader Tom Basso believes a person is a trader whether or not he or she is trading.
Some mistakenly think they must be in and out of the markets every day to call
themselves traders. What makes someone a trader has more to do with their per-
spective on life more than making a given trade. For example, a great trader’s per-
spective must include extreme patience. Like the African lion waiting days for the
right moment to strike its unsuspecting prey, great trading strategy can wait weeks
or months for the right trade with the right odds, and only then pull the trigger.
Additionally, and ideally, traders will go short as often as they go long, enabling
them to make money in both up and down markets. However, many traders won’t
or can’t go short. They struggle with the counterintuitive concept of making money
on market declines. I would hope the confusion associated with making money in
down markets will dissipate, but it won’t. Human nature believes in only up.
Fundamental versus Technical
There are two basic trading theories. The first is fundamental analysis. It is the
study of external factors that affect the supply and demand. Fundamental analysis
uses factors such as Federal Reserve meetings, 24/7 news, weather reports, regu-
latory knowledge, price-earnings ratios, and balance sheet projections to make buy
and sell decisions. By monitoring all fundamentals, one can supposedly predict a
change in direction before that change has been reflected in the price of the mar-
ket, with the belief you can then make money from that knowledge. That means you
can sit around, ponder the viability of Uber’s autonomous car fleet, make your bets
on whatever markets, and the easy bling money rolls in.
The vast majority of Wall Street is fundamental analysis alone. They are the
bankers, academics, brokers, and analysts who always have an opinion or predic-
tion, rain or shine. Many of these Wall Street players have serenaded millions with
fundamental stories for decades. Gullible and naïve investors buy into rosy funda-
mental projections riding bubbles straight up with no clue how to exit. Consider an
exchange with President George W. Bush before the Great Recession:
Question:
“I’m a financial advisor here in Virginia, and I wanted to ask you what your
thoughts are on the market going forward for 2008 and if any of your poli-
cies would make any difference?”
President Bush:
“No (laughter), I’m not going to answer your question. If I were an investor,
I would be looking at the basic fundamentals of the economy. Early on in my
Presidency, somebody asked me about the stock market, and I thought I was
a financial genius, and it was a mistake (laughter). The fundamentals of this
nation are strong. One of the interesting developments has been the role of
exports in overall GDP growth. When you open up markets for goods and
services, and we’re treated fairly, we can compete just about with anybody,
anywhere. And exports have been an integral part, at least of the 3rd quarter
growth. But far be it for me—I apologize—for not being in the position to
answer your question. But I don’t think you want your President opining on
whether the Dow Jones is going to—(laughter)—be going up or down.”
The President’s view is a cardboard cutout of the type of fundamental view shared
by the vast majority of market participants. An excerpt from Yahoo! Finance out-
lining a typical market day is instantly familiar: “It started off decent, but ended up
the fourth straight down day for stocks. Early on, the indices were in the green,
mostly as a continuation from the bounce Monday afternoon, but as the day wore
on and the markets failed to show any upward momentum, the breakdown finally
occurred. The impetus this time was attributed to the weakness in the dollar, even
though the dollar was down early in the day while stocks were up. Also, oil prices
popped higher on wishful thinking statements from a Venezuelan official about
OPEC cutting production. Whether or not these factors were simply excuses for
selling, or truly perceived as fundamental factors hardly matters.”
Millions consume news or fake news drivel such as this every minute, hour, day,
year, and decade. Thousands have watched the likes of CNBC’s Jim Cramer’s Mad
Money show promote similar projections for what seems like decades (actually
back to 2005). But predictions based off fundamental analysis are a crapshoot
guessing game, as you will never know all fundamentals in what has become an
ever-expanding fact and fact-less society.
But instead of helping people to understand news is not at all critical to their
moneymaking decision making, politicians across the globe are gearing up to
stamp out the supposed scourge of fake news. For example, State of California
Assembly member Jimmy Gomez introduced Assembly Bill (AB) 155 in 2017 “to en-
sure that upcoming generations of online readers possess the analytical skills
needed to spot fake news. The bill would direct the Instructional Quality Commis-
sion to develop and adopt curriculum standards and frameworks that incorporate
civic online reasoning, for English Language Arts, Mathematics, History, Social
Science, and Science.”
[Insert your own Orwellian reference.]
Trader Ed Seykota notes across the board cognitive dissonance in play with a sim-
ple story: “One evening, while having dinner with a fundamentalist, I accidentally
knocked a sharp knife off the edge of the table. He watched the knife twirl through
the air, as it came to rest with the pointed end sticking into his shoe. ‘Why didn’t
you move your foot?’ I exclaimed. ‘I was waiting for it to come back up,’ he
replied.”18
Everyone knows an investor waiting for their market to come back, and it often
never does. The financial website Motley Fool has a back-story, a narrative behind
its start that reinforces the folly of fundamental analysis: “It all started with choco-
late pudding. When they were young, brothers David and Tom Gardner learned
about stocks and the business world from their father at the supermarket. Dad, a
lawyer and economist, would tell them, ‘See that pudding? We own the company
that makes it! Every time someone buys that pudding, it’s good for our company.
So go get some more!’ The lesson stuck.”19
The Motley Fools’ David and Tom Gardner’s pudding story is cute, but it’s mis-
leading in design. Their plan gets you in, but it doesn’t get you out or tell you how
much of that pudding stock you should buy. Many low information types believe
that easy to digest narrative. I can only scream inside my head: “Houston, we’ve
got a freaking problem!”
A second market theory, technical analysis, operates in stark contrast to the funny-
mentals. This approach is based on the belief at any given point in time, market
prices reflect all known factors affecting supply and demand. Instead of evaluating
fundamental factors, technical analysis looks at the market prices themselves. But
an understanding of technical analysis can quickly become confusing and contro-
versial. There are essentially two forms of technical analysis. One is based on an
ability to read charts or use indicators to predict market direction.
And predictive technical analysis rightly deserves poignant criticism:
“I often hear people swear they make money with technical analysis. Do they re-
ally? The answer, of course, is that they do. People make money using all sorts
of strategies, including some involving tealeaves and sunspots. The real ques-
tion is: Do they make more money than they would investing in a blind index
fund that mimics the performance of the market as a whole? Most academic
financial experts believe in some form of the random-walk theory and consider
technical analysis almost indistinguishable from a pseudoscience whose predic-
tions are either worthless or, at best, so barely discernibly better than chance as
to be unexploitable because of transaction costs.”21
This is the view of technical analysis held by most who think they know of it—that
it is a form of chart reading, astrology, moon cycle analysis, chart pattern wiggle
feelings, Elliott waves to the first, second, third, fourth, and fifth degree, and—
Barry Ritholtz’s favorite one to skewer—the Death Cross. Big bank equity research
departments add to confusion by asking the wrong question: “The question of
whether technical analysis works has been a topic of contention for over three
decades. Can past prices forecast future performance?”22
It gets worse. Consider a recent Red Alert example from HSBC: “The Head &
Shoulders Top with the neckline acting as resistance comes on top of a potentially
bearish Elliot Wave irregular flat pattern and the fact that the index is now backing
off from the old 2015 highs. A close below 17,992 would be very bearish. Pressure
would ease above 18,449.”23
Good luck with that.
There is a second type of technical analysis that neither predicts or forecasts. This
type is based on reacting to price action, as trend trader Martin Estlander notes:
“We identify market trends, we do not predict them. Our models are kept reactive
at all times.”24
Mebane Faber expands on reaction by noting three criteria are necessary for a
model to be simple enough to follow, yet mechanical enough to remove emotion
and subjective decision making:
1.Simple, purely mechanical logic
2.The same model and parameters for every asset class
3.Price-based only25
Instead of trying to predict market direction (an impossible chore), trend following
reacts to movements whenever they occur. This enables a focus on the actual price
risk, while avoiding becoming emotionally connected with direction, duration, and
fundamental expectations.
This price analysis never allows entry at the exact bottom of a trend or an exit at the
exact top. And you won’t necessarily trade every day or week. Instead, trend fol-
lowing waits patiently for the right conditions. There is no forcing an opportunity
not there. And with this view there are not exact performance goals. Some want a
strategy that dictates, “I must make $400 a day.” The trend following counter is,
“Sure, but what if markets don’t move on a given day?” Trend following works be-
cause you don’t try to outthink it. You are a trend follower, not a trend predictor.26
Discretionary versus Systematic
There are investors and traders, and trading can be fundamentally or technically
based. Further, technical trading can either be predictive or reactive. However, there
is more distinction. Traders can be discretionary or mechanical.
Trader John W. Henry makes a clear distinction between the two strategies: “I be-
lieve that an investment strategy can only be as successful as the discipline of the
manager to adhere to the requirements in the face of market adversity. Unlike dis-
cretionary traders, whose decisions may be subject to behavioral biases, I practice
a disciplined investment process.”27
When Henry speaks of decisions that may be subject to behavioral biases, he is
referring to those who make their buy and sell decisions on fundamentals, the cur-
rent environment, or any number of other whatever factors. It’s a never-ending pa-
rade of data they can supposedly sift through and utilize. In other words, they use
their discretion—hence, the use of discretionary to describe their approach.
Decisions made at the discretion of the trader can be changed or second-guessed
nonstop. These discretionary gut-trading decisions will be colored by personal
bias. I have yet to see a multi-decade track record produced by gut trading. It’s 100
percent fantasy. Many imagine the process is like a fighter pilot strapped into the
cockpit armed with an instinctive feel, or even an innate gift. It’s not that.
Now, a trader’s initial choice to launch a trading system is discretionary. You must
make discretionary decisions such as choosing a system, selecting your portfolio,
and determining a risk percentage (some would argue even these aspects can be
made systematically too). However, after you’ve decided on the system-orientation
basics, you can systematize these discretionary decisions and make them mechan-
ical.
Mechanical or systematic trading systems are based on objective rules. Traders put
rules into computer programs to get in (buy) and out (sell) of a market. A mechan-
ical trading system eliminates emotional vacillation. It forces discipline to stick
with the process. If you rely on mechanical trading system rules, and break them
with discretion, you are guaranteed to go broke.
Henry puts into perspective the downsides of discretionary thinking: “Unlike dis-
cretionary traders, whose decisions may be subject to behavioral biases, we prac-
tice a disciplined investment process. By quantifying the circumstances under
which key investment decisions are made, our methodology offers investors a con-
sistent approach to markets, un-swayed by judgmental bias.”28
Maybe it is rigid to say it’s against the rules to use a little discretion. You might
think, “How boring to live like a CPA.” Where’s the fun if all you ever do is follow a
mechanical model? Successfully making fortunes isn’t about excitement. It’s about
winning. A researcher at Campbell & Company, one of the oldest and most suc-
cessful trend following firms, is adamant: “One of our strengths is to follow our
models and not use discretion. This rule is written in stone at Campbell.”29
Trend trader Ewan Kirk adds:
Systematic trading involves coming up with a statistical model of the markets.
Assuming that model has worked in the past, and that you have developed and
researched and tested your model correctly, then your hypothesis is that it’s
likely to keep working in the future. So the actual execution of trades is just con-
tinuing to follow what the model says. Now that sounds quite mechanical. In
fact, it’s no different than the way any good investor works. Why would you in-
vest with Warren Buffett? Because, over the past 30 years, Warren Buffett has
made money, and you’re assuming that’s going to continue in the future. Con-
ceptually, that’s no different than what we do.31
Traders Todd Hurlbut and Ted Parkhill further note the perils in discretion: “We are systematic. We have seen examples where managers either start to doubt and then
start tinkering so there is what today is called style shift or worse where a manager
dramatically changes the approach to what could be called style ‘flip.’”32
Hiding in Plain Sight
Trend following, and assorted derivatives of price-based trading, is not a new con-
cept. It goes back across names like David Ricardo, Jesse Livermore, Richard Wyck-
off, Arthur Cutten, Charles Dow, Henry Clews, William Dunnigan, Richard Donchi-
an, Nicolas Darvas, Amos Hostetter, and Richard Russell. Believe it or not, it liter-
ally goes back centuries, with data to prove it (see Chapter 19 and 20 in Section III,
“Trend Following Research”).
AQR’s Cliff Asness clarifies: “Historically, it’s been a strategy pursued primarily by
futures traders and in the last 10–20 years by hedge funds. The trading strategy em-
ployed by most managed futures funds boils down to some type of trend following
strategy, which is also known as momentum investing.”33
Even traders not typically associated with trend following eventually find their way.
In Hedge Fund Market Wizards, Jack Schwager asked Ed Thorpe, an American
mathematics professor, author, hedge fund manager, and blackjack player best
known as the “father of the wearable computer,” if he believed “there are trends
inherent in the markets?” Thorpe replied: “Yes. Ten years ago, I wouldn’t have be-
lieved it. But a few years ago, I spent a fair amount of time looking at the strategy.
My conclusion was that it works, but that it was risky enough so that it was hard to
stay with it.”34
Thorpe noted he used trend following, too. And so it goes; price-based trend
strategies discovered by new and old generations at different times. Salem Abra-
ham, now an established trend following veteran, began researching the markets in
his early twenties by asking a simple question: “Who is making money?” His an-
swer was “trend followers” and his journey began.35
Still, not many have made the journey. During the Dot-com era of the late 1990s,
throughout the Fed-induced S&P run-up after March 2009, and even today into
2017, many with zero strategy have made money in other ways, so trend following
becomes a blip on the radar screen—seemingly not so important.
And since trend following has nothing to do with high-frequency trading, short-
term trading, cutting-edge technologies or Wall Street hocus pocus nonsense, its
appeal is universally lost during extraordinary delusions unleashed inside the mad-
ness of crowds—that is, until bubbles pop. Trend following is not sexy until after
the masses get poached and bleed out.
Nonetheless, if you look at how much money trend following has made before,
during, and after assorted market bubbles, it becomes far more relevant to the bot-
tom line of astute market players.
Yet, even when over the top trend following success is thrown onto the table, skep-
tical investors can be tough sells. They might say markets have changed and trend
following no longer works. But philosophically trend following hasn’t changed and
won’t change, even though markets might not always cooperate.
Let’s put change in perspective. Markets behave the same as they did hundreds of
years ago. In other words, markets are the same today because they always
change—humans are involved, after all. This behavioral view is the philosophical
underpinning of trend following. A few years ago, for example, the German mark
had significant trading volume. Then the euro replaced the mark. This was a huge
change, yet a typical one. If you are flexible and have a plan of attack—a solid strat-
egy—mar-ket changes, like changes in life, won’t kill you. Trend followers traded
the mark; now they trade the euro. That’s how to think.
Accepting that inevitability of change is an initial step to understanding. One trend
follower elaborates:
But what won’t change? Change. When a period of difficult performance con-
tinues, however, most investors’ natural conclusion is that something must be
done to fix the problem. Having been through these draw downs before, we know that they are unpleasant, but they do not signal that something is neces-
sarily wrong with the future. During these periods, almost everyone asks the
same question in these exact words: “Have the markets changed?” I always tell
them the truth: “Yes.” Not only have they changed, but they will continue to
change as they have throughout history. Trend following presupposes change. It
is based on change.37
Markets of course are built by design to go up, down, and sideways. They trend or
chop. They flow or don’t. They are consistent, then they surprise. No one accurately
can forecast a trend’s beginning or end until it becomes a matter of record. How-
ever, if your trading strategy is designed to adapt, you can take advantage of
changes:
If you have a valid basic philosophy, the fact that things change turns out to be
a benefit. At least you can survive. At the very least, you will survive over the
long-term. But if you don’t have a valid basic philosophy, you won’t be suc-
cessful because change will eventually kill you. I knew I could not predict any-
thing, and that is why we decided to follow trends, and that is why we’ve been
so successful. We simply follow trends. No matter how ridiculous those trends
appear to be at the beginning, and no matter how extended or how irrational
they seem at the end, we follow trends.38
A valid basic philosophy means a trading strategy that can be defined, quantified,
written down, and measured in terms of numbers. Trend following does not guess
at buys and sells. It knows what to do because valid basic philosophy is codified
into a specific plan for all contingencies.
The Man Group, one of the largest trend following traders, describes the source
behind their profits:
. . . trends as a persistent price phenomenon that stems from changes in risk
premiums—the amount of return investors demand to compensate the risks
they are taking. Risk premiums vary massively over time in response to new
market information, changes in economic environment, or even intangible fac-
tors such as shifts in investor sentiment. When risk premiums decrease or in-
crease, underlying assets have to be priced again. Because investors typically
have different expectations, large shifts in markets result over several months or
even years as expectations are gradually adjusted. As long as there is uncertainty
about the future, there will be trends for trend followers to capture.
Change Is Life
Patrick Welton saw no evidence trend following has devolved. He constructed 120
trend following models. Some were reversal based, and some not. Some were
breakout-style trading systems based on price action, and others relied on volatility
and band-style breakouts. The average holding periods ranged from two weeks to
one year. The results gave almost identical performance characteristics.
Welton addressed head on the misconception that the sources of return for trend
following had changed. He pointed out starting from first principles, it was a fact
the source of return for trend following resulted from sustained market price move-
ments. Human reaction to such events (read: Daniel Kahneman), and the stream
of information describing them, takes time and runs its course unpredictably. The
resulting magnitude and rate of price change could not be reliably forecast. This is
the precise reason why trend following works.40
One fund consultant confronted trend trading skeptics decades before trend fol-
lowing’s huge October 2008 positive returns:
[In the 1980s] on a tour of Germany sponsored by the Deutsche Terminborse,
several advisors and pool operators were making a presentation to a group of
German institutional investors. Among them were two trend-based traders,
Campbell and John W. Henry. During the question-and-answer period, one man
stood and proclaimed: “But isn’t it true that Trend Following is dead?” At this
point, the
moderator asked that slides displaying the performance histories for Campbell
and Henry be displayed again. The moderator marched through the declines,
saying, “Here’s the first obituary for trend-based trading. Here’s the next one
. . . and the next but these traders today are at new highs, and they consistently
decline to honor the tombstones that skeptics keep erecting every time there’s a
losing period.” Campbell and Henry have made their investors hundreds of mil-
lions of dollars since that time. It might, therefore, be a mistake to write yet an-
other series of obituaries.42
Like sunrise, sunset you can always expect a new trend following obituary, obliv-
ious to the data, and rooted in purposeful ignorance, will be written every few years
by an agenda-driven press, EMT defenders, and player haters despite the incredible
amounts of money made by trend following practitioners.
Perplexed at Wall Street’s lack of acceptance, one trend follower sees the danger in
trying to be right: “How can someone buy high and short low and be successful for
two decades unless the underlying nature of markets is to trend? On the other
hand, I’ve seen year-after-year, brilliant men buying low and selling high for a while
successfully and then going broke because they thought they understood why a
certain investment instrument had to perform in accordance with their personal
logic.”43
Trend following trader Paul Mulvaney made the point: “One thing to bear in mind
is that we have made no changes to our trend following strategy since 2005. So in
a way we take the ancient Spartan view that everything that needed to be said about
long-term trend following has already been said.” He continued: “In recent years
our research has focused on execution algorithms—but those are of minor impor-
tance versus the strategic trend following philosophy.”
Here is Mulvaney’s philosophy in performance data format:
Mark Spitznagel, a trader focused on tails and a close associate of Nassim Taleb,
would characterize Mulvaney’s returns as “lumpy” with “extreme asymmetric pay-
offs”—ex-actly how he would refer to his trading world. And whether using Spitz-
nagel’s strategy, or Mulvaney’s go-for-the-gusto high-octane strategy, an oppor-
tunistic plan of attack knows you aim to lose battles, but win the war.
Let me be clear, though: Mulvaney’s track record is but one example for indus-
trious types to go reverse-engineer, to learn step by step how those volatile but
overall up numbers came to be. His performance table is an initial shot across the
bow to bring you into the trend following, month-to-month mindset of no bench-
marks. But trend following is much more than one trend following track record
alone—this strategy has performed consistently for more than a century across an
untold number of traders. And the reasons to explain why markets have tended to
trend more often than not include investors’ behavioral biases, market frictions,
hedging demands, and never-ending market interventions launched by central
banks and governments.44
Follow the Trend to the End When It Bends
In an increasingly uncertain and downright unfriendly world, it is extremely efficient
and effective to base decision making on the single, simple, reliable truth of price.
The 24/7 never-ending fundamental data barrage, such as price-earnings ratios,
crop reports, and economic studies, plays right into the tendency to make trading
more complicated than it need be. Yet by factoring in every possible fundamental
piece of data, which is impossible, you still would not know how much and when
to buy, or how much and when to sell. The truth of price always wins if the debate
is grounded in reason. Price is the only fact.
That said, even if you digest price as the key trading variable, it is not unusual for
traders to focus on only one market—usually individual stocks in their home coun-
try to the exclusion of all other global opportunities. Seeking a maximum degree of
comfort, many follow their one familiar market’s movements faithfully every day.
They never dream of branching out into currencies or futures or coffee or gold. The
idea you could know enough about Tesla and soybeans to trade them the same
might be unfathomable, but think about what cotton, crude oil, Cisco, GE, the U.S.
dollar, the Australian dollar, wheat, Apple, Google, and Berkshire Hathaway all have
in common: price action.
Market prices, traded prices, are the unequivocal objective data reflecting the sum
total of all views. Accepting that truth allows you to compare and study prices,
measuring their movements, even if you don’t know a damn thing about funda-
mentals. You could absolutely look at individual price histories or charts, without
knowing which market is which, and trade them successfully. That is not what they
teach at Harvard or Wharton, but it is the foundation of making millions as a trend
following trader.
Further, don’t try to guess how far a trend will extend. You can’t. You will never
know how high or how low any market might go. Peter Borish, former
second-in-command with Paul Tudor Jones, lays bare the trader’s only concern:
“Price makes news, not the other way around. A market is going to go where a mar-
ket is going to go.”45
The concept of price as the paramount trading signal is too simple for Wall Street
to accept. This confusion or misinformation is seen across the mainstream press
where they always emphasize the wrong numbers. Bill Griffeth, of CNBC, “At some
point, investing is an act of faith. If you can’t believe the numbers, annual reports,
etc., what numbers can you believe?”
He misses the point. It doesn’t matter whether you can or cannot believe an earn-
ings statement. All of those numbers can be doctored, fixed, cooked, or faked. The
traded market price can’t be fixed. It’s the only number you can believe. You can
see it every day. However, this does not diminish confusion. Alan Sloan, a finance
reporter, doesn’t get it: “If some of the smartest people on Wall Street can’t trust
the numbers, you wonder who can trust the numbers.”
I know Sloan is droning on about balance sheets and price-earnings ratios. You
can’t trust those numbers—ever. Bad actors can always alter them. Even if you
knew accurate balance sheet numbers, that info doesn’t necessarily correlate with
buying and selling at the right time.
A critical lesson from an old-pro trend trader:
Political uncertainty is one reason why investment decisions are not driven by
discretionary judgments. How, for example, do you measure the impact of
statements from [central bankers and treasury chiefs]? Even if we knew all the
linkages between fundamentals and prices, unclear policy comments would
limit our ability to generate returns . . . trying to interpret the tea leaves in
Humphrey-Hawkins testimony or the minds of Japanese policy authorities does
not lend itself to disciplined systematic investing. Instead of trying to play a loser’s game of handicapping policy statements, our models let market prices
do the talking. Prices may be volatile, but they do not cloud the truth in market
reactions. Our job is to systematically sift price data to find trends and act on
them and not let the latest news flashes sway our market opinions.46
William Eckhardt, a trend follower and former partner of Richard Dennis (see my
book TurtleTrader), describes how price is to live and die by: “An important feature
of our approach is that we work almost exclusively with price, past and current.
. . . Price is definitely the variable traders live and die by, so it is the obvious
candidate for investigation. . . . Pure price systems are close enough to the North
Pole that any departure tends to bring you farther south.”47
Understanding how a trend follower implements that philosophy is illustrated in
Ed Seykota’s sugar story. He had been buying sugar— thousands of sugar fu-
tures contracts. And every day, the market was closing limit up. Every day, the mar-
ket was going nonstop higher and higher. Seykota kept buying more and more
sugar each day limit up. An outside broker was watching all of Seykota’s action.
And one day the broker called him after the market close, and since he had extra
contracts of sugar that were not balanced out, he said to Seykota, “I bet you want
to buy these other 5,000 contracts of sugar.” Seykota replied, “Sold.”
After the market closes limit up for days in a row, Seykota says, “Sure, I’ll buy more
sugar contracts at the absolute top of the market.” Everybody instinctively wants to
buy sugar on the dip or on the retracement. Let it come down lower they pine. “I
want a bargain” is their thinking—even if the bargain never appears. Trend fol-
lowing works by doing the opposite: It buys higher highs and sells short lower
lows.
Good Traders Confuse Price
The trading histories of Julian Robertson and Louis Bacon, two famed hedge
fund titans, underscore the importance of price for decision making.
After the Dot-com crisis Julian Robertson shut his long-running hedge fund
down. He was a global macro trader who relied on fundamentals for decision
making. Robertson had a close relationship with another global macro trader,
Louis Bacon. Bacon was extremely secretive to the extent that it was nearly
impossible to find out his performance numbers unless you were a client. Al-
though Bacon did not advertise himself as a trend follower, he was focused on
price action:
“If a stock goes from 100 to 90, an investor who looks at fundamentals will
think maybe it’s a better buy. But with Louis [Bacon], he will figure he must
have been wrong about something and get out.” Contrast that, say, with [Julian]
Robertson, who, even after shutting down his firm, was doggedly holding on to
massive positions in such stocks as U.S. Airways Group and United Asset
Management Corp. . . . [Bacon made the comment] in an investor letter that
‘those traders with a futures background are more sensitive to market action,
whereas value-based equity traders are trained to react less to the market and
focus much more on their assessment of a company’s or situation’s
viability.’”49
Every successful trader is a trend follower even if they don’t use the technique,
admit it, or know it.
Trend followers know to pick the trend start is a masochistic exercise. When trends
start they often come from flat markets that don’t appear to be trending any-
where—it’s choppy, up-and-down, trendless, go-nowhere market action. The solu-
tion is to take small bets early to see if the trend will mature and get big enough to
ride.
An executive at trend following pioneer Graham Capital Management clarifies, “The
ability of trend following strategies to succeed depends on two obvious but important assumptions about markets. First, it assumes that price trends occur
regularly in markets. Secondly, it assumes that trading systems can be created to
profit from these trends. The basic trading strategy that all trend followers try to
systematize is to ‘cut losses’ and ‘let profits run.’”50
I asked Charles Faulkner to expand:
The first rule of trading is to, “Cut your losses, and let your profits run.” And
then, that it’s the hardest thing to do. Seldom do any of them wonder why, and
yet this is exactly where the efficient market theory breaks down, and the psy-
chological nature of the markets shows through. When we lose or misplace
something, we expect to find it later. The cat comes back. We find our car keys.
But we know a dollar on the street will not be there with the next person who
passes by. So experience teaches us that losses are unlikely and gains are hard.
“A bird in the hand is worth two in the bush.” This is when I tell them that they
earn their trading profits by doing the hard thing—by going against human na-
ture. This is where the discipline comes in, the psychological preparation, the
months of system testing that give the trader the confidence to actually trade
against his natural tendencies.
If cutting losses and letting profits run is the trend following mantra, it is because
harsh reality dictates you can’t play the game if you run out of money. No money,
no honey! Trend trader Christopher Cruden sarcastically builds the thought: “I
would prefer to finish with a certain currency forecast, based upon my own funda-
mental reading of the market and one that underpins my personal investment
philosophy. . . . The only problem is I can’t tell you when this will happen or
which event will be first. On that basis alone, it seems best to stay with our system-
atic approach.”52
A good example of not letting profits run can be seen in trading strategies that take
profits off the table before the trend is over. For example, one broker told me one
of his strategies was to ride a stock up for a 30 percent gain and then exit. That
was his strategy. Let it go up 30 percent and get out. Sounds reasonable. However,
a strategy that uses profit targets is problematic at a root level. It goes square
against the math of getting rich, which is always without question to let your profits
run. If you can’t predict the end or top of a trend, don’t get out early and risk leav-
ing profits on the table—you will need the biggest winners after all to pay for the
smaller losers.
For example, let’s say you start with $50,000. The market takes off and your ac-
count swells to $80,000. You could, at this point, quickly pull your $30,000 profit
off the table. Your wrong thinking is if you don’t take those profits immediately,
they will be gone.
Trend followers know that a $50,000 account may go to $80,000, back to $55,000,
back up to $90,000, and from there, perhaps, all the way up to $200,000. The per-
son who took profits at $80,000 is not around to take the ride up to $200,000.
Letting your profits run is tough psychologically. But understand in trying to pro-
tect every penny of your profit you never make big profits. Those are the stark
choices for the big boy game.
You are going to have ups and downs in your trading account. Get over it. Losses
are a part of the trading game no matter the strategy. If you want no losses, if you
want positive returns every month, well, you could have had your money with the
Ponzi scheme of Bernard Madoff and his fake monthly 1 percent performance, but
you know how that turned out. You can’t make money if you are not willing to lose.
It’s like breathing in, but not willing to breathe out.53
Think of it this way: If you don’t have losses, you are not taking risks. If you don’t
risk, you won’t ever win big. Losses aren’t the problem. You must always cut them.
Ignore losses with no plan, let them build up, and they will come back to wipe out
your account.
Theoretically, really big losses rarely befall trend following strategy because it elimi-
nates or reverses positions as soon as the market goes against it. The rationale for
hanging in is that any price move could be the beginning of a trend, and the occa-
sional big breakout justifies a string of small losses.54
Surf the Waves
I am fortunate to have learned from trader Ed Seykota starting in 2001 with our first
Virgin Islands meeting, through a 2012 panel with Larry Hite, and up to his 2016
podcast appearance. But early on he told me a story about being in Bermuda with a
new trader who wanted secrets. “Give me the quick-and-dirty version of your mag-
ical trading secrets,” the neophyte beamed.
Seykota took the new trader out to the beach. They stood there watching the waves
break against the shoreline. The newbie asked, “What’s your point?”
Seykota said, “Go down to the shoreline where the waves break. Now begin to time
them. Run out with the waves as they recede and run in as the waves come in. Can
you see how you could get into rhythm with the waves? You follow the waves out
and you follow them in. You follow their lead.”
The truth of trend following is its philosophical underpinnings are relevant not only
to trading, but to life in general, from business to personal relationships. The old-
pro trend followers were clear with me, in their words and actions: Trend following
works best when pursued with the right mindset and unbridled passion.
First, consider the role of proper mindset. As Stanford psychologist Carol Dweck
teaches, “In a fixed mindset, people believe their basic qualities, like their intel-
ligence or talent, are simply fixed traits. They spend their time documenting their
intelligence or talent instead of developing them. They also believe that talent alone
creates success—without effort. They’re wrong. In a growth mindset, people be-
lieve that their most basic abilities can be developed through dedication and hard
work—brains and talent are just the starting point. This view creates a love of
learning and a resilience that is essential for great accomplishment. Virtually all
great people have had these qualities.”55
Second, trading coach and psychologist Brett Steenbarger argues the passion
point: “Find your passion: the work that stimulates, fascinates, and endlessly chal-
lenges you. Identify what you find meaningful and rewarding, and pour yourself
into it. If your passion happens to be the markets, you will find the fortitude to out-
last your learning curve and to develop the mastery needed to become a profes-
sional. If your passion is not the markets, then invest your funds with someone
who possesses an objective track record and whose investment aims match your
own. Then go forth and pour yourself into those facets of life that will keep you
springing out of bed each morning, eager to face each day.”56
In my experience it became crystal clear when used within the context of mindset
and passion, the term trend following can be substituted in this edition for other as-
pects of life. That insight crystallized in a passage from Brenda Ueland’s 1938 book
on creative writing: “Whenever I say writing in this book, I also mean anything you
love and want to do or to make. It may be a six-act tragedy in blank verse, it may be
dressmaking or acrobatics, or inventing a new system of double entry accounting
. . . but you must be sure that your imagination and love are behind it, that you are
not working just from grim resolution, i.e., to impress people.”57
Successful trend followers don’t trade with grim resolve or with the intention to im-
press. They are playing a game to win and enjoying every moment of it. Like other
high-level performers, think professional athletes and world-class musicians, they
understand how critical it is to maintain a winning attitude for success. And as
Larry Hite told me, good trend following traders ask questions:
The first question you have to ask yourself: “who are you?” I’m not kidding. And
don’t look at your driver’s license! But what you got to say to yourself: “What am
I comfortable doing?” Am I an arbitrager? Am I a short-term trader? It is really
important that you understand who you are and what you want to do. The next
thing you have to ask yourself, one of the real details, “What are you going to
do?” What are you going to do exactly? What has to be done? Is it hard to you?
Is it easy? Do you have the materials to do it? One of the great things about the market is the markets don’t care about you. The market doesn’t care what color
you are. The markets don’t care if you are short or tall. They don’t care about
anything. They don’t care whether you leave or stay. The last question you have
to ask yourself: “What follows?” You have to ask yourself, “If I do this and it
works, where am I? What have I got?” Now what I’ve said may really sound like
it’s pretty simple and common sense, [but think about the failed hedge fund
Long-Term Capital Management] those were some very, very smart people
[Nobel Prize winners] who did some pretty stupid things. And they did it be-
cause they didn’t ask themselves the basic questions.
Armed with Hite’s marching orders let’s dive deeper into what it takes for trend fol-
lowing excellence.
Summary Food for Thought
•Galileo Galilei: “All truths are easy to understand once they are discovered;
the point is to discover them.”
•Hendrik Houthakker (1961): “Price changes are not purely random, but
follow certain longer run trends.” Inspired by Benoit Mandelbrot,
Houthakker was an early EMT critic.
•Ed Seykota: “All profitable systems trade trends; the difference in price
necessary to create the profit implies a trend.”
•Prices, not traders, predict the future.
•If you don’t have losses, you are not taking risks. If you don’t risk, you
can’t win anything.
•Price goes either up, down, or sideways. No advance in technology, leap
of modern science, or radical shift in perception will alter this fact.
•What if they told you the best way to get to point B, without bumping into
walls, would be to bump into walls and not worry about it? Don’t worry
about getting to point B, but enjoy bumping into walls.61
•Trend following strategy is not for trading alone. The MIT blackjack team
led by Mike Aponte (podcast episode #22) pursued very similar strategies,
as do venture capitalists like Marc Andreessen. Film producer Jason Blum
also uses an edge-seeking strategy to produce films.
•To receive my free interactive trend following presentation send a picture
of your receipt to receipt@trendfollowing.com.
Author note: The following quotations appear in the hardcover side
margins.
The aim is to make money, not to be right.
Ned Davis
The people that I know who are the most successful at trading are passionate about it.
They fulfill what is the first requirement: developing intuitions about something they
care about deeply, in this case, trading.
Charles Faulkner2
Who will check the ‘fact checkers?’ Who will watch the watchmen?
Anonymous
Too many people simply give up too easily. You have to keep the desire to forge ahead,
and you have to be able to take the bruises of unsuccess. Success is just one long street
fight.
Milton Berle
A study on human behavior shows 90% of the population can be classified into four
basic personality types: Optimistic, Pessimistic, Trusting and Envious. Envious, at 30%,
is the most common.
Universidad Carlos III de Madrid
The free market punishes irresponsibility. Government rewards it.
Harry Browne
The absolute number doesn’t matter, it’s the trend over time.
Seth Godin
Gaslighting is a form of manipulation that seeks to sow seeds of doubt in a targeted individual or members of a group, hoping to make targets question their own memory,
perception, and sanity.
Wikipedia
The joy of winning and the pain of losing are right up there with the pain of winning
and the joy of losing. Also to consider are the joy and pain of not participating. The rela-
tive strengths of these feelings tend to increase with the distance of the trader from his
commitment to being a trader.
Ed Seykota13
If you think education is expensive, try ignorance.
Derek Bok
Nothing has changed during the 21 years [over 40 years now] we’ve been managing
money. Government regulation and intervention have been, are, and will continue to be
present for as long as society needs rules by which to live. Today’s governmental inter-
vention or decree is tomorrow’s opportunity. For example, governments often act in the
same way that cartels act. Easily the most dominant and effective cartel has been
OPEC, and even OPEC has been unable to create an ideal world from the standpoint of
pricing its product. Free markets will always find their own means of price discovery.
Keith Campbell15
He who lives by the crystal ball will eat shattered glass.
Ray Dalio
Whenever we get a period of poor performance, most investors conclude something must
be fixed. They ask if the markets have changed. But trend following presupposes change.
John W. Henry16
With the possible exception of things like box scores, race results, and stock market tab-
ulations, there is no such thing as objective journalism. The phrase itself is a pompous
contradiction in terms.
Hunter S. Thompson
One of our basic philosophical tendencies is that change is constant, change is random,
and trends will reappear if we go through a period of non-trending markets. It’s only a
precursor to future trends and we feel if there is an extended period of non-trending mar-
kets, this really does set up a base for very dynamic trends in the future.
Research at John W. Henry17
Our ace in the hole is that the governments usually screw things up and don’t maintain
their sound money and policy coordination. And about the time we’re ready to give up
on what usually has worked, and proclaim that the world has now changed, the govern-
ments help us out by creating unwise policy that helps produce dislocations and trends.
Jerry Parker20
Ultimately, it is the dollar-weighted collective opinion of all market participants that
determines whether a stock goes up or down. This consensus is revealed by analyzing
price.
Mark Abraham
Now walking into client meetings we hardly ever have a discussion around why trend following works—the battle has been won.
Anthony Todd
It is not the strongest of the species that survive, nor the most intelligent, but the ones
most responsive to change.
Charles Darwin
Investing should be more like watching paint dry or watching grass grow. If you want ex-
citement, take $800 and go to Las Vegas.
Paul Samuelson
The trend is your friend except at the end when it bends.
Ed Seykota30
Defining a trend is like defining love. We know it when we see it, but we are rarely sure
exactly what it is. Fung and Hsieh’s paper goes a long way to doing for trends what
poets have been trying to do for love since time immemorial. They give us a working
model that quantitatively defines their value for us. Traders will not be surprised to
learn that trend following advisors performed best during extreme market moves, espe-
cially during bad months for equities.36
Change is not merely necessary to life—it is life.
Alvin Toffler
If you’re offered a seat on a rocket ship, get on, don’t ask what seat.
Eric Schmidt to Sheryl Sandberg
The people who excel in any field are people who realize that the moment is there to be
seized—that there are opportunities at every turn. They are more alive to the moment.
Charles Faulkner39
The four most expensive words in the English language are: this time it’s different.
Sir John Templeton
They are like surfboard riders, who study the movements of the waves, not in order to
understand why they behave as they do, but simply in order to be on hand whenever
they surge, to catch them at their crest, or as soon thereafter as possible to ride them as
far as they possibly can, and to dissemble before they change direction.
Morton S. Baratz41
Markets don’t move from one state to another in a straight line: There are periods of
countertrend shock and volatility. We spend most of our time trying to find ways to deal
with those unsettling but inevitable events. That being said, it is really not difficult to
put together a simple trend following system that can generate positive returns over a
realistic holding period and there are many, many commercial systems that have been
generating strong, albeit volatile, returns for a long time. So there are definitely firm
grounds for believing in Santa Claus.
Paul Mulvaney
By honest I don’t mean that you only tell what’s true. But you make clear the entire
situation. You make clear all the information that is required for somebody else who is intelligent to make up their mind.
Richard Feynman
Warren Buffett says in the long run the stock market is a weighing machine and in the
short term it is a voting mechanism. He exploits the weighing machine and we exploit
the voting mechanism.
David Harding
Ed Seykota is a genius and a great trader who has been phenomenally successful. When
I first met Ed he had recently graduated from MIT and had developed some of the first
computer programs for testing and trading technical systems. . . . Ed provided an excel-
lent role model. For example, one time, he was short silver and the market just kept
eking down, a half penny a day. Everyone else seemed to be bullish, talking about why
silver had to go up because it was so cheap, but Ed just stayed short. Ed said, “The trend
is down, and I’m going to stay short until the trend changes.” I learned patience from
him in the way he followed the trend.
Michael Marcus48
Be less curious about people and more curious about ideas.
Marie Curie
The wisest trend follower I know has said that every five years some famous trader blows
up and everyone declares trend following to be dead. Then, five years later, some famous
trader blows up and everyone declares trend following to be dead. Then, five years later
. . . was the problem trend following or the trader?
Anonymous
Trend following is similar to being long options because the stop loss creates a limited
downside, and the continuation of the trend creates the large upside. This is why the
phrase for this approach to trading is to cut losses and to let profits run. Of course, if
trends continually fail to materialize, these limited losses can accumulate to large loss-
es. This is also true for any option purchase strategy. For trend followers, the option pre-
mium is paid for after an unsuccessful trade is closed when a stop loss has been reached.
The premium can also be paid after markets have moved a great deal, profits have been
made, and a reversal causes a trailing stop to be hit, and some of the profits reversed.
President, Graham Capital Management51
In Patton, my favorite scene is when U.S. General George S. Patton has just spent
weeks studying the writing of his German adversary Field Marshall Erwin Rommel and
is crushing him in an epic tank battle in Tunisia. Patton, sensing victory as he peers onto
the battlefield from his command post, growls, “Rommel, you magnificent bastard. I
read your book!”
Paul Tudor Jones in George Soros’ The Alchemy of Finance
Bull market babies don’t survive, they revert to the mean.
Michael Covel
I began to realize that the big money must necessarily be in the big swing.
Jesse Livermore
Many people would sooner die than think; in fact, they do so.
Bertrand Russell
Among people who take the trouble to understand what the business is about instead of
assuming it involves speculating on live cattle, it is readily understood.
Campbell & Company58
If you take emotion—would be, could be, should be—out of it, and look at what is, and
quantify it, I think you have a big advantage over most human beings.
John W. Henry59
A trend is a trend is a trend. Gertrude Stein would have said if she were a trader, “Once
you have a game plan, the differences are pretty idiosyncratic.”
Richard Dennis60
Notes
1. Ludwig von Mises, Human Action: A Treatise on Economics (4th rev. ed.) (Irv-
ington-on-Hud-son, NY: The Foundation for Economic Education, 1996).
2. Robert Koppel, The Intuitive Trader (Hoboken, NJ: John Wiley & Sons, Inc.,
1996), 88.
3. von Mises, Human Action.
4. George Francis Train, Young America on Wall Street (London: Sampson Low,
1857), 209.
5. Arthur Crump, The Theory of Stock Exchange Theory (New York: S. A. Nelson,
1903), 50.
6. Albert Williams, How to Win and How to Lose (Chicago: 1883).
7. Ibid.
8. The Art of Investing (New York: Appleton, 1888).
9. John Hill Jr., Gold Bricks of Speculation (Chicago: Lincoln Book Concern, 1904).
10. Louis Guenther, Investments and Speculation (Chicago: La Salle Extension Univ-
ersity, 1910), 121.
11. G. C. Selden, Psychology of the Stock Market (New York: Ticker Publishing Com-
pany, 1912), 12.
12. Wall Street: Money Never Sleeps, directed by Oliver Stone (Los Angeles: 20th
Century Fox, 2010).
13. Jack Schwager, Market Wizards: Interviews with Top Traders (New York: Harper-
Collins, 1993).
14. von Mises, Human Action.
15. Keith Campbell, “Barclay Managed Futures Report,” Barclay Managed Futures
Report 3, no. 3 (third quarter 1992), 3.
16. Allison Colter, “Dow Jones” (July 13, 2001).
17. “Trading System Review” (Futures Industry Association Conference, November
2, 1994).
18. Jack Schwager, Getting Started in Technical Analysis (Hoboken, NJ: John Wiley &
Sons, Inc., 1999).
19. “The History of the Motley Fool,” Fool.com, November 4, 2003.
20. “The State of the Industry,” Managed Account Reports, Inc. (June 2000).
21. John Allen Paulos, A Mathematician Plays the Stock Market (New York: Basic
Books, 2003), 47.
22. “Quantitative Strategy: Does Technical Analysis Work?” Equity Research, Credit
Suisse First Boston (September 25, 2002).
23. Bob Bryan, “RED ALERT—Get Ready for a ‘Severe Fall’ in the Stock Market,
HSBC says,” Business Insider, October 12, 2016,
www.businessinsider.com/hsbc-red-alert-get-ready-for-a-severe-fall-in-the-stock-market-2016-10.
24. Martin Estlander, “Presentation for the Association of Provident Fund of Thai-
land & Partners” (Association of Provident Fund of Thailand & Partners,
Bangkok, February 26, 2015).
25. Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation,” The Jour-
nal of Wealth Management (Spring 2007).
26. Daniel P. Collins, “Kevin Bruce: Improving on a Passion,” Futures (October
2003).
27. “Disclosure Document,” John W. Henry & Company, Inc. (August 22, 2003).
28. Ibid.
29. Carla Cavaletti, “Top Traders Ride 1996 Trends,” Futures (March 1997), 68.
30. Jack Schwager, Getting Started in Technical Analysis (Hoboken, NJ: John Wiley &
Sons, Inc., 1999).
31. Ewan Kirk, “Ewan Kirk of Cantab on Trend Following,” Trend Following (blog),
August 15, 2016,
www.trendfollowing.com/2016/08/15/ewan-kirk-cantab-trend-following/.
32. Mathew Bradbard, “Q&A with Todd Hurlbut and Ted Parkhill for Incline Invest-
ment Management,” RCM Futures—Manager’s Corner,
www.rcmfutures .com/managed-futures/incline-investment.
33. Morningstar, “Interview: Cliff Asness Explains Why He Started a Managed Fu-
tures Fund,” Business Insider, March 5, 2010,
www.businessinsider .com/cliff-asness-new-fund-is-for-wimps-who-cant-handle-the-market-swings-2010-3.
34. Jack Schwager, Hedge Fund Market Wizards (Hoboken, NJ: John Wiley & Sons,
Inc., 2012).
35. Ginger Szala, “Abraham Trading: Trend Following Earns Texas Sized Profits,”
Futures (March 1995), 61.
36. Desmond MacRae, “Valuing Trend-Followers’ Returns,” Managed Account Re-
ports, No. 242 (April 1999), 12.
37. John W. Henry (presentation given to financial consultants, November 17,
2000).
38. John W. Henry (presentation, Geneva, Switzerland, September 15, 1998).
39. Charles Faulkner, Futures 22, no. 12 (November 1993), 98.
40. Patrick Welton, “Has Trend Following Changed,” AIMA Newsletter (June 2001).
41. Morton S. Baratz, The Investor’s Guide to Futures Money Management (Colum-
bia, MD: Futures Publishing Group, 1984).
42. Guest Article, Managed Account Reports 249 (November 1999), 9.
43. John W. Henry (presentation given to financial consultants, November 17,
2000).
44. Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen, “A Century of Evidence on
Trend-Following Investing,” AQR Capital Management (Fall 2014).
45. Peter Borish, “Upstairs/Downstairs Seminar with Tom Baldwin,” Futures Indus-
try Association (1994).
46. “Performance Review,” John W. Henry & Company (February 1999).
47. William Eckhardt, “Tass Twenty Traders Talk,” (presentation, Montreal Ritz
Carlton Hotel, Montreal, Canada, June 29, 1996).
48. Schwager, Market Wizards.
49. Riva Atlas, “Macro, Macro Man,” Institutional Investor Magazine (1996).
50. Robert Murray, “Trend Following: Performance, Risk and Correlation Charac-
teristics” (white paper), Graham Capital Management.
51. Ibid.
52. Christopher Cruden, “Trends in Currency Markets: Which Way the $?” AIMA
Newsletter (June 2002).
53. “The Trading Tribe” (forum response), The Trading Tribe,
www.seykota .com/tribe/.
54. Mary Greenebaum, “Funds: The New Way to Play Commodities,” Fortune
(November 19, 1979).
55. Carol Dweck, “What Is Mindset,” Mindset, accessed December 17, 2016,
http://mindsetonline.com/whatisit/about/.
56. Brett N. Steenbarger, The Psychology of Trading (Hoboken, NJ: John Wiley &
Sons, Inc., 2002), 316–17.
57. Brenda Ueland, How to Write, 10th ed. (New York: Graywolf Press, 1997).
58. Bruce Cleland, “Campbell and Company,” Futures (March 2004): 72.
59. David Whitford, “Why Owning the Boston Red Sox Is Like Running a Suc-
cessful Hedge Fund,” Fortune Small Business (October 25, 2003).
60. “The Whizkid of Futures Trading,” Businessweek, December 6, 1982, 102.
61. Van Tharp, Super Trader: Make Consistent Profits in Good and Bad Markets (New York: McGraw-Hill Education, 2010).
2
Great Trend Followers
Most of us don’t have the discipline to stay focused on a single goal for five, ten, or
twenty years, giving up everything to bring it off, but that’s what’s necessary to
become an Olympic champion, a world class surgeon, or a Kirov ballerina. Even
then, of course, it may be all in vain. You may make a single mistake that wipes
out all the work. It may ruin the sweet, lovable self you were at seventeen. That
old adage is true: You can do anything in life; you just can’t do everything. That’s
what Bacon meant when he said a wife and children were hostages to fortune. If
you put them first, you probably won’t run the three-and-a-half-minute-mile,
make your first $10 million, write the great American novel, or go around the
world on a motorcycle. Such goals take complete dedication.
—Jim Rogers1
The wise and most efficient way to understand trend following is not by only
learning rules that make up the strategy, or by studying behavioral work, but by
reviewing every last detail of the traders who practice it—Anthony Robbins mod-
eling 101. However, many are reluctant to concede they might do better with
mentoring or guidance—even if only from a book. Although they will sign up for
a cooking or language class, and bet their money on social media avatars, they
won’t take advantage of insights from those who have made fortunes. They pre-
fer reinventing the wheel instead of modeling behavior from proven top per-
formers. However, the evidence shows modeling is critical for trend following
success.
Ultimately, I’ve also come to realize through nearly 20 years of research if you
take trend following performance data seriously, you make a choice. You can ac-
cept the data as fact, make an honest assessment of yourself and your approach
to making money, and make a commitment to change. Or you can pretend the
performance of trend following traders doesn’t exist and stay on passive index-
ing autopilot while waiting for the inevitable correction.
Author Tom Friedman sees the immense benefits in thinking wide. He knows
the first step to the contrarian philosophy is that of a generalist:
The great strategists of the past kept forests as well as the trees in view. They
were generalists, and they operated from an ecological perspective. They
understood the world is a web, in which adjustments made here are bound to
have effects over there—that everything is interconnected. Where, though,
might one find generalists today? . . . The dominant trend within universities
and the think tanks is toward ever-narrower specialization: a higher premium
is placed on functioning deeply within a single field than broadly across sev-
eral. And yet without some awareness of the whole—without some sense of
how means converge to accomplish or to frustrate ends—there can be no
strategy. And without strategy, there is only drift.2
The traders I have profiled in Trend Following see the playing field as generalists.
They see what is important and cut the extraneous. Charles Faulkner notes you
must also know you:
Being able to trade your system instead of your psychology means separating
yourself from your trading. This can begin with your language. “I’m in the
trading business” and “I work as a trader” are very different from “I’m a trad-
er” or “I own a few stocks and bonds” (from a major East Coast speculator).
The market wizards I’ve met seem to live by William Blake’s phrase, “I must
make my own system or be enslaved by another’s.” They have made their
own systems—in their trading and in their lives and in their language. They
don’t allow others to define them or their terms. And they are sometimes con-
sidered abrupt, difficult, iconoclastic, or full of themselves as a result. And they know the greater truth—they are themselves and they know what works
for them.
David Harding is a trend following trader not originally profiled in my first edi-
tion. He has established himself as a leader of a new generation of trend fol-
lowers which includes Leda Braga, Cliff Asness, Martin Lueck, Anthony Todd,
Svante Bergström, Gerard van Vliet, Ewan Kirk, Martin Estlander, Zbigniew Her-
maszewski, Natasha Reeve-Gray, and Jean-Philippe Bouchaud.
After Harding, I reintroduce all the legendary trend following pros. They provide
timeless insights, motivation and lessons for all aspiring trend following
traders—from the brand new with zero experience to professionals with perhaps
all the wrong experience. There are fantastic lessons from the superstar names,
no doubt, but 100 years from now those names will be different. The names al-
ways change, but trend following strategy endures.
David Harding
David Harding has had rock and roll success as a trend following trader. Today, his
trend following fund for clients exceeds $30 billion in assets, give or take a billion
or two to the upside. He had a long stretch where his firm made 20 percent a year,
but has dropped some with his explosion of assets under management.
Born in London and reared in Oxfordshire, Harding was always interested in in-
vesting— result of his father’s influence, a horticulturalist who enjoyed betting on
the markets. His mother by comparison was a French teacher. As a young man he
had a natural inclination for science and quickly found a way to put the talent to
use. Early in his career he took a job at Sabre Fund Management where he de-
signed trading systems. Soon thereafter he met Michael Adam and Martin Lueck.
The trio went on to launch Adam, Harding, and Lueck (AHL) a trend following firm
managing money for clients. In a few years the Man Group bought AHL out and
built its trend following firm and systems into a monster with billions under
management.3 Harding, while wealthy from the sale, knew much of Man Group’s
success was built around his trading systems. But he wanted more than to rest on
his buyout winnings, and over time built his new firm Winton Capital into a jugger-
naut. All that success comes with a certain philosophical underpinning. But before
jumping into his philosophy, consider his performance (see Table 2.1):
TABLE 2.1: Monthly Performance Data for Winton Futures Fund (%)
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Year
²⁰¹⁶
3.51%
1.76%
−2.92%
−1.49%
−1.64%
5.21%
0.73%
−1.72%
−0.30%
−2.64%
−1.23%
−1.06%
²⁰¹⁵
2.89%
−0.01%
2.04%
−3.24%
0.11%
−3.15%
3.90%
−4.27%
3.47%
−1.42%
3.44%
−1.58%
1.72%
²⁰¹⁴
−2.04%
2.29%
−0.57%
1.81%
1.92%
0.18%
−2.09%
3.98%
−0.39%
3.55%
5.28%
0.64%
15.23%
²⁰¹³
2.27%
−0.35%
2.06%
3.05%
−1.85%
−2.18%
−1.18%
−2.92%
3.09%
2.77%
2.70%
0.52%
7.98%
²⁰¹²
0.66%
−0.80%
−0.66%
0.02%
0.06%
−3.39%
4.32%
−1.15%
−2.25%
−2.55%
1.18%
1.51%
−3.24%
²⁰¹¹
0.11%
1.62%
0.20%
3.06%
−2.22%
−2.55%
4.64%
1.55%
0.20%
−2.35%
0.94%
1.54%
6.68%
−2.51%
2.29%
4.64%
1.58%
1.46%
4.92%
0.84%
2.62%
3.89%
²⁰¹⁰
−0.85%
−2.83%
−2.23%
14.27%
²⁰⁰⁹
0.92%
−0.32%
−1.78%
−3.08%
−2.08%
−1.31%
−1.55%
0.31%
2.73%
−1.54%
5.01%
−2.53%
−5.38%
²⁰⁰⁸
3.92%
8.21%
−0.92%
−0.97%
1.95%
5.22%
−4.66%
−3.09%
−0.38%
3.65%
4.48%
1.93%
20.25%
²⁰⁰⁷
4.03%
−6.39%
−4.13%
6.13%
5.04%
1.83%
−1.38%
−0.96%
6.83%
2.38%
2.45%
0.12%
16.13%
²⁰⁰⁶
3.93%
−2.74%
3.88%
5.68%
−3.21%
−1.34%
−0.62%
4.58%
−1.43%
1.43%
3.10%
2.03%
15.83%
²⁰⁰⁵
−5.16%
5.72%
4.70%
−4.03%
6.49%
2.85%
−2.15%
7.66%
−6.50%
−3.02%
7.05%
−4.59%
7.65%
²⁰⁰⁴
2.65%
11.93%
−0.50%
−8.27%
−0.16%
−3.12%
0.88%
2.64%
4.78%
3.37%
6.38%
−0.58%
20.31%
²⁰⁰³
5.30%
11.95%
−11.14%
2.07%
10.18%
−5.85%
−1.15%
0.69%
0.71%
5.46%
−2.68%
10.00%
25.52%
²⁰⁰²
−10.81%
−6.14%
11.44%
−4.66%
−3.80%
7.32%
4.79%
5.48%
7.42%
−7.76%
−1.09%
13.46%
12.86%
²⁰⁰¹
4.58%
0.57%
7.48%
−5.23%
−3.32%
−2.95%
0.72%
0.02%
4.48%
12.45%
−7.56%
−4.02%
5.56%
²⁰⁰⁰
−3.66%
1.75%
−3.13%
1.53%
−0.50%
−1.28%
−4.33%
2.82%
−7.54%
2.50%
7.10%
16.04%
9.72%
¹⁹⁹⁹
−1.51%
3.55%
−4.24%
10.09%
−8.58%
5.31%
−1.93%
−3.64%
−0.16%
−6.13%
13.12%
9.20%
13.24%
¹⁹⁹⁸
1.50%
3.27%
8.02%
−1.48%
8.53%
3.23%
1.35%
11.06%
4.52%
−5.65%
1.18%
9.19%
53.26%
¹⁹⁹⁷
−12.97%
9.96%
8.34%
3.68%
I have had the opportunity to talk with Harding on multiple occasions. He always
comes across as down-to-earth, a hard worker, but also highly competitive. He
wants to win. Harding did not start out with the silver spoon. He worked. To hear
him describe it, he engaged in the sort of deliberate practice that Anders Ericsson
researched:
I worked for a company [early on], and the people who ran that took a very old-
fashioned approach to trading. About 10 people and I spent the first half of
every day drawing about 400 charts by hand. It was very tedious. I did this for
about two years. The act of laboriously updating these charts forces you to
focus in much more minute detail on data than you normally would, and over a
period of time, I became completely convinced the market was not efficient,
contrary to the theory at the time.4 I became convinced that markets weren’t
efficient and absolutely trended. . . . We trade everything using trend following
systems, and it works. By simulation, you come up with ideas and hypotheses,
and you test those. Over the years, what we’ve done, essentially, is conduct experiments. But instead of using a microscope or a telescope, the computer is
our laboratory instrument. And instead of looking at the stars, we’re looking at
data and simulation languages . . . it’s counterintuitive to think in terms of
statistics and probability. It takes discipline and training; it tortures the machin-
ery. People are much better, for instance, at judging whether another person is
cheating in a human relationship. We’re hugely social creatures. We’re keen on
our intuition. But when our intuition is wrong, we’ll still be very resistant to
being corrected. What are traders’ biggest failures about understanding risk?
There’s a human desire to seek spurious certainty. We try to come to a yes-no
answer, one that’s absolute, when the right answer might be neither yes nor no.
People see things in black and white when often they need to be comfortable
with shades of gray.5
Shades of gray are tough medicine to swallow, a tough philosophy to believe down
in your core. No one wants to think that hardcore when it comes to money. You
might want to imagine uniform precision as possible, but if the guys who make the
most money think like Harding, it’s smart to try and think that way, too. At the end
of the day, perhaps the best lessons I took from Harding came from his original
internally published book, The Winton Papers. His decision-making philosophy
should be absorbed before anyone ever puts a dollar to work in the markets:
The aggregate effect of shared mental biases and imitation results in patterns of
behavior, which while they are nonconsistent with Mr. Spock-like, rational deci-
sion-mak-ing or with informational efficiency, are demonstrably systematic. The
market equivalent of these behavioral patterns is trending, whereby prices tend
to move persistently in one direction or another in response to information. The
widespread adoption of investing fashions, like indexation, introduces market
mechanisms, which magnify herding behavior on a large scale.6
Although Harding’s words were written before the events of 2008, his insights
explain the crash that followed. To those who want to learn how to trade, to those
who don’t want to affix blame for down performance, Harding offers a way out. But
he knows his agnostic approach has critics: “Most people believe it doesn’t work
or if it did it soon won’t work. We almost never do anything based on our opinions.
If we do it’s based on opinions about mathematical phenomenon and statistical
distribution, not opinions about Fed policy.”
Summary Food for Thought
•David Harding on EMT: “Economists, academics, modelers, gurus
and geeks need to recognize that though a grand and beautifully sim-
ple theory applying across financial markets may be desirable, it is
most likely impossible.”
•Harding: “… the essence of trend following has been effective beyond
my wildest dreams and, for me it has been more risky to diversify away
from it …”
•Harding: “As the years have unfolded and I have had experience of the
seemingly magical phenomenon of trends, my prejudice in favor of
this unloved and unheralded investment approach has hardened. To a
statistician this is called a Bayesian Philosophy.”
•Harding: “Humans are prone to unpredictable behavior, to overre-
action or slumbering inaction, to mania and panic.”
Bill Dunn
Bill Dunn’s firm made 50 percent in 2002 when the majority of investors were los-
ing big from the Dot-com blowout. The firm made 21 percent in the one month of
October 2008 when most of Wall Street was melting down. And into 2017 the fir-
m’s track record exceeds 40+ years. Dunn Capital performance data is a clear, con-
sistent, and dramatic demonstration of trend following.
Dunn was the original founder and chairman of Dunn Capital Management, Inc. By
his original design the firm has always traded for above average returns. Dunn has
no defined target for return (other than positive). There is nothing in their risk
management that precludes annual returns approaching 100 percent. There is no
policy, for example, if a Dunn portfolio was up 50 percent by mid-year, they would
rest, and dial back for the rest of the year. Further, since 1984 their track record
shows 10 drawdowns in excess of 25 percent (Did you know Warren Buffet has
drawdowns too?). But whatever the level of volatility, this independent, self-
disciplined, and long-term trend follower never deviates from the core strategy:
We have a risk budgeting scheme that certainly was ahead of its time in 1974
and is still—in our opinion—state of the art in [2017].7
It is easy to believe that Dunn Capital adheres to core rules set forth 40 years ago if
you understand sound business principles: “Essentially, whatever you find will be
as true 10 years from now, 20 years from now, 30 or 50 years from now as it is
today and as it was 50 years ago. And if you can put your finger on those truths,
then you’ve made a contribution.”9
Dunn Capital has always believed in order to make money you must live with
volatility. Clients who invest must have absolute no-questions-asked trust in the fir-
m’s decision making. This trend follower has no patience for questions about their
ability to take and accept losses. This “full throttle” approach has proven itself for
40 years, making everyone involved, owners and clients, rich.
The Dunn risk-budgeting scheme or money management is based on objective deci-
sion making. “Caution is costly” could be the motto. At a certain point if they enter
a market and if the market goes down to a point, they exit. To Dunn, trading with-
out a predefined exit strategy is a recipe for disaster.
Dunn Capital’s risk management system enables the firm to balance overall port-
folio volatility—something the average or even professional investor ignores. The
more volatile a market, the less they trade. The less volatile a market, the more they
trade. For Dunn, if risk-taking is a necessary means to potential profit, then posi-
tion sizing should always be titrated to maintain the targeted risk constraint, which
in turn should be set at the maximum level acceptable.
The Dunn system of risk management ensures discipline:
One of our areas of expertise in the risk-budgeting process is how risk is going
to be allocated to say a yen trade and how much risk is going to be allocated to
an S&P trade and what is the optimal balance of that for a full 22 market port-
folio. The risk parameters are really defined by their buy and sell signals so it is
just a matter of how much you are going to commit to that trade so that if it
goes against you, you are going to lose only x percent.12
Extreme Performance Numbers
Like Dunn Capital’s philosophy this chart (Figure 2.1) assumes an in-your-face
attitude and that is not negative. That performance data compares returns if you
had hypothetically invested $1,000 with Dunn and $1,000 with the S&P. It de-
mands a choice—either put your money with Dunn, learn to trend follow your-
self, or pretend trend following does not exist.
FIGURE 2.1: Dunn Capital Management: Composite Performance 1974–2016
Next, consider two charts that reflect different periods of Dunn Capital’s trading
history but tell the same story about their approach. The first one (Figure 2.2) is
a Japanese yen trade from December 1994 to June 1996, where Dunn made a
monumental killing.
FIGURE 2.2: Dunn Capital’s Japanese Yen Trade
Source: Dunn Capital Management
Nineteen ninety-five was obviously a great year for Dunn Capital. And in 2003
Bill Dunn walked through his trend following homerun with an audience that
came away with an invaluable lesson:
This is 18 months of the Japanese yen and as you can see, it went up and
down and there was some significant trends so we should have had an
opportunity to make some money and it turns out we did. Because the WMA
is a reversal system, it’s always in the market, it’s either long or short, trying
to follow and identify the major trends. So while this is the first signal that’s
shown on the chart and is long, we obviously must have been short coming
in to this big rise. The rise was enough to tell us we should quit being short and start being long and it seemed like a pretty smart thing do and after we
saw that big rise up.13
TABLE 2.2: Monthly Performance Data for Dunn Capital Management WMA Pro-
gram 1984–2016 (%)
Dunn Capital is riding the trend up that first big hill of the yen in March 1995.
They are making decisions within the context of their mechanical system. Bill
Dunn continues: “Then we have significant retracement, which caused a short
signal for the WMA program; our model has always incorporated near-term
volatility and this volatility as we went long was far less than the volatility that
was going on when we went short.”14
Bill Dunn summarizes the trade: “Now also because the volatility was very high
here, this rise was not enough to give us a long signal and as a result, we rode
this short position for nearly a year all the way down—where we got a long signal
that was wrong and we reversed and went down to short. Now that was a very,
very good market for our program, but some markets are not so good.”15
The confidence in Bill Dunn’s tone and delivery cannot be replicated in print. I
feel fortunate to have the original tape.
Be Nimble
Bill Dunn, with a straight face after riding a trend to great profit, once noted:
“The recent volatility in the energy complex has been quite exciting and poten-
tially rewarding for the nimble.”16
What does Dunn mean by nimble? They mean they are ready to make decisions
based on market movement. When an opportunity to get on a potential trend ap-
pears, they are prepared. They take the leap. They are nimble when relying on
their system; they react to the Japanese yen move with precise rules because they
trust their trading plan and risk management.
The second chart is the British pound (Figure 2.3) where, unlike the Japanese
yen, the market proved unfavorable for Dunn Capital. It was a whipsaw market,
which is always difficult for trend followers. You can see how they entered and
were stopped out; then entered and were stopped out again. Remember, trend
following doesn’t predict market direction or duration, it reacts—so small losses
are always part of the game. Dunn managed the small losses because the British
pound was only a portion of their portfolio. Their yen trade more than made up
for losses on the British pound trade, because no matter how uncomfortable
others are with that approach, for Dunn, big winners offset small losers in the
long run.
FIGURE 2.3: Dunn Capital’s British Pound Trade
Source: Dunn Capital Management
If you told Bill Dunn his approach made you uncomfortable, he would be blunt:
“We don’t make market predictions. We just ride the bucking bronco.”17
Dunn’s failed British pound trades demonstrate exactly what he means when he
says, “We just ride the bucking bronco.” In hindsight you might ask yourself why
was Dunn Capital trading the British pound if they were losing. The simple an-
swer is they nor anyone else could have predicted whether or not the British
pound would be the next great home run. The real question is, “Do you stay out
of the game because you can’t predict how the game is going to unfold?”
Early Years
Bill Dunn grew up in Kansas City and Southern California. After graduating from
high school, he served three years with the U.S. Marine Corps. In the ensuing
years he received a bachelor degree in engineering physics from the University of
Kansas in 1960 and a doctorate in theoretical physics from Northwestern Univ-
ersity. For the next two years he held research and faculty positions at the Univ-
ersity of California and Pomona College. He then worked for organizations near
Washington, D.C., developing and testing logistical and operational systems for
the Department of Defense. He enjoyed the R&D side of things, but wanted to
go beyond theoretical. The markets became his real world.
Around the age of 35 Dunn got it. He was working out of his home in suburban
Fairfax, Virginia when he came across a newsletter touting a commodity trading
system “which almost sounded too good to be true.” Upon testing, it turned out
to be the case and he set about developing his new system. Using daily data,
Dunn’s original system looked for big trends as defined by a percentage of a
price move from a recent low or high. It traded each market three to five times a
year, automatically reversing if the trend moved in the other direction. Dunn
determined position size by risking 2 percent to 6 percent of equity under man-
agement on each trade.18
It’s not uncommon for long-term trend followers to have trades in place for well
over a year, hence the term long. If you want day-trading insanity or the feeling of
exhilaration in Las Vegas, Dunn Capital is not the firm you should choose as the
trading role model. Following their computerized trading system, Dunn holds
long-term positions in major trends, typically trading only two to five times per
year in each market. Their original system was a reversal system, whereby it is al-
ways in the market either long or short. Dunn notes proudly they have held win-
ning positions for as long as a year and a half.19
Early on Bill Dunn needed more capital to execute his particular plan of attack on
trading. He found it in the person of Ralph Klopenstein. Ralph helped launch
Dunn by giving him a $200,000 house account to manage. Dunn, still a Defense
Department systems analyst, realized his trading hobby would require a whole
lot of other people’s money to properly use his promising system.20
That’s a great lesson: When you stop trying to please others and concentrate on
pleasing yourself you become aware of what you are passionate about in life.
And when that happens, all sorts of supporters come out of the woodwork to
help you achieve your goals. Bill Dunn is serendipity proof positive.
Life inside Dunn Capital
Years back Marty Bergin (podcast episode #525) arranged for me to visit Stuart,
Florida and spend a day at Dunn Capital. In one of those classic small-world sto-
ries Bergin had been my baseball coach when I was 16 in Northern Virginia out-
side Washington D.C. Today, he is the president and owner of Dunn Capital
while Bill Dunn remains chairman emeritus.
Amazingly, their long time office is on a quiet street located off a waterway in the
heart of Stuart, a quiet retirement community 30 miles from West Palm Beach.
There is no grand entrance at Dunn Capital, so after you enter, your only re-
course is to see if anyone is in. It feels more like an accountant’s office than a
high-powered trading firm. In fact, the atmosphere is no atmosphere. Dunn is a
shining example of why location, pretentious offices, and intense activity have
little to do with long-term trading success.
There are not hundreds of employees at Dunn Capital because it doesn’t take
armies to run the fund. Plus, not all employees are traders. One issue to deal
with when running a fund is not necessarily trading, but accounting and regu-
latory concerns. No one at Dunn is tied to screens discretionarily trading. Trades are systematically entered only after an alarm goes off indicating a buy or sell
signal.
Another reason Dunn Capital has less infrastructure is because they have a few
relatively well-chosen clients. In fact, Bill Dunn was fond of saying, “If people
want to invest with me, they know where to find me.” Dunn’s investors benefit
from the fact there is no disconnect between their bottom line as a fund man-
ager and the investor’s bottom line—to wit, trading profits.
Dunn Capital is different than many because they compound absolute returns.
They leave their own money on the table by reinvesting in the fund. As a result,
Dunn’s assets are not only made up of clients, but owners and employees too,
all systematically reinvesting profits over a very long time.
By focusing on profits and incentive fees Dunn Capital makes money only when
the fund (read: clients) makes money. They don’t charge a management fee.
With no management fee, there is no incentive to constantly raise capital. The
only incentive is to make money. If Dunn makes money, the firm gets a portion
of the profits. Compounding, or reinvesting your profits, makes sense if you’re
serious about making money, and Dunn is serious.
In the time I spent with Bill Dunn, Marty Bergin and other staff I was impressed
with their matter-of-fact, no-BS attitude. In fact, the very first time I met Bill Dunn
he was wearing khakis and a Hawaiian shirt, and made it clear while he looked
out over the waterways of Florida, it was his reasoned way or the highway.
No Profit Targets
Dunn Capital doesn’t say, “We want 15 percent a year.” The market can’t be or-
dered to give a trader a steady 15 percent rate of return, but even if it could, is a
steady 15 percent the right way in the first place? If you started with $1,000, what
rate of return would you rather have over a period of three years: +15 percent, +15
percent, and +15 percent or the unpredictable –5 percent, +50 percent, and +20
percent? At the end of three years the first hypothetical investment opportunity
would be worth $1,520 but the second investment would be worth $1,710. The
second one would be a stream of returns representative of a Dunn type trading
style.
You can’t dial in a return for a given year. There are no profit targets that work.
Bill Dunn explained:
We only have two systems. The first system is the one I started with in 1974.
The other system, we developed and launched in 1989. The major strategic
elements of these two models—how and when to trade, how much to buy
and sell—have never changed in almost 30 years. We expect change. None of
the things that have happened in the development of new markets over the
past 30 years strike us as making the marketplace different in any essential
way. The markets are just the markets. I know that is unusual. I know in the
past five years a lot of competitors have purposefully lowered the risk on their
models i.e., they are deleveraging them or trying to mix them with other
things to reduce the volatility. Of course, they have also reduced their
returns.23
He is addressing a critical issue: reducing risk to reduce volatility for nervous
clients. The result is always lower absolute returns. If you remain fixated on
volatility as an enemy, instead of seeing volatility as the source of profit, you will
never get this.
Dunn Capital by definition is very good at using risk management—more com-
monly called money management, or as Van Tharp calls it, position sizing—to
their advantage. In June 2002 Dunn returned 24.26 percent, then followed that
with 14.84 percent for July. By that time he was up 37 percent for the same year in which buy-and-holders of the NASDAQ for this period were crushed. Dunn Cap-
ital finished 2002 up more than 50 percent. Their 2008 performance was huge
again—a big up year when most of the world was collapsing.
How does Dunn do it:
•Cuts losses.
•Never changes core strategy: Dunn Capital’s performance is not a re-
sult of human judgment. Their trend following is quantitative and
systematic with no discretionary overrides of system-generated trade
signals. This is foreign to those who watch CNBC for stock tips.
Dunn’s trading style doesn’t drift.
•Long-term holding: For holding periods of approximately 3.75 years
and beyond, all returns are positive for Dunn Capital. Lesson? Stay
with a system for the long haul and do well.
•Compounding: Dunn Capital compounds relentlessly. The firm plows
profits back into their trading system and builds upon fresh gains.
•Recovery: Dunn Capital had losing years of 27.1 percent in 1976 and
32.0 percent in 1981, followed by multi-year gains of 500 percent and
300 percent, respectively. You must be able to accept drawdowns
and understand that recovery is around the corner.
•Going short: Dunn Capital goes short as often as he goes long. Buy-
and-holders generally never consider the short side. If you are not bi-
ased to trend direction, you can win either way.
Dunn Capital has had its share of drawdowns, but their approach remains clear
and calm: “Some experience losses and then wait for gains, which they hope will
come soon . . . But sometimes they don’t come soon and sometimes they don’t
come at all. And the traders perish.”25
Nevertheless, don’t think for a second you are not going to suffer drawdowns,
either by trading like Dunn Capital or letting them manage your money. And
drawdowns—a.k.a. your account going down—will make you feel like you need
an extra dose of Prilosec.
There are great lessons to be learned from Dunn Capital’s performance data, but
I found insight in their writings as well26:
1.As global monetary, fiscal, and political conditions grow increas-
ingly unsustainable, the trend following strategy that Dunn Capital
steadfastly employs may possibly be one of the few beneficiaries.
2.The only thing that can be said with certainty about the current state
of the world economy is that there are many large, unsustainable
imbalances and structural problems that must be corrected. Per-
haps the equity markets are correctly predicting a rapid return to
more stable and prosperous times. Perhaps not. Regardless, there
seems to be more than ample fodder for the creation of substantial
trends in the coming months.
3.On the truly bright side, it is comforting to know that the opinions
expressed in this letter will have absolutely no bearing on the time-
tested methods that Dunn Capital uses to generate trading profits
and manage risk.
I love that even though Bill Dunn, Marty Bergin and the firm have strong political
opinions, they know opinions mean zilch when it comes to proper trading. Their
political and economic opinions do not form the basis of when to buy and sell.
These problems prevent clients from seeing Dunn Capital’s perspective:
•Clients usually do not understand trend following’s nature. They
often panic and pull out just before the big move makes a lot of
money.
•Clients may start asking for the trader to change their approach. Al-
though they may not have articulated this directly to the fund man-
ager, they really wanted the trend following strategy customized for them before investing their money in the first place. The manager is
then faced with a difficult decision: Take the client’s money and make
money through management fees (which can be lucrative) or trade
the capital as originally designed. Trading a trend following system as
originally designed is the optimal path in the long run.
There must be a match between trader and client as Bill Dunn noted: “A person
must be an optimist to be in this business, but I also believe it’s a cyclical phe-
nomenon for several other reasons. In our 18 years [40+ now] of experience,
we’ve had to endure a number of long and nasty periods during which we’ve
asked ourselves this same question. In late 1981, our accounts had lost about 42
percent over the previous 12 months, and we and our clients were starting to
wonder if we would ever see good markets again. We continued to trade our
thoroughly researched system, but our largest client got cold feet and withdrew
about 70 percent of our total equity under management. You guessed it. Our
next month was up 18 percent, and in the 36 months following, their withdrawal
of our accounts made 430 percent!”27
Check Your Ego
Dunn Capital once posted a want ad that caught my eye. Part of it read: “Candi-
dates . . . must NOT be constrained by any active non-compete agreement and
will be required to enter into a confidentiality and non-compete agreement. Only
long-term, team players need apply (no prima donnas). Salary: competitive base
salary, commensurate with experience, with bonus potential and attractive bene-
fits, beginning at $65,000.”28
Notice that Dunn Capital says, “No prima donnas.” Readers of this ad can
choose either to work for Dunn or attempt to be Dunn on their own, but they
cannot have both. Trend following demands taking personal responsibility for
one’s actions, and Dunn Capital makes it clear they are responsible.
An interesting trait seen in many trend followers is their honesty. If you listen
closely to their words and review their performance, they tell you exactly what
they are doing and why. Dunn Capital is a great example in action.
Summary Food for Thought
•Dunn Capital’s performance data is one of the clearest, most consis-
tent, and dramatic demonstrations of trend following success available.
•Originally, Dunn Capital’s designed risk was a 1 percent chance of a 20
percent or greater loss in a given month. In January 2013 Dunn Imple-
mented an Adaptive Risk Profile. Dunn’s VaR target is no longer static.
Now the firm targets a dynamic monthly VaR between 8–22 percent
based on market conditions. Dunn recalibrates its portfolio daily to
gear the risk to what it measures as the favorability of markets to trend
following. The average monthly VaR going forward should be about 15
percent, which translates into an annualized volatility of ∼23 percent
over time.
John W. Henry
Since my first edition, John W. Henry has retired to his hobbies as owner of the
Boston Red Sox and the Liverpool Football Club. His current net worth of $2.2 bil-
lion started with trading—because let’s face it owning those teams required capital.
Guess where he got the money to buy? Trend following. And given the time-
lessness of his wisdom, investors will improve their financial condition by con-
sidering John W. Henry’s trading career.
Interestingly, the early performance data of Dunn Capital and John W. Henry shows
them to be trend followers cut from similar cloth—high octane. They are both
astonishingly successful self-made men who started without formal association to
Wall Street. They developed trading systems in the 1970s that made them millions
of dollars. Their correlated performance data showed they both traded for absolute
returns and often traded in the same trends at the same time.
Henry captured some of the great trends of his generation. By all available evidence
Henry was on the other side of the Barings Bank blowout in 1995. In the zero-sum
game, he won what Barings Bank lost. In 2002, Henry was up 40 percent while the
NASDAQ was spiraling downwards. He, like Dunn, didn’t have a strategy that
could be remotely considered “active” or “day trading,” but when his trading sys-
tem told him, “It’s time,” he literally blew the doors off the barn with spectacular
returns in short order. Did he have down years? Yes, from time to time, but he was
right there again making huge money in 2008 when everyone else was losing.
Also, as the owner of the Boston Red Sox, Henry applies the basic tenets of trend
following—simple heuristics for decision making, mathematics, statistics, and
application of a system—to the world of sports.
Prediction Is Futile
Henry was always blunt about prediction fantasies:
I don’t believe that I am the only person who cannot predict future prices. No
one consistently can predict anything, especially investors. Prices, not in-
vestors, predict the future. Despite this, investors hope or believe that they
can predict the future, or someone else can. A lot of them look to you to pre-
dict what the next macroeconomic cycle will be. We rely on the fact that other
investors are convinced that they can predict the future, and I believe that’s
where our profits come from. I believe it’s that simple.
Because trend following is primarily based on a single piece of data—the price—
it is difficult to paint the true story of what that means. Henry was always able to
articulate clearly and consistently how he traded, year after year, to those willing
to listen carefully. To generate his profits, he relied on the fact other traders
thought they could predict where the market will go and often ended up as
losers. Henry would tell you that he routinely won the losses of the market
losers in the zero-sum trading game.
On the Farm
John W. Henry was born in Quincy, Illinois, to a successful farming family. For a
Midwestern farm boy in the 1950s, there was nothing in the world like baseball,
and from the time nine-year-old Henry went to his first major league game, he
was hooked. In the summer he would listen to the great St. Louis Cardinals
broadcaster Harry Caray night after night. Henry described himself as having
average intelligence, but a knack for numbers. And like many young baseball
fans, he crunched batting averages in his head.
Henry attended community colleges and took numerous night courses, but
never received his college degree. It wasn’t for lack of interest, however. When he was attending a class taught by Harvey Brody at UCLA, they collaborated on
and published a strategy for beating blackjack odds. When his father died, Henry
took over the family farms, teaching himself hedging techniques on the side. He
began speculating in corn, wheat, and soybeans. And it wasn’t long before he
was trading for clients. In 1981, he founded John W. Henry and Company, Inc. in
Newport Beach, California.31
Henry’s first managed account was staked with $16,000 and he now owns the
Boston Red Sox. Don’t you think the best question to ask is, “How?” A former
president at his trading firm speaks to their success:
There has been surprisingly little change. Models we developed 20 years ago
are still in place today. Obviously, we trade a different mix of markets. We’ve
also added new programs over the last 20 years, but relative to many of our
peers, we have not made significant adjustments in our trading models. We
believe that markets are always changing and adjusting, and the information
that’s important to investors will also change. In the 1980s, everyone was
interested in the money supply figures . . . everyone would wait by their
phones until that number came out. In the 1990s, the information du jour
was unemployment numbers. But people’s reactions to the markets are fairly
stable. Uncertainty creates trends and that’s what we’re trying to exploit. Even
if you have better and faster dissemination of information, the one thing we
haven’t really improved is people’s ability to process information. We’re try-
ing to exploit people’s reaction, which is embedded in prices and leads to
trends. These reactions are fairly stable and may not require major adjust-
ments of models.32
He reiterates an important philosophical tenet of trend following: In looking at
the long-term, change is constant. And because change is constant, uncertainty
is constant. And from uncertainty, trends emerge. It is the exploitation of these
trends that forms the basis of trend following profit. All of your cutting-edge
technology or news reading is not going to help you trade trends.
When I spoke with Henry’s president, he sounded like classic traders from 100
years earlier:
•“We stick to our knitting.”
•“Most people don’t have the discipline to do what they need to do.”
•“We like to keep it sophisticatedly simple.”
•“Our best trading days are when we don’t trade.”
•“We make more money the less we trade.”
•“Some of our best trades are when we are sitting on our hands doing
nothing.”
•“We don’t want to be the smartest person in the market. Trying to be
the smart person in the market is a losing game.”
He was not being flippant. His tone was matter of fact. He wanted people to
understand why his firm succeeded. A few years ago he gave a great analogy
about the emotional ups and downs: “Looking at the year as a mountain ride
. . . Anyone who has ridden the trains in mountainous Switzerland will remem-
ber the feeling of anxiety and expectations as you ascend and descend the
rugged terrain. During the decline, there is anxiety because you often do not
know how far you will fall. Expectations are heightened as you rise out of the val-
ley because you cannot always see the top of the mountain.”33
Worldview Philosophy
Trend followers like Henry could not have developed his trading systems with-
out first deciding how he was going to view the world. Through experience,
education, and research, he came to an understanding of how markets work be-
fore he determined how to trade them. What he found was market trends are more pervasive than people think, and trends could have been traded in the
same way 200 years ago as they are today.
Henry spent years studying historical price data from the eighteenth and nine-
teenth centuries in order to prove his research. When he explained his philos-
ophy he was crystal clear about what it was and what it was not:
•Long-term trend identification: Trading systems ignore short-term
volatility in the attempt to capture superior returns during major
trending markets. Trends can last as long as a few months or years.
•Highly disciplined investment process: Methodology is designed to
keep discretionary decision making to a minimum.
•Risk management: Traders adhere to a strict formulaic risk manage-
ment system that includes market exposure weightings, stop-loss
provisions, and capital commitment guidelines that attempt to pre-
serve capital during trendless or volatile periods.
•Global diversification: By participating in more than 70 markets and
not focusing on one country or region, they have access to opportu-
nities that less diversified firms may miss.
The uninformed dismiss trend following as predictive technical analysis. Henry
was not a predictive indicator guru: “Some people call what we do technical
analysis, but we just identify and follow trends. It’s like, if you are in the fashion
world, you have to follow trends, or you’re yesterday’s news. But as with tech-
nical analysis, trend followers believe that markets are smarter than any of their
individual participants. In fact, they make it their business not to try to figure out
why markets are going up or down or where they’re going to stop.”36
Henry’s use of fashion as a metaphor goes beyond obvious comparison be-
tween trends in clothing and in markets. To be fashionable you have no choice
but to follow trends. Likewise, trend followers have no choice but to react and
follow trends, and like those who follow fashion early, successful trend followers
exploit trends long before the public is clued in.
Trend followers would agree with H. L. Mencken when he said, “We are here and
it is now. Further than that, all human knowledge is moonshine.” They under-
stand attending to what is taking place in the market from moment to moment
isn’t a technique; it is what is and that is all. The moment, the here and now, is
the only place that is truly measurable.
Henry illustrated the point in a coffee trade: “All fundamentals were bearish: The
International Coffee Organization was unable to agree on a package to support
prices, there was an oversupply of coffee, and the freeze season was over in
Brazil . . . his system signaled an unusually large long position in coffee. He
bought, placing 2 percent of the portfolio on the trade. The system was right.
Coffee rallied to $2.75 per lb. from $1.32 in the last quarter of the year, and he
made a 70 percent return. ‘The best trades are the ones I dislike the most. The
market knows more than I do.’”37
What You Think You Know Gets You in Trouble
Henry knew the complicated, difficult elements of trend following were not
about what you must master, but what you must eliminate from your market
view.
On why long-term approaches work best:
“There is an overwhelming desire to act in the face of adverse market moves.
Usually it is termed ‘avoiding volatility’ with the assumption that volatility is bad.
However, I found avoiding volatility really inhibits the ability to stay with the
long-term trend. The desire to have close stops to preserve open trade equity has
tremendous costs over decades. Long-term systems do not avoid volatility; they
patiently sit through it. This reduces the occurrence of being forced out of a position that is in the middle of a long-term major move.”38
On stocks: “The current thinking is that stocks have outperformed everything
else for 200 years. They may have a little relevance for the next 25 years. But
there is no one in the year 2000 that you can convince to jettison the belief that
200 years of performance will not cause stocks to grow to the sky. Right now
people believe in data that supports the inevitable growth in prices of stocks
within a new landscape or new economy. What will be new to them is an in-
evitable bear market.”40
For all his talk about avoiding predictions, Henry is making one here. He is pre-
dicting stocks can’t go up forever because eventually trends reverse themselves.
He is also pointing out that as a trend follower he was prepared to take action
and profit (which he did during the market crash of October 2008).
Starting with Research
Henry has influenced many traders. One of his former associates presented
these observations in his new firm’s marketing materials:
•The time frame of the trading system is long-term in nature, with the
majority of profitable trades lasting longer than six weeks and some
lasting for several months.
•The system is neutral in markets until a signal to take a position is
generated.
•It is not uncommon for markets to stay neutral for months at a time,
waiting for prices to reach a level that warrants a long or short posi-
tion.
•The system incorporates predefined levels of initial trade risk. If a
new trade turns quickly unprofitable, the risk control parameters in
place for every trade will force a liquidation when the preset stop-loss
level is reached. In such situations, a trade can last for as little as one
day.
This same employee participated in a conference seminar while at Henry’s firm.
The conference was sparsely attended and, as happens when someone speaks to
a small audience, the conversation became more informal and more revealing:
We are very well aware of the trends that have taken place in the last 20 years
and we are just curious to see are we in a period in this century that trend fol-
lowing seems to work? Have we lucked out that we happen to be in this
industry during trends for the last decade or two? We went back to the 1800s
and looked at interest rates, currency fluctuations, and grain prices to see if
there was as much volatility in an era that most people don’t know much
about as there has been this decade. Much to our relief and maybe also sur-
prise, we found out that there were just as many trends, currencies, interest
rates, and grain prices back in the 1800s as there has been exhibited this last
decade. Once again, we saw the trends were relatively random, unpredictable,
and just further supported our philosophy of being fully diversified, and don’t
alter your system to work in any specific time period.
He added:
Hours and hours were spent in the depths of the university library archives.
They gave us Xerox burns on our hands, I think, photo-copying grain
prices, and interest rate data—not only in the U.S., but also around the world.
We looked at overseas interest rates back to that time period. A lot of it is a
little bit sketchy, but it was enough to give us the fact that things really
jumped around back then as they do now.42
It reminded me of the scene in the Wizard of Oz when Toto pulls back the curtain
to reveal how the wizard works his magic. It was clear there were no secret formulas or hidden strategies. There were no short cuts. This was slow,
painstaking trench warfare in the bowels of a research library, armed only with a
photocopier to memorialize price histories.
Years later I was inspired to do my own price research. My objective in the mo-
ment was not to use price data in a trading system, but to see also how little
markets had changed. One of the best places to research historical market data
in newspapers and magazines from over 100 years ago is the U.S. National
Agricultural Library. Don’t be misled by the word Agricultural. You can review the
stacks at this library and spend hours poring over magazines from the 1800s.
Like Henry’s firm, I discovered through weeks of research that markets were in-
deed the same then as now.
On the Record
I had the chance to hear Henry speak in person at a FIA Research Division Din-
ner in New York City years back. This was only months after the Barings Bank
debacle. During the Q&A Henry revealed the qualities shared by all successful
trend followers. He refused to waste time discussing fundamentals and offered a
genuine appreciation of the nature of change:
Moderator:
The question that always comes up for technicians is, “Do you believe the mar-
kets have changed?”
Henry:
It always comes up whenever there are losses, especially prolonged losses. I
heard it, in fact, when I started my career 14 years ago. They were worrying, “Is
there too much money going into trend following?” You laugh, but I can show
you evidence in writing of this. My feeling is that markets are always changing.
But if you have a basic philosophy that’s sound, you’re going to be able to take
advantage of those changes to greater or lesser degrees. It is the same with
using good, sound business principles—the changing world is not going to
materially hurt you if your principles are designed to adapt. So the markets have
changed. But that’s to be expected and it’s good.
Female Voice:
John, you’re noted for your discipline. How did you create that, and how do you
maintain that?
Henry:
Well, you create discipline by having a strategy you really believe in. If you really
believe in your strategy, that brings about discipline. If you don’t believe in it, in
other words, if you haven’t done your homework properly, and haven’t made
assumptions that you can really live with when you’re faced with difficult peri-
ods, then it won’t work. It really doesn’t take much discipline, if you have a
tremendous confidence in what you’re doing.
Male Voice:
I’d like to know if your systems are completely black box.
Henry:
We don’t use any black boxes. I know people refer to technical trend following
as black box, but what you have is really a certain philosophy of trading. Our
philosophy is that there is an inherent return in trend following. I know CTAs
that have been around a lot longer than I have, who have been trading trends:
Bill Dunn, Millburn, and others who have done rather well over the last 20 to
30 years. I don’t think it’s luck year after year after year.
Leda Braga, the most successful female trend follower today, builds on Henry’s
earlier message with comparable timelessness: “We’re actually a white box, the
white of the mind. We are fully auditable. If you are a pension fund with long-term
liabilities, you want some reassurance that the business is sustainable. The hedge
fund business is filled with very talented people, but talented people retire. What formulas or hidden strategies. There were no short cuts. This was slow,
painstaking trench warfare in the bowels of a research library, armed only with a
photocopier to memorialize price histories.
Years later I was inspired to do my own price research. My objective in the mo-
ment was not to use price data in a trading system, but to see also how little
markets had changed. One of the best places to research historical market data
in newspapers and magazines from over 100 years ago is the U.S. National
Agricultural Library. Don’t be misled by the word Agricultural. You can review the
stacks at this library and spend hours poring over magazines from the 1800s.
Like Henry’s firm, I discovered through weeks of research that markets were in-
deed the same then as now.
On the Record
I had the chance to hear Henry speak in person at a FIA Research Division Din-
ner in New York City years back. This was only months after the Barings Bank
debacle. During the Q&A Henry revealed the qualities shared by all successful
trend followers. He refused to waste time discussing fundamentals and offered a
genuine appreciation of the nature of change:
Moderator:
The question that always comes up for technicians is, “Do you believe the mar-
kets have changed?”
Henry:
It always comes up whenever there are losses, especially prolonged losses. I
heard it, in fact, when I started my career 14 years ago. They were worrying, “Is
there too much money going into trend following?” You laugh, but I can show
you evidence in writing of this. My feeling is that markets are always changing.
But if you have a basic philosophy that’s sound, you’re going to be able to take
advantage of those changes to greater or lesser degrees. It is the same with
using good, sound business principles—the changing world is not going to
materially hurt you if your principles are designed to adapt. So the markets have
changed. But that’s to be expected and it’s good.
Female Voice:
John, you’re noted for your discipline. How did you create that, and how do you
maintain that?
Henry:
Well, you create discipline by having a strategy you really believe in. If you really
believe in your strategy, that brings about discipline. If you don’t believe in it, in
other words, if you haven’t done your homework properly, and haven’t made
assumptions that you can really live with when you’re faced with difficult peri-
ods, then it won’t work. It really doesn’t take much discipline, if you have a
tremendous confidence in what you’re doing.
Male Voice:
I’d like to know if your systems are completely black box.
Henry:
We don’t use any black boxes. I know people refer to technical trend following
as black box, but what you have is really a certain philosophy of trading. Our
philosophy is that there is an inherent return in trend following. I know CTAs
that have been around a lot longer than I have, who have been trading trends:
Bill Dunn, Millburn, and others who have done rather well over the last 20 to
30 years. I don’t think it’s luck year after year after year.
Leda Braga, the most successful female trend follower today, builds on Henry’s
earlier message with comparable timelessness: “We’re actually a white box, the
white of the mind. We are fully auditable. If you are a pension fund with long-term
liabilities, you want some reassurance that the business is sustainable. The hedge
fund business is filled with very talented people, but talented people retire. What we do, this effort to articulate the investment process through algorithms, through
equations, through code, means that the intellectual property exists in its own
right. If I disappear tomorrow, it’s fine.”44
As a side note, what that John W. Henry transcript cannot recreate on the page is
the audience reaction. I remember looking around at the Henry fans jammed into
that Wall Street hotel suite and thinking, “Everyone in this room is far more inter-
ested in viewing Henry as a personality—a rock star—instead of knowing what he
does to make money.”
Change Is Overrated
Henry was publicly forthright for years. For instance, his presentation in Geneva,
Switzerland, could have been a semester course in trend following for those
open to the message: “We began trading our first program, in 1981 and this was
after quite a bit of research into the practical aspects of a basic philosophy of
what drives markets. The world was frighteningly different in those days than it is
today when I was designing what turned out to be a trend following system. That
approach—a mechanical and mathematical system—has not really changed at
all. Yet the system continues to be successful today, even though there has been
virtually no change to it over the last 18 years.”45
I can’t help but notice the “we haven’t changed our system” chorus is not only
sung by Dunn, but by Henry and many other trend followers. Consider an exam-
ple of a winning trend for Henry (see Figure 2.4): “We took a position around
March or April 1998 in the South African rand, short (which would be this partic-
ular chart; this is the dollar going up against the rand). You can see it takes time
for these things and if you’re patient, you can have huge profits, especially if you
don’t set a profit objective.”46
FIGURE 2.4: Henry South African Rand Trade
Source: Barchart.com
Moreover, Henry did well in the historical Japanese yen trade shown in Figure
2.5. Henry concluded: “You can see that in this enormous move, when the dol-
lar/yen went from 100 to 80 in that particular month we were up 11% just in the
Japanese yen that quarter.”47
FIGURE 2.6: Hypothetical $1,000 Growth Chart for Campbell & Company
Fade the Fed
Overreaction to Federal Reserve announcements is part of Wall Street life. Some
so-called pros take the Federal Reserve’s words and act on them even if there is
no way to know what any of it means. And does it make logical sense to worry
about what the Fed is going to do if there is no way to decipher it? The Fed to
the best of my knowledge has never offered any statement you could rely on that
says, “Buy 10,000 shares of GOOG now and sell here.”
Henry’s trend following system was never predicated on the Fed’s statements: “I
know that when the Fed first raises interest rates after months of lowering them,
you do not see them the next day lowering interest rates. And they don’t raise
rates and then a few days later or a few weeks later lower them. They raise, raise,
raise, raise . . . [pause] . . . raise, raise, raise. And then once they lower, they
don’t raise, lower, raise, lower, raise, lower. Rather they lower, lower, lower,
lower. There are trends that tend to exist, whether they are capital flows or inter-
est rates . . . if you have enough discipline, or if you only trade a few markets,
you don’t need a computer to trade this way.”48
Henry knows the human mind creates anxiety by conjuring up terrifying future
market scenarios. He kept focused in the present on what he could control—his
system. That attitude for dealing with the Fed never changes, no matter who is
playing the game.
Trading Retirement
John W. Henry shut his trend following firm down in 2012, but most of his as-
sets under management were pulled in 2007 before the financial crisis in October 2008. That meant billions in Merrill Lynch assets left Henry’s firm and
went to other trend following firms (e.g., firms in London). And by the time
2008 unfolded, his money under management had decreased so much that even
his great 2008 performance was not enough.
Many will tell you John W. Henry was simply too volatile for modern tastes
(whatever modern means exactly), and when taking a look at his programs’ track
records, there were big numbers on both sides. Take his Financials & Metals 36
percent annualized volatility for example, or the multiple years with above 40
percent gains or more than 17 percent losses, and you can see that Henry’s
model was one of high risk for high return.49
Not surprisingly, his exit from trend following has left some confused. This 2016
note in my inbox illustrates: “I recently purchased your Trend Following book
(2009 edition) and have been eagerly reading it for the past several days. After
reading about the success of John W. Henry, I decided to look him up and
discovered he had to close his firm a few years ago after experiencing unsus-
tainable losses. In your book, you frequently discuss how time and time again
critics argue that trend following is dead, yet they are consistently proven wrong.
My question is, if trend following is such a reliable strategy, how could one of
the most successful trend followers collapse? In general, I agree with all of the
points you make in your book, but I worry that if someone who is exceedingly
versed in the methods of trend following can lose huge sums of money, then
someone like me, with absolutely no experience using trend following tech-
niques, is also bound to fail.”
Great question. An insider with Henry at the time provided insights instructive
for the confused or skeptical:
•“It is a fallacy to say John W. Henry collapsed.” His clients moved on
to other trend following firms. Firm assets went from over $2 billion
to $150 million in around 1.5 years.
•The firm did not close because of “unsustainable” losses but more
from a re-deployment of his talents and investment capital.
•Big funds are all about “distribution.” That means keeping brokers
happy, as they live and die with commissions. Henry’s peers weath-
ered the storm.
•Competition replaced older firms who did not respond to vagaries of
the brokerage industry. Trend following assets under management
exploded inside several London-based firms (e.g., Winton, Aspect,
Cantab, etc.).
•Henry essentially moved into venture capital. Red Sox Baseball was
not a hobby—it was a business transaction. He also bought Fenway
Park, the broadcasting, the Boston Globe, and Liverpool Football Club
(U.K.). People don’t think of Henry as a venture capitalist, but he be-
came one.
•Henry still trades his own money as a trend follower with “two” of
his original “guys” there.
As an investor you have to dig deep past headline reading. You have to under-
stand all issues associated with any investment—trend following included. And
if you think trend following died because John W. Henry or any other one person
stopped running a trend fund, you may want to ponder a more complete view,
not the incomplete one. Go do the autopsy. Find out why. And hypothetically,
even if John W. Henry was the only trend follower to have ever walked the planet,
his public 30-year track record requires an objective postmortem.
Summary Food for Thought
•John W. Henry’s first managed fund was staked with $16,000 in 1981.
He now owns the Boston Red Sox.
•Henry had a four-point investment philosophy: long-term trend identi-
fication, highly disciplined investment process, risk management, and
global diversification.
Ed Seykota
After you enter the world of markets you will eventually run across Market Wizards
by Jack Schwager. Of all the trader interviews in Market Wizards the most memo-
rable is with Ed Seykota. While some may perceive him as extremely direct, most
will agree his thinking is unique. One profound and now famous statement of his:
“Everybody gets what they want out of the market.” This was a response to a ques-
tion about trading, but I feel certain Seykota would say it also applies to life.
Even though he is almost unknown to both traders and laymen alike, Seykota’s
achievements rank him as one of the great trend followers (and traders) of all time.
I first met him at a small beachside café. I had received an invitation from him to
get together to discuss the outreach possibilities of the Internet. During that first
meeting, he asked me what I thought Richard Dennis was looking for when he
hired his student traders, the Turtles (Seykota knew my website
www.turtletrader.com). My reply was to say Dennis was looking for students who
could think in terms of odds. His response was to ask me if my reply was my own
thinking or something I was told by someone else. This was my indoctrination to
his direct nature.
This story passed along from an associate is pure Seykota:
I attended a day-long seminar in February 1995 in Toronto, Canada where Seyko-
ta was one of the guest speakers. The whole audience peppered him with ques-
tions like: Do you like gold, where do you think the Canadian $ is headed, how
do you know when there is a top, how do you know when the trend is up etc.?
To each of these, he replied: “I like gold—it’s shiny, pretty—makes nice jewelry”
or “I have no idea where the Canadian dollar is headed or the trend is up when
price is moving up, etc.” His replies were simple, straight-forward answers to
the questions asked of him. Later, I learned through the event organizer that a
large majority of the audience (who paid good money, presumably to learn the
“secrets” of trading from a Market Wizard) were not impressed. Many felt they
had wasted their time and money listening to him. Seykota’s message couldn’t
be clearer to anyone who cared to listen. The answers were found in the very
questions each person asked. Don’t ask, “How do you know the trend is mov-
ing up?” Instead, ask, “What is going to tell me the trend is up?” Not, “What
do you think of gold?” Instead, ask, “Am I correctly trading gold?” Seykota’s an-
swers effectively placed everyone in front of a huge mirror, reflecting their trad-
ing self back at them. If you don’t even know the question to ask about trading,
much less the answers, get out of the business and spend your life doing some-
thing you enjoy.52
Think about how you would have reacted to his speech.
Performance
Seykota earned, after fees, nearly 60 percent on average each year from 1990 to
2000 managing proprietary money in his managed futures program.53
But he is different than Harding, Henry, and Dunn. He literaly has been a one-
man shop his entire career. There is no fancy office or other employees. He does
not hold himself out as a fund manager and he is extremely selective of clients.
He doesn’t care whether people have money or that they want him to trade or
not. Seykota takes big risks and he gets big rewards—that takes a strong stom-
ach.
Seykota was born in 1946. He earned his Bachelor of Science from MIT in 1969
and by 1972 had embarked on the trading career he pursues to this day—
investing for his own account and the accounts of a few select others. He was
self-taught, but influenced in his career by Amos Hostetter and Richard Donchi-
an.
Originally, he took a job with a major broker. He then conceived and developed
the first commercial computerized trading system for client money in the futures
markets. And according to Market Wizards, he increased one client’s account
from $5,000 to $15,000,000 in 12 years.
His trading is largely confined to the few minutes it takes to run his internally
written computer program, which generates trading signals for the next day. He
also mentors traders through his website and his Trading Tribe, a widespread
community of like-minded traders. He has served as a teacher and mentor to
some great traders, including Michael Marcus and David Druz.
The Secret
Seykota debunks market ignorance with terse, Zen-like statements that force the
listener to look inward: “The biggest secret about success is that there isn’t any
big secret about it, or if there is, then it’s a secret from me, too. The idea of
searching for some secret for trading success misses the point.”55
That self-deprecating response emphasizes process over outcome, but don’t be
misled by his modesty, for he gets impatient with hypocrisy and mindlessness.
He is a fearless trader and does not suffer fools gladly. Yet when he remembers
his first trade, I saw the passion: “The first trade I remember, I was about five
years old in Portland, Oregon. My father gave me a gold-colored medallion, a
sales promotion trinket. I traded it to a neighbor kid for five magnifying lenses. I
felt as though I had participated in a rite of passage. Later, when I was 13, my fa-
ther showed me how to buy stocks. He explained that I should buy when the
price broke out of the top of a box and to sell when it broke out of the bottom.
And that’s how I got started.”56
Later on he was more directly inspired: “I saw a letter published by Richard
Donchian, which implied that a purely mechanical trend following system could
beat the markets. This too seemed impossible to me. So I wrote computer pro-
grams (on punch cards in those days) to test the theories. Amazingly, his
[Donchian] theories tested true. To this day, I’m not sure I understand why or
whether I really need to. Anyhow, studying the markets, and backing up my opin-
ions with money, was so fascinating compared to my other career opportunities
at the time, that I began trading full time for a living.”57
Trading was now in his blood, and at age 23 he went out on his own with about a
half-dozen accounts in the $10,000–25,000 range.58 He found an alternative to
the Wall Street career built only on commissions. From the beginning he worked
for incentive fees alone. If he made money for his clients, he got paid. If he did
not make money, he did not get paid. Most brokers, index fund managers, and
hedge funds don’t work like that.
Never Mind the Cheese
As a new trader, Seykota passed through Commodities Corporation, a trader
training ground in Princeton, New Jersey. One of his mentors was Amos Hostet-
ter. Hostetter made phenomenal amounts of money trading. When a market’s
supply-and-demand prospects looked promising, Hostetter would put up one-
third of his ultimate position. If he lost 25 percent he’d get out. “Never mind the
cheese,” he’d crack, “let me out of the trap.” But when the market swung his way
he’d add another third, taking a final position when prices climbed half as high
as he thought they’d go. Hostetter’s strategies were so successful they were
computerized so other traders could learn to duplicate his success.59
His get-out-of-the-trap strategies influenced many top traders of the last 30
years. Who else passed through Commodities Corp.? Traders with names like
Paul Tudor Jones, Bruce Kovner, Louis Bacon, and Michael Marcus paid their
dues there. Interestingly, in the mid-1990s, long after the majority of well-known trend followers had left, I visited Commodities Corporation’s offices.
Midway through the tour, I bumped into a stressed-out energy trader. After a few
minutes of conversation, we began to chat about his trading style, which was
based on fundamentals. Throughout the entire conversation, he was glued to the
monitor. When I brought up trend following, he assured me it did not work. I
was surprised that a trader working for a famous firm, known for training bril-
liant trend followers, was completely blinded to even the possibility that trend
following worked. I realized then even those closest to trend following’s roots
had no appreciation for it.
System Dynamics
Along with Hostetter, MIT’s Jay Forrester was a strong influence on the then
young Seykota: “One of my mentors, Jay Forrester, was a stickler for clear writ-
ing, a sign of clear thinking.”60
Forrester taught Seykota about system dynamics, which is a method for studying
the world around us. Unlike other scientists, who study the world by breaking it
up into smaller and smaller pieces, system dynamicists look at things as a
whole. The central concept to system dynamics is understanding how all the ob-
jects in a system interact with one another. A system can be anything from a
steam engine, to a bank account, to a basketball team. The objects and people in
a system interact through feedback loops, where a change in one variable affects
other variables over time, which in turn affects the original variable, and so on.
An example of this is money in a bank account. Money in the bank earns inter-
est, which increases the size of the account. Now the account is larger, it earns
even more interest, which adds more money to the account. This goes on and
on. What system dynamics attempts to do is understand the basic structure of a
system, and thus understand the behavior it can produce. Many of these
systems and problems that are analyzed can be built as models on a computer.
System dynamics takes advantage of the fact a computer model can be of much
greater complexity and carry out more simultaneous calculations than can the
mental model of the human mind.61
This type of thought process and computer modeling is not only a foundation of
his success, but also can be seen across the entire trend following success land-
scape.
FAQs
Examples of Seykota’s clear wisdom63:
To avoid whipsaw losses, stop trading.
Lesson: You will have losses. Accept them.
Here’s the essence of risk management: Risk no more than you can afford to lose,
and also risk enough so that a win is meaningful. If there is no such amount, don’t
play.
Lesson: Position sizing or money management is crucial.
Trend following is an exercise in observing and responding to the ever-present mo-
ment of now. Traders who predict the future dwell upon a nonexistent place, and
to the extent they also park their ability to act out there, they can miss opportu-
nities to act in the now.
Lesson: All you have is now. It is much better to react to the fact of market move-
ments in present time than a future time that doesn’t exist.
Markets are fundamentally volatile. No way around it. Your problem is not in the
math. There is no math to get you out of having to experience uncertainty.
Lesson: You can crunch all the numbers you like, but your “gut” still has to han-
dle the ups and downs. You have to live with and feel the uncertainty.
I recall, in the old days, people showing a lot of concern that markets are different
and trend following methods no longer work.
Lesson: Today or yesterday, skeptics abound. They sound like broken records in
their desires to see trend following debunked.
It can be very expensive to try to convince the markets you are right.
Lesson: Go with the flow. Leave your personal or fundamental opinions at the
door. Do you want to be right or make money? Losers try to convince everyone
they are right.
When magazine covers get pretty emotional, get out of the position. There’s noth-
ing else in the magazine that works very well, but the covers are pretty good. This
is not an indictment of the magazine people, it’s just that at the end of a big
move there is a communal psychological abreaction that shows up on the covers of
magazines.65
Lesson: Crowd psychology is real and the price reflects all.
Students
Seykota’s track record is impressive, but one of his students, Easan Katir,
offered a warning:
Journalists, interviewers, and such like to hedge their praise and use phras-
es such as “one of the best traders,” etc. If one looks at Ed Seykota’s model
account record and compares it with anyone else, historical or contem-
porary, he is the best trader in history, period. Isn’t he? Who else comes
close? I don’t know of anyone. Livermore made fortunes, but had draw-
downs to zero. There are numerous examples of managers with a few years
of meteoric returns who subsequently blow up. The household names, Buf-
fet and Soros, are less than half of Ed’s return each year. One might apply
filters such as Sharpe ratios, AUM, etc., and perhaps massage the results.
But as far as the one central metric—raw percentage profit—Ed is above
anyone else I know, and I’ve been around managing money for 20 years.
Jason Russell provided a glimpse into the Seykota process:
Through working with Ed, I have learned many things in the past couple of
years, one of the most important being: Apply trend following to your life
as well as to your trading. Freeing yourself from the need to understand
“why” is as useful when dealing with family, friends, and foes as it is when
entering or exiting a trade. It also has the added benefit of making you a
much better trader.
Russell further sees the simplicity:
There is simplicity beyond sophistication. Ed spends a lot of time there. He
listens, he feels, he speaks with clarity. He is a master of his craft. Before
working with Ed, I spent years learning, reading, and earning various desig-
nations. All of this has been useful as it provides me with a high level of technical proficiency. However, somehow through this whole process, I
have gained a strong appreciation for simplifying. Miles Davis was once
asked what went through his mind when he listened to his own music. He
said: “I always listen to what I can leave out.” That sounds like Ed.
David Druz, featured in my book The Little Book of Trading (Wiley, 2011), de-
scribed working with Seykota:
It was one of the most incredible experiences of my life. He is the smartest
trader I have ever seen. I don’t think anybody comes close. He has the
greatest insights into how markets work and how people operate. It’s al-
most scary being in his presence. It was tough surviving working with him
because of the mental gymnastics involved. If you have a personality weak-
ness, he finds it—fast. But it’s a positive thing because successful traders
must understand themselves and their psychological weaknesses. My time
with Ed was one of the greatest times of my life and gave me tremendous
confidence—but I don’t trade any differently because of it. A guy like Ed
Seykota is magic.66
Seykota would be the first to say he is no magician. Although it may be human
nature to attribute phenomenal trading success to magical powers, trend fol-
lowing is a form of trial and error. The errors are all the small losses incurred
while trying to find those big trends.
Jim Hamer felt it was important to talk life beyond the markets:
I lived with Ed and his family for a little over two months in early 1997. One
of the more amazing things I observed about Ed is that he has gifts in so
many areas, trading being just one of them. He showed me a music video
that he produced many years ago. It was an excellent production. He also
recorded an album several years before the video. He is a very talented
musician. My favorite song was Bull Market, which he used to play for me
on his acoustic guitar. During the time I was with him, he was very in-
volved in experiments that attempted to redefine airflows as they relate to
the Bernoulli Principle. He spent an enormous amount of time putting to-
gether academic papers and sending them to several experts in the field
concerning this work. He is the consummate scientist. One day, we took a
“field trip” to visit Ed’s state legislator to discuss Charter School legislation
and the impact on Ed’s children and the students of Nevada. Not long after
I left, Ed ran for the local school board. He has a keen interest in and
knowledge of education. Ed Seykota will never be defined solely by trading.
He has a love of learning and is a modern-day Renaissance man.
Summary Food for Thought
•Ed Seykota: “Win or lose, everybody gets what they want out of the
market. Some people seem to like to lose, so they win by losing
money.”
•Seykota: “To avoid whipsaw losses, stop trading.”
•Seykota: “Until you master the basic literature and spend some time
with successful traders, you might consider confining your trading to
the supermarket.”
•Seykota: “I don’t predict a non-existing future.”
Keith Campbell
Considering he founded one of the largest (in terms of client assets) and oldest
trend following firms, Keith Campbell and his firm, Campbell & Company, were
nearly non-existent for their first three decades. Back in the day a search revealed
little to no information. Like many of the earliest trend following traders their re-
turns and legacy are a matter of public record (if you know where to look), but as
2017 shows the firm has evolved.
As the world of funds and quant strategy has changed and investor needs have ex-
panded, Campbell’s approach has shifted some. While still possessing a trend fol-
lowing core expertise, the firm also offers a number of strategies oriented around
other alpha generators. Several members of their firm have appeared on my pod-
cast and their transparency in discussing their evolution is refreshing.
But for a moment let’s go back in time to the roots. In the 1960s Keith Campbell
took a job in California where he could both ski and surf—a healthy motivation!
When his roommate moved out of their apartment he advertised for a replacement
and ended up with Chet Conrad, a commodity broker. Campbell recalled that,
“(Conrad) got me into trading as a customer. But he was always moaning he didn’t
have enough money to trade.” Campbell then put together $60,000 from 12 in-
vestors to form his first futures fund with three advisors—a fundamentalist, a bar
chartist, and a point-and-figure advocate. When that fund struggled he started the
Campbell Fund and took it over on January 1, 1972. A few years later, Campbell and
Conrad went their separate ways. Conrad relocated to Lake Tahoe, Nevada, on a
gutsy sugar trade that turned a borrowed $10,000 into $3 million. Campbell re-
mained with his fund and now has seen his firm through formal succession plans
to ensure continuity of leadership (he stepped away from overseeing day to day
operations).69
Yet it is unfair to refer to Campbell & Company with the word “commodity” alone
because Campbell trades far more than commodities. They currently deploy several
dozen models across commodities, fixed income, foreign exchange and cash equi-
ties. They’ve also evolved risk management enhancements that allow strategies
with constant or dynamic risk targets. Will Andrews, CEO at Campbell & Company:
“We have great pride in our diversified flagships and our experience in trend fol-
lowing. That continues to be the core of our offering, but we recognize the need for
a broader set of strategies and access points for our evolving client base.”
But I still love that early Campbell wisdom—those legendary pearls. For example,
one Campbell executive noted back in the day: “I’m very uncomfortable with black
box trading where I’m dealing with algorithms I don’t understand. Everything we
do we could do on the back of an envelope with a pencil.”70
That back-of-an-envelope remark is a revelation to those that imagine trend fol-
lowing trading as overly complex. And by no means do I imply running a multi-
billion dollar fund with multiple strategies is simple (it’s not), but trend following
as a strategy can always be explained on the back of an envelope—even if it’s a big
envelope. The real lesson with Campbell, like with other great trend followers, is
the discipline to stick to rules in tough times.
Mike Harris, President at Campbell & Company, however, wanted me to see Camp-
bell today too, “We’ve also seen investor interest come full circle. After years of
being pushed to offer solutions beyond trend following, more recently we’ve seen
renewed interest in pure trend strategies and the potential ‘Crisis Alpha’ they can
provide. Our dynamic trend strategy is a good example of responding to this inter-
est. We’ve been able to combine our years of expertise in trend following with a
sophisticated dynamic risk-targeting framework that’s designed with the specific
goal of delivering returns during equity crisis periods. Many investors have told us
that they look to trend following allocations specifically for that equity crisis protec-
tion so we’ve developed programs with that focus.”
Campbell versus Benchmarks
While I am no proponent of benchmarking, the following chart (Table 2.3)
shows drawdown comparisons across asset classes:
TABLE 2.3: Worst-Case Cumulative Percentage Decline, January 1988–December
2016
Many skeptics like to think trend followers are the only ones with drawdowns.
The chart, however, shows the truth of drawdowns across several indexes and
fund types. The key is to accept drawdowns and be able to manage them when
they occur. Otherwise, you are left watching the NASDAQ drop 77 percent peak
to trough over 2000–2002 with no plan on what to do next.
Still, Campbell’s strategies were often doubted by Wall Street, especially the old-
guard efficient market types that griped about the riskiness of trend following.
Campbell counters: “A common perception is that futures markets are extremely
volatile, and that investing in futures is therefore very risky, much riskier than eq-
uity investments. The reality is that, while not for everyone, generally futures
prices are less volatile than common stock prices. It is the amount of leverage
available in futures, which creates the perception of high risk, not market volatil-
ity. The actual risk involved in futures trading depends, among other things,
upon how much leverage is used.”72
Managing leverage is crucial component for risk management regardless of strategy. It is a key part that allows traders to keep coming back day after day and
year after year to trade and win.
Correlation and Consistency
Most trend followers earn their returns at different times than common bench-
mark measures, such as the S&P stock index. Campbell (see Table 2.4) is lowly
correlated with major stock market indexes.
TABLE 2.4: Correlation Analysis between Campbell Composite and S&P 500
Index, January 1988–December 2016
SOURCE: Campbell & Company
Even more remarkable than the low correlation to the S&P, Campbell’s perfor-
mance (see Table 2.5) is consistent over total months, total years, and five
rolling time windows:
TABLE 2.5: Past Consistency Campbell Managed Futures, January 1988–
December 2016 (estimates)
SOURCE: Campbell & Company
Qualitatively you are not terribly more knowledgeable about Campbell & Com-
pany now. But quantitatively their performance numbers demonstrate something
way more than an anomaly or luck.
Summary Food for Thought
•Will Andrews: “With 45 years of experience the one thing we know is
that the markets never stop evolving and you must evolve with them.”
•Mike Harris: “This brave new world and its unknowns are scary for
most people but we see it as a potential opportunity as a lot of re-
re-pric- could need to happen. A dramatic drop in correlation be-
tween asset classes and markets improves opportunities. Markets are
slow to price in changes, which often leads to trends. We can capture
large moves, whether up or down.”
Jerry Parker
I first visited Jerry Parker’s original office in Manakin-Sabot, Virginia, in 1994. Man-
akin-Sabot is a rural Richmond suburb. It’s in the sticks. I make that point because
a few months before I was in Salomon Brothers’ office in lower Manhattan, gazing
for the first time across their huge trading floor, which seemed like the epicenter of
Wall Street. The light bulb of geographic irrelevance went off when Parker’s unpre-
tentious offices in Manakin-Sabot hit my eyes. You never would have guessed this
was where the thoughtful, laid-back CEO of Chesapeake Capital Management man-
aged over $1 billion.
Parker grew up in Lynchburg, Virginia, and graduated from the University of Vir-
ginia. He was working as an accountant in Richmond when he applied to Richard
Dennis’ training program and was the first student Dennis accepted. Pragmatic and
consistent, he went on to start his own money management firm, Chesapeake Cap-
ital, in 1988. He made the decision to risk less and make less for clients, so he took
his Turtle approach, a trend following strategy and ratcheted it down a few degrees.
In other words, he took an aggressive system for making money and customized it
to investors who were comfortable with lower leverage.
Even though he was shooting for lower risk he returned 61.82 percent on his
money in one incredible year of 1993. That put his firm on the map. However, he is
generally in the 12–14 percent return range today. His more conservative approach
to trend following is different than Dunn who has always pushed systems for abso-
lute returns. Parker does it a little differently, but no less successfully. I have always
walked away from him impressed each time at how straightforward and unas-
suming he was.
Skeptics
Parker gave a rare speech at the height of the Dot-com bubble. His address
covered a full range of trend following philosophies. However skeptical Parker’s
audience, it did not prevent him from offering simple, direct, and solid advice
about trading to those willing to accept it.
•Dangers of a buy and hold mentality: “The strategy of buy and hold is
bad. Hold for what? A key to successful traders is their ability to
leverage investments . . . many [traders] are too conservative in their
willingness to leverage.”76
•Folly of predicting where markets may be headed: “I don’t know nor do
I care. The system that we use at Chesapeake is about the market
knowing where it’s going.”77
•His trend following trading system: “This flies in the face of what
clients want: fancy schools, huge research, an intuitive approach that
knows what’s going to happen before it happens, e.g., be overweight
in the stock market before the rate cut. But obviously you can’t know
what’s going to happen before it happens, and maybe the rate cut is
the start of a major trend, and maybe it’s okay to get in after. That’s
our approach. No bias short or long.”78
•Counter-trend or day trading: “The reason for it is a lot of traders as
well as clients don’t like trend following. It’s not intuitive, not nat-
ural, too long-term, not exciting enough.”79
•The wishful thinking of market disaster victims: “They said ‘the mar-
ket’s wrong, it’ll come back.’ The market is never wrong.”80
Ask yourself if you want to be right or do you want to win. They are different
questions.
Intelligence
Trend following success is much more predicated on discipline than pure aca-
demic achievement. Parker is candid about intelligence: “We have a system in which we do not have to rely on our intellectual capabilities. One of the main
reasons why what we do works in the markets is that no one can figure out what
is happening.”81
The great trend followers admit pure IQ is no savior. They also know the latest
news of the day does not figure into decisions about when to buy, when to sell,
or how much to buy or sell. Parker adds, “Our pride and opinions should not
interfere with sound trading approaches.”83
Salem Abraham
Salem Abraham does it differently than most. He truly proves physical location is
meaningless. It would be hard to find a financial firm in the United States as re-
moved from Wall Street, geographically and culturally, as Abraham Trading Com-
pany. Housed in the same building where his grandfather Malouf Abraham once
chewed the fat with local politicians and ranchers, the company has evolved into
one of the nation’s most unusual trading operations.84
It was while he was a student at Notre Dame University that Abraham found he had
a natural ability for and interest in trading. Like Greg Smith, one of Seykota’s stu-
dents, he researched which traders were the most successful and discovered trend
following. Abraham returned home to the family ranch in Canadian, Texas, after
graduating and discussed the idea of trading for a living with his “granddad,” who
cautiously agreed to help him get started as a trader. According to Abraham he was
to “try it out for six months,” and then discard the idea (“throw the quote machine
out the window”) if he failed.85
There was no failure for Abraham. He quickly developed a Wall Street business in
the most anti–Wall Street way. Abraham’s firm’s culture is astonishingly different:
“No one at the company has an Ivy League degree. Most of the employees at Abra-
ham Trading have backgrounds working at the area’s feedlots or natural-gas
drilling and pipeline companies. Their training in the complexities of trading and
arbitrage is provided on the job. ‘This beats shoveling manure at 6 am in the morn-
ing,’ said Geoff Dockray, who was hired as a clerk for Mr. Abraham after working at
a feedlot near Canadian. The financial markets are complicated but they’re not as
relentless as dealing with livestock all the time.”86
Abraham’s meat-and-potatoes approach to trading: “The underlying premise of
Abraham Trading’s approach is that commodity interests will, from time to time,
enter into periods of major price change to either a higher or lower level. These
price changes are known as trends, which have been observed and recorded since
the beginning of market history. There is every reason to believe that in free mar-
kets prices will continue to trend. The trading approach used by Abraham is de-
signed to exploit these price moves.”87
When asked about his relationship with Jerry Parker, Abraham gave an example of
six degrees of separation: “We do in fact know Jerry Parker with Chesapeake Cap-
ital. The shortest version I can give you is he is my dad’s sister’s husband’s broth-
er’s daughter’s husband. I’m not sure you can call that related but something like
that. I first learned about the futures industry by talking to him while he visited in-
laws in Texas.”
The lesson learned: Keep your eyes open to possibilities, as you never know when
opportunity will appear. At the time, however, Parker knew Abraham’s age (and
success) could cause problems: “Sometimes people have a tendency to resent a
young guy who’s making so much money. I just think he has a lot of guts.”89
The core lesson to be learned from Abraham is that if you want to become a trend
follower, get out there and meet the players. Parker and Abraham are realists. They
play the zero-sum game hard in similar ways and excel at it, but they have also
found a way to balance their lives. Without compromising integrity they have found
a way to apply their trend trading philosophy.
Summary Food for Thought
•Jerry Parker: “A key to successful traders is their ability to leverage in-
vestments. Many traders are too conservative in their willingness to
leverage.”
•Parker: “A lot of traders as well as clients don’t like trend following. It’s
not intuitive, not natural, too long-term, not exciting enough.”
•Parker: “The market is never wrong.”
•More on Jerry Parker and Salem Abraham can be found in my second
book, TurtleTrader.
Richard Dennis
Richard Dennis is retired. His exit was often misinterpreted by the press as a death
knell for trend following. It is true Dennis’ career had big ups and downs, but trend
following never stopped.
Dennis was born and raised in Chicago in close proximity to the exchanges. He
began trading as a teenager with $400 saved from his pizza delivery job. Because
he was too young to qualify for membership on the exchange, he would send sig-
nals to his father who would do the actual trading. At 17 he finally landed a job in
the pit as a runner on the exchange floor and started trading.90
TurtleTraders
Eventually, Dennis would achieve fantastic wealth with profits in the hundreds of
millions of dollars. However, his real fame would come from his experiment in
teaching trading to new traders.
In 1983 he made a bet with his partner William Eckhardt. Dennis believed trading
could be taught. Eckhardt belonged to the “you’re born with it or you’re not” camp.
They decided to experiment by seeing whether they could teach novices successful
trading. Twenty-plus students were accepted into two separate training programs.
Legend has it Dennis named his students “Turtles” after visiting a turtle-breeding
farm in Singapore.
How did it start? Dennis ran classified ads saying Trader Wanted and was immedi-
ately overwhelmed by some 1,000 queries from would-be traders. He picked 20+
novices, trained them for two weeks, and then gave them money to trade for his
firm. His Turtles included two professional gamblers, a fantasy-game designer, an
accountant, and a juggler. Jerry Parker, the former accountant who now manages
more than $1 billion, was one of several who went on to become top money
managers.92
Although Dennis appears to own the mantle of trend following teaching professor,
there are many other trend followers, including Seykota, Dunn, and Henry, who
have served as teachers to successful traders. Also keep in mind not all the Turtles
turned out winners. After they left Dennis’s tutelage several Turtles failed (i.e., Cur-
tis Faith, who later served jail time). Perhaps, too, after some Turtles went out on
their own they could not cope without the safety net. Jerry Parker is a monster
exception to that theory—he is absolutely the most successful of the Turtles.
This is not a criticism of the system Dennis taught his students. It is rather an ac-
knowledgment that some could not stick with his trading system. In stark contrast,
Bill Dunn was completely unknown to the general public when the Turtles burst
onto the scene in the 1980s. Since that time Dunn has slowly overtaken all Turtles
in terms of absolute performance. I wonder if something about the initial one-man
shop of Dunn set in motion habits enabling his firm to roar past the Turtles, who
had the head start. For years, many Turtles also refused to acknowledge they were
trend followers, while Dunn was candid. Maybe the hype and mystery set forward
in the Market Wizards books did not help in the long run.
Nevertheless, the story of the Turtles is so amazing still in 2017 that the criteria
Dennis used to select his students is insightful.
Selection Process
Dale Dellutri, a former executive at Dennis’s firm, managed the Turtle group. He
said they were looking for “smarts and for people who had odd ideas.” Ultimately,
they selected several blackjack players, an actor, a security guard, and a designer of
the fantasy game Dungeons & Dragons. One of the ways they screened candidates
was by having them answer true-or-false questions.
The following true-or-false questions were sent to the Turtles and were used to de-
cide who was picked and who went home:
1.One should favor being long or being short, whichever one is comfort-
able with.
2.On initiation, one should know precisely at what price to liquidate if a
profit occurs.
3.One should trade the same number of contracts in all markets.
4.If one has $100,000 to risk, one ought to risk $25,000 on every trade.
5.On initiation, one should know precisely where to liquidate if a loss
occurs.
6.You can never go broke taking profits.
7.It helps to have the fundamentals in your favor before you initiate.
8.A gap up is a good place to initiate if an uptrend has started.
9.If you anticipate buy stops in the market, wait until they are finished
and buy a little higher than that.
10.Of three types of orders (market, stop, and resting), market orders
cost the least skid.
11.The more bullish news you hear and the more people are going long,
the less likely the uptrend is to continue after a substantial uptrend.
12.The majority of traders are always wrong.
13.Trading bigger is an overall handicap to one’s trading performance.
14.Larger traders can “muscle” markets to their advantage.
15.Vacations are important for traders to keep the proper perspective.
16.Under trading is almost never a problem.
17.Ideally, average profits should be about three or four times average
losses.
18.A trader should be willing to let profits turn into losses.
19.A very high percentage of trades should be profits.
20.A trader should like to take losses.
21.It is especially relevant when the market is higher than it’s been in 4
and 13 weeks.
22.Needing and wanting money are good motivators to good trading.
23.One’s natural inclinations are good guides to decision making in
trading.
24.Luck is an ingredient in successful trading over the long run.
25.When you’re long, “limit up” is a good place to take a profit.
26.It takes money to make money.
27.It’s good to follow hunches in trading.
28.There are players in each market one should not trade against.
29.All speculators die broke.
30.The market can be understood better through social psychology than
through economics.
31.Taking a loss should be a difficult decision for traders.
32.After a big profit, the next trend following trade is more likely to be a
loss.
33.Trends are not likely to persist.
34.Almost all information about a commodity is at least a little useful in
helping make decisions.
35.It’s better to be an expert in one to two markets rather than try to
trade 10 or more markets.
36.In a winning streak, total risk should rise dramatically.
37.Trading stocks is similar to trading commodities.
38.It’s a good idea to know how much you are ahead or behind during a
trading session.
39.A losing month is an indication of doing something wrong.
40.A losing week is an indication of doing something wrong.
41.The big money in trading is made when one can get long at lows after
a big downtrend.
42.It’s good to average down when buying.
43.After a long trend, the market requires more consolidation before an-
other trend starts.
44.It’s important to know what to do if trading in commodities doesn’t
succeed.
45.It is not helpful to watch every quote in the markets one trades.
46.It is a good idea to put on or take off a position all at once.
47.Diversification in commodities is better than always being in one or
two markets.
48.If a day’s profit or loss makes a significant difference to your net
worth, you’re overtrading.
49.A trader learns more from his losses than his profits.
50.Except for commission and brokerage fees, execution “costs” for
entering orders are minimal over the course of a year.
51.It’s easier to trade well than to trade poorly.
52.It’s important to know what success in trading will do for you later in
life.
53.Uptrends end when everyone gets bearish.
54.The more bullish news you hear, the less likely a market is to break
out on the upside.
55.For an off-floor trader, a long-term trade ought to last three or four
weeks or less.
56.Others’ opinions of the market are good to follow.
57.Volume and open interest are as important as price action.
58.Daily strength and weakness is a good guide for liquidating long-term
positions with big profits.
59.Off-floor traders should spread different markets of different market
groups.
60.The more people are going long, the less likely an uptrend is to con-
tinue in the beginning of a trend.
61.Off-floor traders should not spread different delivery months of the
same commodity.
62.Buying dips and selling rallies is a good strategy.
63.It’s important to take a profit most of the time.
Not all were true or false. Dennis also asked essay questions:
1.What were your standard test results on college entrance exams?
2.Name a book or movie you like and why.
3.Name a historical figure you like and why.
4.Why would you like to succeed at this job?
5.Name a risky thing you have done and why.
6.Explain a decision you have made under pressure and why that was
your decision.
7.Hope, fear, and greed are said to be enemies of good traders. Explain
a decision you may have made under one of these influences and how
you view that decision now.
8.What are some good qualities you have that might help in trading?
9.What are some bad qualities you have that might hurt in trading?
10.In trading would you rather be good or lucky? Why?
11.Is there anything else you’d like to add?
Those questions might seem simplistic, but Dennis did not care: “I suppose I
didn’t like the idea that everyone thought I was crazy or going to fail, but it didn’t
make any substantial difference because I had an idea what I wanted to do and how
I wanted to do it.”95
Dennis placed passion to achieve at the top. You have to wake up with inner drive
and desire to make it happen. You have to go for it. He also outlined the trend fol-
lowing problem with profit targets—a key lesson taught to the Turtles: “When you
have a position, you put it on for a reason, and you’ve got to keep it until the rea-
son no longer exists. Don’t take profits just for the sake of taking profits.”96 Den-
nis made it clear if you didn’t know when a trend would end, but you did know it
could go significantly higher, then don’t get off.
Yet even though some of his Turtle students had successful money management
careers, Dennis did not do well when trading for clients. His most recent stab at
managing money for others resulted in a compounded annual return of 26.9 per-
cent (after fees). That included two years when performance was over 100 percent.
But he stopped trading for clients after a drawdown in 2000. His clients pulled
their money right before his trading would have rebounded. Doubt me? Use Dunn
Capital or any other trend follower as a proxy and you will see what happened in
the fall of 2000. If those impatient clients had stayed with Dennis they would have
been richly rewarded.
One of the most crucial lessons a trader can learn is trading for your own account
and for clients are different. John W. Henry was blunt with me saying it was never
easy losing money for clients. On the other hand, traders who concentrate on ex-
panding their own capital have a great advantage. Fund managers must always deal
with the pressure and expectations of clients.
Summary Food for Thought
•Richard Dennis: “Trading was even more teachable than I imagined. In
a strange sort of way, it was almost humbling.”
•Dennis: “When you have a position, you put it on for a reason, and
you’ve got to keep it until the reason no longer exists. Don’t take profits
just for the sake of taking profits. You have to have a strategy to trade,
know how it works, and follow through on it.”
•Dennis: “You don’t get any profits from fundamental analysis; you get
profit from buying and selling.”
•The narrative of Richard Dennis and his students can be found in my
book TurtleTrader.
Richard Donchian
Richard Donchian is known as the father of trend following. His original technical
trading system became the foundation on which later trend followers built their
systems. From the time he started the industry’s first managed fund in 1949 until
his death, he shared his research and served as a teacher and mentor to numerous
present-day trend followers.
Donchian was born in 1905 in Hartford, Connecticut. He graduated from Yale in
1928 with a BA in economics. He was so fascinated by trading that even after los-
ing his investments in the 1929 stock market crash, he returned to work on Wall
Street.
In 1930 he managed to borrow some capital to trade shares in Auburn Auto, what
William Baldwin in his article on Donchian called, “the Apple Computer of its day.”
The moment after he made several thousand dollars on the trade he became a mar-
ket technician, charting prices and formulating buy and sell strategies without con-
cern for an investment’s basic value.100
From 1933 to 1935 Donchian wrote a technical market letter for Hemphill, Noyes &
Co. He stopped his financial career to serve as an Air Force statistical control offi-
cer in World War II, but returned to Wall Street after the war and became a market
letter writer for Shearson Hamill & Company. He began to keep detailed technical
records on futures prices, recording daily price data in a ledger book. Barbara
Dixon, one of his students, observed how he computed his moving averages and
posted his own charts by hand, developing his trend following signals—without
the benefit of an accurate database, software, or any computing capability. His
jacket pockets were always loaded down with pencils and a pencil sharpener.102
Dixon makes it clear her mentor’s work preceded and prefigured that of academic
theorists who developed the modern theory of finance. Long before Harvard’s John
Litner published his quantitative analysis of the benefits of including managed
futures in a portfolio with stocks and bonds, Donchian used concepts like diversi-
fication and risk control that won William Sharpe and Harry Markowitz Nobel
prizes in economics in 1990.103
Personification of Persistence
Richard Donchian was not an overnight sensation. After 42 years, Donchian was
still managing only $200,000. Then, in his mid-60s, everything came together,
and a decade later, he was managing $27 million at Shearson American Express,
making $1 million a year in fees and commissions and another million in trading
profits on his own money.104
Donchian of course didn’t predict price movements; he followed them. His
explanation for his success was simple and as old as the Dow Theory itself:
“Trends persist.” He added: “A lot of people say things like: Gold has got to
come down. It went up too fast. That’s why 85 percent of commodities investors
lose money. The fundamentals are supposed to be bullish in copper. But I’m on
the short side now because the trend is down.”106
These classic Donchian trading rules were first published over 75 years ago:
General Guides
1.Beware of acting immediately on a widespread public opinion. Even
if correct, it will usually delay the move.
2.From a period of dullness and inactivity, watch for and prepare to
follow a move in the direction in which volume increases.
3.Limit losses and ride profits, irrespective of all other rules.
4.Light commitments are advisable when market position is not cer-
tain. Clearly defined moves are signaled frequently enough to make
life interesting and concentration on these moves will prevent unprofitable whip-sawing.
5.Seldom take a position in the direction of an immediately preceding
three-day move. Wait for a one-day reversal.
6.Judicious use of stop orders is a valuable aid to profitable trading.
Stops may be used to protect profits, to limit losses, and from cer-
tain formations such as triangular foci to take positions. Stop or-
ders are apt to be more valuable and less treacherous if used in
proper relation to the chart formation.
7.In a market in which upswings are likely to equal or exceed down-
swings, heavier position should be taken for the upswings for per-
centage reasons—a decline from 50 to 25 will net only 50 percent
profit, whereas an advance from 25 to 50 will net 100 percent profit.
8.In taking a position, price orders are allowable. In closing a posi-
tion, use market orders.
9.Buy strong-acting, strong-background commodities and sell weak
ones, subject to all other rules.
10.Moves in which rails lead or participate strongly are usually more
worth following than moves in which rails lag.
11.A study of the capitalization of a company, the degree of activity of
an issue, and whether an issue is a lethargic truck horse or a spir-
ited race horse is fully as important as a study of statistical reports.
Donchian Technical Guidelines
1.A move followed by a sideways range often precedes another move
of almost equal extent in the same direction as the original move.
Generally, when the second move from the sideways range has run
its course, a counter move approaching the sideways range may be
expected.
2.Reversal or resistance to a move is likely to be encountered:
•On reaching levels at which in the past, the commodity has
fluctuated for a considerable length of time within a narrow
range
•On approaching highs or lows
3.Watch for good buying or selling opportunities when trend lines are
approached, especially on medium or dull volume. Be sure such a
line has not been hugged or hit too frequently.
4.Watch for “crawling along” or repeated bumping of minor or major
trend lines and prepare to see such trend lines broken.
5.Breaking of minor trend lines counter to the major trend gives most
other important position taking signals. Positions can be taken or
reversed on stop at such places.
6.Triangles of ether slope may mean either accumulation or distri-
bution depending on other considerations, although triangles are
usually broken on the flat side.
7.Watch for volume climax, especially after a long move.
8.Don’t count on gaps being closed unless you can distinguish be-
tween breakaway gaps, normal gaps, and exhaustion gaps.
9.During a move, take or increase positions in the direction of the
move at the market the morning following any one-day reversal,
however slight the reversal may be, especially if volume declines on
the reversal.
Students
Barbara Dixon was one of the more successful female trend traders in the busi-
ness. She graduated from Vassar College in 1969, but because she was a woman
and a history major, no one would hire her as a stockbroker. Undaunted, she fi-
nally took a job at Shearson as a secretary for Donchian. Dixon received three
years of invaluable tutelage in trend following under Donchian. When Donchian
moved to Connecticut she stayed behind to strike out on her own in 1973. Before long she had some 40 accounts ranging from $20,000 to well over $1 million.
Dixon saw uncomplicated genius in Donchian’s trading: “I’m not a mathema-
tician. I believe that the simple solution is the most elegant and the best. No-
body has ever been able to demonstrate to me that a complex mathematical
equation can answer the question, ‘Is the market moving in an uptrend, down-
trend, or sideways?’ Any better than looking at a price chart and having simple
rules to define those three sets of circumstances. These are the same rules I
used back in the late 70s.”107
Donchian was once again ahead of his time when he taught the importance of
fast and simple decision making. Dixon was fond of pointing out a good system
is one that keeps you alive and your equity intact when trends evaporate. She ex-
plained that the reason for any system is to get you into the market when a trend
establishes. Her message: “Don’t give up the system even after a string of losses
. . . that is important because that’s just when the profits are due.”108
She also doesn’t attempt to predict price moves, nor expect to be right every
time. She knows she can’t forecast the top or bottom of a price move. The hope
is it continues indefinitely because you expect to make money over the long run,
but on individual trades you admit when you’re wrong and move on.109
Today most market players still fixate on the new and fresh fast-money idea of
the day, yet I still find almost every word Donchian (or Dixon) wrote newer,
fresher and more honest than anything currently broadcast on CNBC. My fa-
vorite Donchian wisdom tackles an issue that people are still struggling with in
2017: “It doesn’t matter if you’re trading stocks or soybeans. Trading is trading,
and the name of the game is increasing your wealth. A trader’s job description is
stunningly simple: Don’t lose money. This is of utmost importance to new
traders, who are often told ‘do your research.’ This is good advice, but should be
considered carefully. Research alone won’t ensure a profit, and at the end of the
day, your main goal should be to make money, not to get an A in How to Read a
Balance Sheet.”
Richard Donchian’s blunt and a-touch-too-honest talk may explain why the Ivy
League’s finance curriculums do not include his exploits.
Summary Food for Thought
•Richard Donchian’s account dropped below zero following the 1929
stock market crash.
•Donchian was one of the Pentagon whiz kids in World War II working
closely with Robert McNamara.
•Donchian did not start his trend following fund until age 65. He traded
into his nineties and personally trained legions in the art of trend fol-
lowing and trained women at a time when women had little respect on
Wall Street.
•Donchian: “Nobody has ever been able to demonstrate to me that a
complex mathematical equation can answer the question, ‘Is the market
moving in an up trend, downtrend, or sideways.’”
Jesse Livermore and Dickson Watts
Richard Donchian had influences. And Jesse Livermore, born in South Acton,
Massachusetts in 1877, was a big one. At the age of 15 he went to Boston and
began working in Paine Webber’s Boston brokerage office. He studied price move-
ments and began to trade their price fluctuations. When Livermore was in his 20s
he moved to New York City to speculate. After 40 years of trading he developed a
knack for speculating on price movements. One of his foremost rules: “Never act
on tips.”
The unofficial biography of Livermore was Reminiscences of a Stock Operator, first
published in 1923 and written by journalist Edwin Lefevre. Readers likely guessed
Lefevre as a pseudonym for Livermore himself. Reminiscences of a Stock Operator
went on to become a Wall Street classic. Numerous quotations and euphemisms
from the book are so embedded in trading lore traders today don’t have the slight-
est idea where they originated110:
1.It takes a man a long time to learn all the lessons of his mistakes. They
say there are two sides to everything. But there is only one side to the
stock market; and it is not the bull side or the bear side, but the right
side.
2.I think it was a long step forward in my trading education when I real-
ized at last that when old Mr. Partridge kept on telling the other cus-
tomers, “Well, you know this is a bull market!” he really meant to tell
them that the big money was not in the individual fluctuations but in
the main movements—that is, not in reading the tape, but in sizing up
the entire market and its trend.
3.The reason is that a man may see straight and clearly and yet become
impatient or doubtful when the market takes its time about doing as
he figured it must do. That is why so many men in Wall Street, who are
not at all in the sucker class, not even in the third grade, nevertheless
lose money. The market does not beat them. They beat themselves, be-
cause though they have brains they cannot sit tight. Old Turkey was
dead right in doing and saying what he did. He had not only the courage
of his convictions but the intelligent patience to sit tight.
4.The average man doesn’t wish to be told that it is a bull or bear mar-
ket. What he desires is to be told specifically which particular stock to
buy or sell. He wants to get something for nothing. He does not wish
to work. He doesn’t even wish to have to think. It is too much bother
to have to count the money that he picks up from the ground.
5.A man will risk half his fortune in the stock market with less reflection
than he devotes to the selection of a medium-priced automobile.
Think about the wild speculation that took place during the Dot-com bubble of the
late 1990s, the wild speculation that ended with the October 2008 market crash,
the current-day Federal Reserve market propping, and then remember Livermore
was referring to a market environment nearly 100 years ago.
Livermore did write one book: How to Trade in Stocks: The Livermore Formula for
Combining Time, Element and Price. It was published in 1940. The book is difficult
to find, but a little persistence paid off. Livermore was by no means a perfect trader
(and he says so). He was no role model. His trading style was bold and extremely
volatile. He went broke several times making and losing millions. Yet his personal
trading does not detract from his wisdom.
One early trend trader who had an influence on Livermore was Dickson Watts.
Watts was president of the New York Cotton Exchange between 1878 and 1880. His
mindset still inspires in 2017:
All business is more or less speculation. The term speculation, however, is com-
monly restricted to business of exceptional uncertainty. The uninitiated believe
that chance is so large a part of speculation that it is subject to no rules, is gov-
erned by no laws. This is a serious error.
Let’s first consider the qualities essential to the equipment of a speculator:
1.Self-reliance: A man must think for himself, must follow his own con-
victions. Self-trust is the foundation of successful effort.
2.Judgment: That equipoise, that nice adjustment of the facilities one to
the other, which is called good judgment, is an essential to the specu-
lator.
3.Courage: That is, confidence to act on the decisions of the mind. In
speculation, there is value in Mirabeau’s dictum: Be bold, still be bold;
always be bold.
4.Prudence: The power of measuring the danger, together with a certain
alertness and watchfulness, is important. There should be a balance
of these two, prudence and courage; prudence in contemplation,
courage in execution. Connected with these qualities, properly an out-
growth of them, is a third, viz: promptness. The mind convinced, the
act should follow. Think, act, promptly.
5.Pliability: The ability to change an opinion, the power of revision. “He
who observes,” says Emerson, “and observes again, is always formi-
dable.”
These qualifications are mandatory to achieve successful speculation, but they
must be conducted in a balanced manner. A deficiency or an over plus of one
quality will destroy the effectiveness of all. The possession of such faculties, in a
proper adjustment is, of course, uncommon. In speculation, as in life, few suc-
ceed, many fail.112
Jesse Livermore’s take is less academic and more emotional than Watts’s, but spot
on enduring: “Wall Street never changes, the pockets change, the suckers change,
the stocks change, but Wall Street never changes, because human nature never
changes.”
Summary Food for Thought
•David Ricardo (1772–1823) inspired and influenced Watts, Livermore, and
Donchian. He was arguably the very first trend following trader.
•Seeing the invisible, otherwise known as risk.
•Michael Melissinos: “The trend following philosophy is based on adapting
to evolving conditions in the now. It’s about learning from the past in
order to make the right decisions today. The goal is not to eliminate losses
from investing, but to manage them in a way that doesn’t kill us.”
•Bill Gurley on not pursuing Google: “I go back, and the learning is that if
you have remarkably asymmetric returns you have to ask yourself, ‘how
high could up be and what could go right?’ Because it’s not a 50/50 thing.
If you thought there was a 20% chance you should still do it because the
upside is so high.”113
•Miles Davis: “When you hit a wrong note, it’s the next note that makes it
good or bad.”
Author note: The following quotations appear in the hardcover side
margins.
People are mathaphobic.
David Harding
Technical trading is not glamorous. It will rarely tell that you bought at the lows and
sold at the highs. But trading should be a business, and a systematic program is a plan
to profit over time, rather than from a single trade. High expectations are essential to
success, but unrealistic ones just waste time. Computers do not tell the user how to
make profits in the market; they can only verify our own ideas.
Cognitrend
When I first got into commodities, no one was interested in a diversified approach.
There were cocoa men, cotton men, grain men—they were worlds apart. I was almost
the first one who decided to look at all commodities together. Nobody before had looked
at the whole picture and had taken a diversified position with the idea of cutting losses
short and going with a trend.
Richard Donchian
One of the only things I could say with certainty was that markets trend because I can
observe trends in any financial market, in any time era.
Michael Platt Hedge Fund Market Wizards
Whenever you can, count.
Sir Francis Galton8
The novice trader is at a disadvantage because the intuitions that he is going to have
about the market are going to be the ones that are typical of beginners. The expert is
someone who sees beyond those typical responses.
Charles Faulkner10
Like so many others who share his libertarian views, Bill Dunn’s journey to Free Minds
and Free Markets began in 1963 when he read Ayn Rand’s short collection of essays on
ethics.
Reason Magazine11
The beginning is the most important part of the work.
Plato
Gas Station Proprietor: “Look, I need to know what I stand to win.”
Anton Chigurh: “Everything.”
Gas Station Proprietor: “How’s that?”
Anton Chigurh: “You stand to win everything. Call it.”
Gas Station Proprietor: “Alright. Heads then.”
[Chigurh removes his hand, revealing the coin is indeed heads]
Anton Chigurh: “Well done.”21
Confidence comes from success, to be sure, but it can also come from recognizing that a
lot of carefully examined failures are themselves one path to success.
Denise Shekerjian22
Money management is the true survival key.
Bill Dunn24
Change is not merely necessary to life—it is life.
Alvin Toffler
Men’s expectations manifest in trends.
John W. Henry29
There is no Holy Grail. There is no perfect way to capture that move from $100/ounce
to $800/ounce in gold.
John W. Henry30
How are we able to make money by following trends year in and year out? Trends de-
velop because there’s an accumulating consensus on future prices, consequently there’s
an evolution to the believed true price value over time. Because investors are human
and they make mistakes, they’re never 100 percent sure of their vision and whether or
not their view is correct. So price adjustments take time as they fluctuate and a new
consensus is formed in the face of changing market conditions and new facts. For some
changes, this consensus is easy to reach, but there are other events that take time to
formulate a market view. It’s those events that take time that form the basis of our
profits.
John W. Henry
We have made our business managing risk. We are comfortable with risk and we get
our reward from risk.
John W. Henry34
Life is a school of probability.
Walter Bagehot35
The game of speculation is the most uniformly fascinating game in the world. But it is
not a game for the stupid, the mentally lazy, the person of inferior emotional balance,
or the get-rich-quick adventurer. They will die poor.
Jesse Livermore
We don’t predict the future, but we do know that the next five years will not look like
the last five years. That just doesn’t happen. Markets change. And our results over the
next three years will not replicate the last three. They never do.
John W. Henry39
There are only a limited number of Fed meetings a year; however, this is supposed to
help us infer the direction of interest rates and help us manage risk on a daily basis.
How do you manage risk in markets that move 24 hours a day, when the fundamental
inputs do not come frequently? In the grain markets, crop reports are fairly limited, and
demand information comes with significant lags, if at all. Under these types of condi-
tions, simple approaches, such as following prices, may be better.
Mark S. Rzepczynski41
We can’t always take advantage of a particular period. But in an uncertain world, per-
haps the investment philosophy that makes the most sense, if you study the impli-
cations carefully, is trend following. Trend following consists of buying high and selling
low. But trends are an integral, underlying reality in life. How can someone buy high
and sell low and be successful for two decades unless the underlying nature of markets is
to trend? On the other hand, I’ve seen year-after-year, brilliant men buying low and sell-
ing high for a while successfully and then going broke because they thought they under-
stood why a certain investment instrument had to perform in accordance with their per-
sonal logic.
John W. Henry43
Everything flows.
Heraclitus
I always know what’s happening on the court. I see a situation occur, and I respond.
Larry Bird
The chief obstacle is that we are quick to be satisfied with ourselves. If we find someone
to call us good men, cautious and principled, we acknowledge him. We are not content
with a moderate eulogy, but accept as our due whatever flattery has shamelessly
heaped upon us. We agree with those who call us best and wisest, although we know
they often utter many falsehoods: we indulge ourselves so greatly that we want to be
praised for a virtue which is the opposite of our behavior. A man hears himself called
‘most merciful’ while he is inflicting torture... So it follows that we don’t want to change
because we believe we are already excellent.
Seneca
Win or lose, everybody gets what they want out of the market. Some people seem to
like to lose, so they win by losing money.
Ed Seykota50
Fortune tellers live in the future. So do people who want to put things off. So do fun-
damentalists.
Ed Seykota51
Pyramiding instructions appear on dollar bills. Add smaller and smaller amounts on the
way up. Keep your eye open at the top.
Ed Seykota54
The guy with discretion has what, a crystal ball?
Leda Braga
I believe babies are born as innovative personalities, but our social processes work to
stamp out exploration and questioning.
Jay Forrester
If a gambler places bets on the input symbol to a communication channel and bets his
money in the same proportion each time a particular symbol is received, his capital will
grow (or shrink) exponentially. If the odds are consistent with the probabilities of occur-
rence of the transmitted symbols (i.e., equal to their reciprocals), the maximum value of
this exponential rate of growth will be equal to the rate of transmission of information.
If the odds are not fair, i.e., not consistent with the transmitted symbol probabilities but
consistent with some other set of probabilities, the maximum exponential rate of growth
will be larger than it would have been with no channel by an amount equal to the rate
of transmission of information.
J. L. Kelly, Jr62
For a system trader, it’s way more important to have your trading size down than it is
to fine tune your entry and exit points.
David Druz64
The difference between a successful person and others is not a lack of strength, not a lack
of knowledge, but rather a lack of will.
Vince Lombardi
Apprenticing with Ed Seykota is like getting a drink of water at a fire hydrant.
Thomas Vician Jr.
You’ve got to have a longer perspective and confidence in the veracity of the approach
that you’re using.
Campbell and Company67
Measure what is measurable, and make measurable what is not so.
Galileo Galilei68
The mathematics are very important, but it’s only one piece of the puzzle. The most
important thing overall is the total investment process, of which the signal generator is
an important part. Portfolio structuring, risk management, execution strategies, capital
management, and leverage management may not be directly connected to the algo-
rithm that generates the buy and sell signals, but they are all hugely important.
Campbell & Company71
Campbell & Company analyzes only technical market data, not any economic factors
external to market prices.73
Our trend following methods do not pretend to determine the value of what we are
trading, nor do they determine what that value ought to be, but they do produce abso-
lute returns fairly consistently.
Campbell & Company74
Technical traders do not need to have a particular expertise in each market that they trade. They don’t need to be an authority on meteorological phenomena, geopolitical
occurrences or the economic impact of specific worldwide events on a particular market.
Jerry Parker75
I participated in the Richard Dennis “Turtle Program.” The methods we were taught
and the trading experience received were all a technical approach to trading the com-
modity markets. The most important experience that led me to utilize a technical ap-
proach was the amount of success that I experienced trading Rich’s system.
Jerry Parker82
The only cardinal evil on earth is that of placing your prime concern within other men.
I’ve always demanded a certain quality in the people I liked. I’ve always recognized it at
once—and it’s the only quality I respect in men. I chose my friends by that. Now I know
what it is. A self-sufficient ego. Nothing else matters.
Ayn Rand88
Trading was even more teachable than I imagined. In a strange sort of way, it was al-
most humbling.
Richard Dennis91
I agree with the metaphysics of technical analysis that the fundamentals are dis-
counted. You don’t get any profits from fundamental analysis; you get profit from buy-
ing and selling. So why stick with the appearance when you can go right to the reality of
price and analyze it better?
Richard Dennis93
There’s nothing quite as good or bad as trading. They give you a number every day.
That’s what’s good about it, and that’s what’s bad about it. That’s what makes it hard.
That’s what makes it worth doing.
Richard Dennis94
All a company report and balance sheet can tell you is the past and the present. They
cannot tell future.
Nicolas Darvas
Always say ‘yes’ to the present moment. Surrender to what is. Say ‘yes’ to life and see
how life starts suddenly to start working for you rather than against you.
Eckhart Tolle
Chance is commonly viewed as a self-correcting process in which a deviation in one
direction induces a deviation in the opposite direction to restore the equilibrium. In fact,
deviations are not corrected as a chance process unfolds, they are merely diluted.
Amos Tversky
No trader can control volatility completely, but you can improve your odds.
Student of Richard Dennis
Whatever you use should be applied in some quantitative, rigorous fashion. You should
use science to determine what works and quantify it. I’m still surprised today at how I
can expect so strongly that a trading methodology will be profitable but, after running it
though a simulation, I discover it’s a loser.
Paul Rabar97
I don’t think trading strategies are as vulnerable to not working if people know about
them, as most traders believe. If what you are doing is right, it will work even if people
have a general idea about it. I always say that you could publish trading rules in the
newspaper and no one would follow them. A key is consistency and discipline.
Richard Dennis98
I became a computer applicant of Dick’s [Donchian] ideas. He was one of the only peo-
ple at the time who was doing simulation of any kind. He was generous with his ideas,
making a point to share what he knew; it delighted him to get others to try systems. He
inspired a great many people and spawned a whole generation of traders, providing
courage and a road map.
Ed Seykota99
We started our database using punch cards in 1968, and we collected commodity price
data back to July 1959. We back-tested the 5 and 20 and the weekly rules for Dick. I
think the weekly method was the best thing that anyone had ever done. Of all Dick’s
contributions, the weekly rules helped identify the trend and helped you act on it. Dick is
one of those people who today likes to beat the computer—only he did it by hand.
Dennis D. Dunn101
I remember in 1979 or 1980, at one of the early MAR conferences, being impressed by
the fact that I counted 19 CTAs who were managing public funds, and I could directly
identify 16 of the 19 with Dick Donchian. They had either worked for him or had had
monies invested with him. To me, that’s the best evidence of his impact in the early
days. Dick has always been very proud of the fact that his people have prospered. He
also was proud that after too many years in which his was the lone voice in the wilder-
ness, his thinking eventually came to be the dominant thinking of the industry.
Brett Elam105
Losing an illusion makes you wiser than finding a truth.
Ludwig Borne
Can one know absolutely when price will trend? No. Does one have to know absolutely
in order to have a profitable business? No. In fact, a great number of businesses are
based on the probability that a time-based series will trend. In fact, if you look at insur-
ance, gambling, and other related businesses, you will come to the conclusion that even
a small positive edge can mean great profits.
Forum Post
Nobody will deny that there is at least some roughness everywhere.
Benoit Mandelbrot
We love volatility and days like the one in which the stock market took a big plunge, for
being on the right side of moving markets is what makes us money. A stagnant market
in any commodity, such as grain has experienced recently, means there’s no opportunity
for us to make money.
Dinesh Desai111
Bottomless wonders spring from simple rules, which are repeated without end.
Benoit Mandelbrot
Neither a state nor a bank ever have had unrestricted power of issuing paper money without abusing that power.
David Ricardo
Notes
March 2006: Changed from market-specific parameter set selection to portfolio-
wide parameter set selection. Increased the number of parameter sets from 3 to
100+. Increased markets traded from 26 (financial) to 52 (fully diversified). January
2013–Present: WMA utilizes a dynamic risk management methodology referred to
as the Adaptive Risk Profile (“ARP”), which gears exposure to current market
conditions. ARP serves to establish the size of WMA’s portfolio positions based on
a proprietary metric that incorporates expected returns, volatility and inter-market
correlations. The program’s risk target varies daily and is high only when a prepon-
derance of the signals are in agreement and the correlation matrix of WMA’s posi-
tions is favorable. Monthly VaR at the 99% confidence level is expected to be in the
range of −22% to −8%, with an average monthly VaR of 15%. This translates into an
annualized volatility of ∼23% over time. Previously (November 1984–December
2012) WMA targeted a static monthly VaR of −20% at the 99% confidence level.
During that time (339 months), the 20% monthly loss level was penetrated 4 times,
or 1.18%.
1. Jim Rogers, Investment Biker (New York: Random House, 1994).
2. Thomas Friedman, The Lexus and the Olive Tree (New York: Farrar, Straus and
Giroux, 1999).
3. Leah McGrath Goodman, Trader Monthly,
www.traderdaily.com/magazine/article/17115.html.
4. Ibid.
5. Ibid.
6. David Harding, The Winton Papers, Winton Capital Management,
www .wintoncapital.com.
7. Daniel P. Collins, “Seeding Tomorrow’s Top Traders; Managed Money; Dunn
Capital Management Provides Help to Commodity Trading Advisor Start-ups,” Fu-
tures 32, no. 6 (May 1, 2003): 67.
8. J. R. Newman (ed.), The World of Mathematics (New York: Simon & Schuster,
1956).
9. Jim Collins, Good to Great (New York: Harper Business, 2001).
10. Robert Koppel, The Intuitive Trader (Hoboken, NJ: John Wiley & Sons, Inc.,
1996), 74.
11. The Reason Foundation,www.reason.org.
12. Collins, “Seeding Tomorrow’s Top Traders.”
13. Bill Dunn, “Tricycle Asset Management,” (presentation, Market Wizards Tour,
May 15, 2003, Saskatoon, Saskatchewan).
14. Ibid.
15. Ibid.
16. Amy Rosenbaum, “1990s Highs and Lows: Invasions, Persuasions and Volatil-
ity,” Futures 19, no. 14 (December 1990): 54.
17. Andrew Osterland, “For Commodity Funds, It Was as Good as It Gets,”
Businessweek, September 14, 1998.
18. Jack Reerink, “Dunn: Slow Reversal Pays Off,” Futures 25, no. 3 (March 1996).
19. Mike Mosser, “Learning from Legends,” Futures 29, no. 2 (February 2000).
20. “How Managed Money Became a Major Area of the Industry; Futures Market,”
Futures 21, no. 9 (July 1992): 52.
21. No Country for Old Men, directed by Ethan Coen and Joel Coen (Santa Monica,
CA: Miramax Films, 2007).
22. Denise G. Shekerjian, “Uncommon Genius” (New York: Penguin, 1990).
23. Mary Ann Burns, “Industry Icons Assess the Managed Futures Business,” Fu-
tures Industry Association (May/June 2003).
24. Reerink, “Dunn: Slow Reversal Pays Off.”
25. Carla Cavaletti, “Comeback Kids: Managing Drawdowns According to Com-
modity Trading Advisors,” Futures 27, no. 1 (January 1998): 68.
26. “Dunn Capital Management Monthly Commentary,” Dunn Capital Manage-
ment (February 2003).
27. Keith Campbell, “Barclay Managed Futures Report,” Barclay Managed Futures Report 3, no. 3 (third quarter 1992): 2.
28. “Job Wanted” (advertisement), Dunn Capital Management,
www.monster .com.
29. Ginger Szala, “John W. Henry: Long-Term Perspective,” Futures (1987).
30. John W. Henry (presentation, Geneva, Switzerland, September 15, 1998).
31. Lois Peltz, The New Investment Superstars (New York: John Wiley & Sons, Inc.,
2001).
32. Mary Ann Burns, “Industry Icons Assess the Managed Futures Business,” Fu-
tures Industry Association (May/June 2003).
33. Mark S. Rzepczynski, “John W. Henry & Co. Year in Review,” (December 2000).
34. Oliver Conway, cover story about John W. Henry & Company, Inc., Managed
Derivatives (May 1996).
35. W. H. Auden and L. Kronenberger, eds., The Viking Book of Aphorisms (New
York: Viking, 1966).
36. Michael Peltz, “John W. Henry’s Bid to Manage the Future,” Institutional In-
vestor (August 1996).
37. Szala, “John W. Henry.”
38. Peltz, The New Investment Superstars.
39. John W. Henry (presentation, November 17, 2000).
40. Peltz, The New Investment Superstars.
41. “2002 Year in Review,” John W. Henry & Company, Inc. (2002).
42. “Futures Industry Association Conference Seminar,” Trading System Review
(November 2, 1994).
43. John W. Henry (presentation, Morgan Stanley Dean Witter Achieve Conference,
Naples, Florida, November 17, 2000).
44. Azeez Mustapha, “Leda Braga: A High Earning Hedge Fund Manager,” ADVFN
Financial News, May 8, 2014,
http://uk.advfn.com/newspaper/azeez-mustapha/26204/leda-braga-a-high-earning-hedge-fund-manager.
45. John W. Henry (presentation, Geneva, Switzerland, September 15, 1998).
46. Ibid.
47. Ibid.
48. FIA Research Division dinner, New York, April 20, 1995.
49. “The Alternative Files, History of Managed Futures,” Attain Capital Manage-
ment (January 2014).
50. Jack Schwager, Market Wizards: Interviews with Top Traders (New York: Harper
Business, 1989), 172.
51. “The Trading Tribe” (forum response), The Trading Tribe,
www.seykota .com/tribe/.
52. E-mail, www.TurtleTrader.com.
53. Daniel P. Collins, “Long-Term Technical Trend-Following Method for Managed
Futures Programs,” Futures 30, n. 14 (November 2001): 22.
54. Ed Seykota, “The Trading Tribe,” www.seyokota.com/tribe/.
55. Thom Hartle, ed., “Ed Seykota of Technical Tools,” Technical Analysis of Stocks &
Commodities 10, no. 8 (August 1992): 328–31. (Used with permission;
www.traders.com.)
56. Ibid.
57. Ibid.
58. Ibid.
59. Shawn Tully, “Princeton’s Rich Commodity Scholars,” Fortune, February 9,
1981, 94.
60. “The Trading Tribe” (forum response), The Trading Tribe,
www.seykota .com/tribe/.
61. “System Dynamics,” last modified June 23, 1997,
http://web.mit.edu/sysdyn/sd-intro/.
62. J. L. Kelly Jr., “A New Interpretation of Information Rate,” Bell System Technical
Journal (July 1956): 917–26.
63. “The Trading Tribe” (forum response), The Trading Tribe,
www.seykota .com/tribe/.
64. Jack Reerink, “The Power of Leverage,” Futures 24, no. 4 (April 1995): 59.
65. Gibbons Burke, “How to Tell a Market by Its Covers: Financial Market Predictions Based on Magazine Covers,” Futures 22, no. 4 (April 1993): 30.
66. Your Trading Edge, www.yte.com.au.
67. Joe Niedzielski, “Wild Market Swings Take Toll on Commodity Trading Advis-
ers,” Dow Jones Newswires, April 25, 2000.
68. I. Gordon and S. Sorkin, eds., The Armchair Science Reader (New York: Simon &
Schuster, 1959).
69. Darrell R. Jobman, “How Managed Money Became a Major Area of the Indus-
try,” Futures 21, no. 9 (July 1992): 52.
70. “Campbell & Company (presentation, excerpt),” Futures Industry Association
Conference.
71. Mary Ann Burns, “Industry Icons Assess the Managed Futures Business,” Fu-
tures Industry Association (May/June 2003).
72. “Value of Adding Managed Futures” (marketing documents), Campbell & Com-
pany.
73. “2003 Disclosure Document,” Campbell & Company.
74. Desmond McRae, “31-Year Track Record of 18.1%,” Managed Futures (March
2003).
75. “Barclay Managed Futures Report,” Barclay Trading Group, Ltd. 2, no. 3 (third
quarter 1991): 2.
76. The Futures and Industry Association’s Future and Options Expo ’98, Sher-
aton Chicago Towers & Hotel, Chicago, October 14–16, 1998.
77. Ibid.
78. Ibid.
79. Ibid.
80. Ibid.
81. Chuck Epstein, “The World According to J. Parker,” Managed Account Reports
(November 1998).
82. “Barclay Managed Futures Report,” Barclay Trading Group, Ltd. 2, no. 3 (third
quarter 1991): 7.
83. Ibid.
84. Simon Romero, “A Homespun Hedge Fund, Tucked Away in Texas,” New York
Times, December 28, 2003, 1.
85. Futures (March 1995).
86. Romero, “A Homespun Hedge Fund.”
87. “Program Description: Trading Methods and Strategies,” Abraham Trading
Company, www.abrahamtrading.com.
88. Ayn Rand, The Fountainhead (New York: Bobbs-Merrill, 1943).
89. Romero, “A Homespun Hedge Fund.”
90. Jack Schwager, Market Wizards: Interviews with Top Traders (New York: New
York Institute of Finance, 1989).
91. Stanley W. Angrist, “Commodities: Winning Commodity Traders May Be Made,
Not Born,” Wall Street Journal, September 5, 1989.
92. Greg Burns, “Rich Dennis: A Gunslinger No More,” Businessweek, April 7, 1997.
93. Susan Abbott, “Richard Dennis: Turning a Summer Job into a Legend,” Futures,
September 1983, 58.
94. Ibid., 59.
95. Ibid., 57.
96. Ibid., 58.
97. Paul Rabar, “Managed Money: Capitalizing on the Trends of 1990,” Futures 20,
no. 3 (March 1991).
98. Schwager, Market Wizards.
99. Barbara Dixon, “Richard Donchian: Managed Futures Innovator and Mentor,”
Futures Industry Association.
100. William Baldwin, “Rugs to Riches (Section: The Money Men),” Forbes (March
1, 1982).
101. Dixon, “Richard Donchian.”
102. Ibid.
103. Ibid.
104. Baldwin, “Rugs to Riches.”
105. Dixon, “Richard Donchian.”
106. Baldwin, “Rugs to Riches.”
107. “Futures Industry Association Review: Interview: Money Managers,” Futures
Industry Association, www.fiafii.org.
108. Barbara S. Dixon, “Discretionary Accounts,” Managed Account Reports, Report
No. 20, no. 14: 5.
109. Barbara S. Dixon, “Discretionary Accounts,” Managed Account Reports, Report
No. 20, no. 14: 5.
110. Edwin Lefèvre, “Reminiscences of a Stock Operator,” (New York: George H.
Doran Company, 1923).
111. Andrew Leckey, “Dabble, Don’t Dive, in Futures,” Chicago Tribune (October 2,
1986, C1).
112. Dickson G. Watts, Speculation as a Fine Art (reprint, Flint Hill, Virginia: Fraser
Publishing Co., 1997).
113. Eric Johnson, “Benchmark’s Bill Gurley says he’s still worried about a bubble,”
Recode (September 12, 2016),
www.recode.net/2016/9/12/12882780/bill-gurley-benchmark-bubble-venture-capital-startups-uber.
3
Performance Proof
Even if you are a minority of one, the truth is the truth.
—Gandhi
What we’ve got here is failure to communicate. Some men you just can’t reach, so
you get what we had here last week, which is the way he wants it.
—Cool Hand Luke
Anyone can tell you they have a successful method or system, but the only
objective measurement is raw data. If a claim is to be made, it must be sup-
ported. The numbers in this volume, across numerous third-party reporting ser-
vices and inside disclosures on file with American and international regulatory
authorities, don’t lie. You could be the skeptic and say: “Hold on, the numbers
could be faked!” That doesn’t fly with decades of data across unrelated traders
located in dozens of countries. This is not about one isolated Bernie Madoff
track record open to hanky-panky. Thus, in reviewing legendary trend following
performance histories and assorted research studies I alone might own (my in-
sider investigation methods are a whole other book), I zeroed in on six key data
concepts:
1.Absolute returns
2.Volatility
3.Drawdowns
4.Correlation
5.Zero sum
6.Berkshire Hathaway
Absolute Returns
An absolute return trading strategy means you are trying to make the most money
possible. Author Alexander Ineichen defines it succinctly: An absolute return man-
ager is essentially an asset manager without a benchmark—Bench marking can be
viewed as a method of restricting investment managers so as to limit the potential
for surprises, either positive or negative.2
Trend following in its purest form doesn’t track or attempt to mimic any particular
index—ever. If trend following had a coat of arms, Absolute Returns would be
emblazoned upon it. It thrives and profits from the surprises benchmarking artifi-
cially stops.
However, not all trend followers are shooting for absolute returns or the most
amount of money possible. Not all play the game full tilt. Jerry Parker, for example,
purposefully aims for lower returns to cater to a different client base (those who
want less risk and less return).
But John W. Henry long made the case “[that] the overall objective is to provide
absolute returns. Relative return managers, such as most traditional equity or fixed-
income managers, are measured on how they perform relative to some pre-
determined benchmark. We have no such investment benchmark, so its aim is to
achieve returns in all market conditions, and is thus considered an absolute return
manager.”3
Shoot for a benchmark in returns and you run with the crowd. Benchmarks such as
the S&P might make you feel safe, even when that feeling is clearly artificial. Trend
following, on the other hand, understands that trading for absolute returns and not
from blind adherence to benchmarks is the best way to handle uncertainty.
The concept of indexing and benchmarking is very useful in the EMT world of
traditional long-only passive investing, but it has almost zero usefulness for an
absolute return process. Again, it gets back to what it takes to achieve an absolute
return—you need an enormous amount of latitude and freedom in executing a
trading strategy to ensure capital preservation and achieve a positive return. At its
core, the concept of absolute return investing is antithetical to benchmarking,
which encourages traditional managers to have similarly structured portfolios and
look at their performance on a relative basis.4
If you base your trading strategy on benchmark comparisons, it doesn’t matter
whether you are a talented trader or not because all decisions are about the
averages. Why is any trading skill relevant? It’s not. That’s why 80 percent of mutual
funds don’t beat averages.
Volatility versus Risk
There are organizations that rank and track monthly performance numbers. One
organization gives a star ranking (like Morningstar):
The quantitative rating system employed ranks and rates the performance of all
commodity trading advisors (CTA) . . . Ratings are given in four categories: a)
equity, b) performance, c) risk exposure, and d) risk-adjusted returns. In each
category, the highest possible rating is five stars and the lowest possible rating
is one star. The actual statistics on which the percentiles are based as follows:
1.Performance: Rate of Return
2.Risk: Standard Deviation
3.Risk Adjusted: Sharpe Ratio
4.Equity: Assets5
Dunn Capital once received one star for risk, the implication being that an invest-
ment with Dunn is more risky. However, these rankings don’t give accurate infor-
mation on Dunn’s true risk. This rating group uses standard deviation as their
measure of risk. But this is a measure of volatility and not necessarily risk. High
volatility alone does not necessarily mean higher risk.
It’s doubtful Dunn, with a track record exceeding 40 years, is overly concerned
about being inaccurately penalized, but using standard deviation as a risk measure-
ment does distort a true understanding.
This same firm’s ranking of then-active trader Victor Niederhoffer demonstrates
the star system’s weakness. At the time of Niederhoffer’s public-trading demise in
1997, he was rated as four stars for risk. Based on Niederhoffer’s past performance,
the rankings were saying he was a much safer bet than Dunn. Obviously the star
system failed for people who believed Niederhoffer was less risky. Standard devi-
ation as a risk measure does trend following an injustice. One of my goals is to
dispel the simplistic notion trend following is risky or that all trend following strate-
gies have high standard deviations, which means they are bad.
A good illustration begins with this 10-year chart of various trend following perfor-
mances (see Table 3.1).
TABLE 3.1(a): Absolute Return: Annualized ROR (January 1993–June 2003)
Data Source: BarclayHedge
*The Offensive/Defensive Ratio (“ODR”) calculation measures the Average Winning
Months/Average Losing Months. Programs with a higher ODR indicates the program is
successful at releasing the upside potential when the environment is good; conversely
they are good at limiting losses when times are less favorable for the strategy.
Just saying a trader is volatile and thus bad makes little sense if you examine abso-
lute return performance (Table 3.1). Raw absolute returns should count for
something far more than fear or career risk—they equal the only way to massive
wealth.
Nonetheless, volatility (what standard deviation measures) is still a pejorative for
most market participants. Volatility scares them, even when a young student can
quickly analyze any historical data series to see volatility is normal and expected.
But most investors try to run away from the hint of volatility—even when running
is not possible. Some markets and traders are more volatile than others, but de-
grees of volatility are basic facts of life. To trend following, volatility is the pre-
cursor to profit. If you have no volatility, you have no opportunity for profit.
The press is always confused as seen in BusinessWeek: “Trend followers are trying
to make sense out of their dismal recent returns. ‘When you look past the super-
ficial question of how we did, you look under the hood and see immense change in
the global markets,’ says John W. Henry’s president. ‘Volatility is just a harbinger
of new trends to come.’ Maybe. But futures traders are supposed to make money
by exploiting volatility. Performance isn’t a ‘superficial question’ if you were among
the thousands of commodity-fund customers who lost money when the currency
markets went bonkers.”8
Focusing on one period in isolation while ignoring a complete performance history
misrepresents the full picture. I wondered if this reporter had written a follow-up
article correcting his observations about trend following, because the following
year trend trader Dunn produced a 60.25 percent return, and trend trader Parker
produced a 61.82 percent return. It didn’t surprise me BusinessWeek archives re-
vealed no correction.
Volatility
Hedge fund researcher Nicola Meaden compared monthly standard deviations
(volatility as measured from the mean) and semi-standard deviations (volatility measured on the downside only) and found that although trend following ar-
guably experiences higher volatility, it is often concentrated on the upside (posi-
tive returns), not the downside (negative returns).
Trend following performance is thus unfairly penalized by performance mea-
sures such as the Sharpe ratio. The Sharpe ratio ignores whether volatility is on
the plus or minus side because it does not account for the difference between
the standard deviation and the semi-standard deviation. The actual formula is
identical, with one exception—the semi-standard deviation looks only at obser-
vations below the mean. If the semi-standard deviation is lower than the stan-
dard deviation, the historical pull away from the mean has to be on the plus side.
If it is higher, the pull away from the mean is on the minus side. Meaden points
out the huge difference that puts trend following volatility on the upside if you
compare monthly standard (12.51) and semi-standard (5.79) deviation.10
Here is another way of thinking about upside volatility: Ponder a market going
up. You enter at $100 and the market goes to $150. Then the market drops to
$125. Is that necessarily bad? No. Because after going from $100 to $150 and
then dropping back to $125 the market might then zoom up to $175. This is up-
side volatility in action. Even Harry Markowitz (see podcast episode #235), who
won the Nobel Prize for his mean-variance theory, has noted semi-variance is a
better risk measure. He has even said he might not have won that Nobel Prize if
he built CAPM around semi-variance.
Quite simply, Trend following has greater upside volatility and less downside
volatility than traditional equity indices because it exits losing trades quickly.
Trend trader Graham Capital mitigates the fear: “A trend follower achieves posi-
tive returns by correctly targeting market direction and minimizing the cost of
this portfolio. Thus, while trend following is sometimes referred to as being
‘long volatility,’ trend followers technically do not trade volatility, although they
often benefit from it.”11
The question, then, is not how to reduce volatility (you can’t control the market
after all), but how to manage it through proper position sizing or money man-
agement. You have to get used to riding the bucking bronco. Great trend traders
don’t see straight-up equity curves in their accounts, so you are in good com-
pany when it comes to the up and down nature of making big money.
John W. Henry sees the distinction: “Risk is very different from volatility. A lot
of people believe there is no difference, but there’s a huge difference and I can
spend an hour on that topic. Suffice it to say that we embrace both volatility and
risk and, for us, risk is that we’re going to lose if we risk two tenths of one per-
cent on a particular trade. That is, to us, real risk. Giving back a profit to you
probably seems like risk, to us it seems like volatility.”
Henry’s world-view didn’t avoid high volatility. The last thing he wanted to expe-
rience is volatility that forced him out of a major trend before he could make a
profit. Dinesh Desai, a trend follower from the 1980s, was fond of saying he
loved volatility. Being on the right side of a volatile market was the reason he re-
tired rich.
Even with predictable and ongoing volatility debates, trend following has one of
the longest-standing track records in the hedge fund industry and has consis-
tently demonstrated its diversifying power. The ability to take short positions
objectively is absolutely crucial. As a strategy with a relatively low Sharpe ratio, it
needs to be well understood by investors, so the size of positions is in line with
their particular risk tolerance.13
However, the skeptics and critics always view high volatility as only bad. For
example, a fund manager with $1.5 billion in assets remains on the sidelines,
refusing to believe in trend following: “My biggest source of hesitancy about the
asset class [trend following] is its reliance on technical analysis. Trading advisors
do seem to profit, but because they rarely incorporate economic data, they simply ride price trends until they reverse. The end result of this crude approach
is a subpar return to risk ratio.” Another money manager opines: “Why should I
give money to a AA baseball player when I can hire someone in the major
leagues?”14
Looking at the absolute performance of great trend traders and calling it AA
baseball makes little objective sense. I doubt this guy made it past October
2008, unless he was bailed out. Of course, the funds and banks that all blew out
then were all considered Major League. But if you can get beyond the “volatility is
the devil” propaganda it’s easy to see how you can benefit from volatility.
Trend follower Jason Russell says it well:
Volatility matters when you feel it. All the charts, ratios, and advanced math in
the world mean nothing when you break down, vomit, or cry due to the
volatility in your portfolio. I call this the vomitility threshold. Understanding
your threshold is important for it is at this point that you lose all confidence
and throw in the towel. Traders, portfolio managers, and mathematicians
seem well equipped to describe risk with a battery of formulas and ratios they
use to measure volatility. However, even if you can easily handle the math, it
can be a challenge to truly conceptualize it. I can sum it up as follows: Sur-
render to the reality that volatility exists or volatility will introduce you to the
reality that surrender exists.
Building on Russell’s point David Harding was asked: “You’ve attracted quite a
lot of new money into the fund since you’ve launched, but particularly in the last
couple of years. Why?”
Harding replied, “The market has bought what actually is quite a complicated
story. [Our story] is not simple. In our early years, we were impeded by the ter-
rific performance of Dot-com stocks. Later people became very attracted to
certain types of hedge funds, which produced very smooth and steady returns;
something which we’ve never purported to do. But now that the story has been
got across better, people are, I think, realizing that [we are] a good horse to back
in the race.”
Drawdowns
With trend following, however, comes the inevitable drawdown. A drawdown is any
losing period during an investment record. It is defined as the percent retrench-
ment from an equity peak to an equity valley. A drawdown is in effect from the time
an equity retrenchment begins until a new equity high is reached—that is, in terms
of time, a drawdown encompasses both the period from equity peak to equity val-
ley (length) and the time from the equity valley to a new equity high (recovery).16
For example, if you start from $100,000 and drop to $50,000, you are in a 50 per-
cent drawdown. You could also say you have lost 50 percent. The drawdown is
thus a reduction in your account equity. Yes, that happens for buy and holders,
too, but the big difference is that trend following has an exit strategy built in. Not
surprisingly, many investors and regulators have made drawdown for trend fol-
lowing a dirty word, while leaving mutual funds free to disguise their true draw-
downs.
Dunn Capital’s retort:
Investors should be aware of the volatility inherent to [our] trading programs.
Because the same portfolio risk profile is intrinsic to all . . . programs, in-
vestors in any . . . program can be expected to experience volatility similar to
our composite record. During 40+ years of trading, the composite record, on a
month-to-month basis, has experienced eight serious losses exceeding 25 per-
cent. The eighth such loss equaled 40 percent, beginning in September 1999
and extending through September 2000. This loss was recovered in the three-
month period ending in December 2000. The most serious loss in our entire
history occurred over a four-month period, which ended in February 1976 and
equaled 52 percent [Dunn did have a 57 percent drawdown in 2007, which it
recovered from and made new highs as recently as July 2016]. Clients should
be prepared to endure similar or worse periods in the future. The inability (or
unwillingness) to do so will probably result in serious loss, without the oppor-
tunity for subsequent recovery.18
Unless you understand Dunn’s philosophy, you might refuse to invest, even
though that 40-year plus track record is the envy of Monday morning quarterbacks.
Examine their drawdown history in Figure 3.1. I used this same chart in Chapter 2
to illustrate performance, but it serves another purpose.
FIGURE 3.1: Drawdown Chart
Source: Dunn Capital Management
Imagine the valleys between the peaks are filled with water. First, place a piece of
paper over the chart and then slowly move the paper to the right and uncover the
chart. Imagine you have made a large investment in the fund. How do you feel as you move the page? How long can you remain underwater? How deep can you
dive? Do you pull out the calculator and figure out what you could have earned at
the bank? Do you figure out you lost enough to buy a vacation, car, house, or per-
haps solve the hunger crisis of a small nation?
To the eyes-wide-open player this drawdown chart (Figure 3.1) is tolerable because
of the absolute returns over the long-term, but that doesn’t make it easy to accept.
An accurate discussion of drawdown inevitably leads to the recovery conversation,
which means bringing capital back to the point where a drawdown began. Histor-
ically, trend following has quickly made money back during recovery from draw-
downs.
However, you can’t neglect the math associated with losing money and making it
back. What if you start with $100 and it drops to $50? You are now in a 50 percent
drawdown. How much do you have to make to get back to breakeven (Table 3.2)?
You need 100 percent to get back. That’s right—when you go down 50 percent you
need to make back 100 percent to get back to breakeven. Notice as drawdown in-
creases (see Table 3.2), the percent gain necessary to recover to the breakeven
point increases at a much faster rate. Trend following strategy lives with this chart
daily. It handles this math:
TABLE 3.2: Drawdown Recovery Chart
David Harding goes after drawdown haters:
A key measure of track record quality and strategy “riskiness” in the managed
futures industry is drawdown, which measures the decline in net asset value
from the historic high point. Under the Commodity Futures Trading Commis-
sion’s mandatory disclosure regime, managed futures advisors are obliged to
disclose as part of their capsule performance record their “worst peak-to-valley
drawdown.” As a description of an aspect of historical performance, drawdown
has one key positive attribute: It refers to a physical reality, and as such, it is
less abstract than concepts such as volatility. It represents the amount by which
you are less well off than you were; or, put differently, it measures the magni-
tude of the loss an investor could have incurred by investing with the manager
in the past. Managers are obliged to wear their worst historical drawdown like a
scarlet letter for the rest of their lives.21
If the complete story of an absolute return trading strategy is understood, draw-
down fear is mitigated.
However, you can’t eliminate catastrophic risk, much less drawdowns, from trad-
ing. A great example of getting scared at the wrong time during a drawdown can be
seen in this trader’s story: “I [once] opened an account for a client. At the time we were down 10–12 percent, and I explained the drawdown and our expectation for
losses. Suddenly, when his account went down 20 percent, he became very anx-
ious. He eventually closed his account. He made the business decision to stop
trading because of the pain he was feeling from the drawdown. I continued to track
his account hypothetically so I could see what would happen if he would have con-
tinued trading.”
He added: “As it turns out, he closed his account within 2 days of the drawdown
low. Had he stayed invested he would be up +121.1 percent from his closing value,
and +71.6 percent from his starting value (through October 2008). I am reminded
of a statement quoted many times from Peter Lynch, the manager of the Fidelity
Magellan Fund. In light of Lynch’s trading success, he revealed over 50 percent of
the investors in his fund lost money. He explained the reason—most investors
pulled out at the wrong time. They traded with their gut and treated drawdowns as
a cancer, rather than the natural ebb and flow of trading.”
Interestingly, there is another perspective on drawdowns that few consider. When
you look at trend following performance data—for example, Dunn’s track record—
you can’t help but notice certain times look better than others to invest.
Some clients do look at that performance chart and buy when the fund is experi-
encing a drawdown. Because if Dunn is down 30 percent and you know from anal-
ysis of past performance data that recovery from drawdowns can be quick, then
buying while on sale is an option. This is commonly referred to as equity curve
trading. Trend trader Tom Basso:
I haven’t met a trader yet that wouldn’t say privately that he would tend to buy
his program on a drawdown, particularly systematic traders. But, investors seem
to not add money when, to traders, it seems to be most logical to do so . . .
Why don’t investors invest on drawdowns? I believe the answer to that question
lies in the investing psychology of buying a drawdown. The human mind can
easily extrapolate three months of negative returns into “how long at this rate
will it take to lose 50 percent or everything?” Rather than seeing the bargain and
the positive return to risk, they see only the negative and forecast more of the
same into the future.24
Not only do some trend followers tell clients to buy into their funds during a draw-
down, they also buy into their own funds during the drawdowns. I know employees
at top trend following funds who are too happy when they are in a drawdown be-
cause they can buy their fund cheap.
Other trading styles have drawdowns, too. For example, some of the best names
on Wall Street (non-trend followers) had tough sledding in 2008—but they don’t
have the drawdown stigma associated with trend following:
•Warren Buffett (Berkshire Hathaway): –43 percent
•Ken Heebner (CMG Focus Fund): –56 percent
•Harry Lange (Fidelity Magellan): –59 percent
•Bill Miller (Legg Mason Value Trust): –50 percent
•Ken Griffin (Citadel): –44 percent
•Carl Icahn (Icahn Enterprises): –81 percent
•T. Boone Pickens: Down $2 billion since July 2008
•Kirk Kerkorian: Down $693 million on Ford shares alone
It is paramount to determine how quickly you can recover from a drawdown and
get back to making new money again—regardless of trading strategy.
Correlation
Correlation comparisons help to show trend following as a legitimate style and
demonstrate the similarity in strategy used among trend followers. Correlation is
not only important in assembling the portfolio you trade, but it is also a critical tool
for analyzing and comparing performance histories of trend followers.
In a research paper titled Learning to Love Non-Correlation, correlation is defined as
a statistical term giving the strength of linear relationship between two random
variables. It is the historical tendency of one thing to move in tandem with another.
The correlation coefficient is a number from –1 to +1, with –1 being the perfectly
opposite behavior of two investments (e.g., up 5 percent every time the other is
down 5 percent). The +1 reflects identical investment results (up or down the same
amount each period). The further away from +1 one gets (and thus closer to –1),
the better a diversifier one investment is for the other. But to keep things simple,
another description of correlation is instructive: the tendency for one investment to
zig while another zags.27
Let’s look an an example. I took the monthly performance numbers of trend fol-
lowers and computed their correlation coefficients. Comparing correlations gave
the evidence that trend followers trade typically the same markets in the same way
at the same time.
Look at the correlation chart (see Table 3.3(a)) and ask yourself: “Why do two trend
followers who don’t work in the same office, who are on opposite sides of the
continent, have the same three losing months in a row with similar percentage
losses?” Then ask: “Why do they have the same winning month, then the same two
losing months, and then the same three winning months in a row?” The rela-
tionship is there because they can respond only to what the market offers. The
market offers trends to everyone equally. They’re all looking at the same market,
aiming for the same target of opportunity.
AbrDiv: Abraham Trading; CamFin: Campbell & Company; CheDiv: Chesapeake
Capital Corporation; DUNWor: DUNN Capital Management, Inc.; EckSta: Eckhardt
Trading Co.; JohFin: John W. Henry & Company, Inc.; ManAHL: Man Inv. Prod-
ucts, Ltd.; MarSta: Mark J. Walsh & Company; RabDiv: Rabar Market Research.
Table 3.3(b): also shows trend followers using similar techniques.
Data Source: BarclayHedge
* Average excludes Barclay CTA Index and S&P 500
Interestingly, correlation can be a touchy subject. The Turtles were all grateful to
Richard Dennis for his mentoring, but some were ambivalent over time, obviously
indebted to Dennis, but struggling to achieve their own identity: “One Turtle says
his system is 95 percent Dennis’ system and the rest his ‘own flair . . . I’m a long
way from someone who follows the system mechanically . . . but by far, the struc-
ture of what I do is based on Richard’s systems, and certainly, philosophically,
everything I do in terms of trading is based on what I learned from Richard.’”28
Even when correlation data shows similar patterns among Dennis’s Turtle stu-
dents, the desire to differentiate is stronger than their need to honestly address
obvious similarities in their return streams: “There no longer is a turtle trading
style in my mind. We’ve all evolved and developed systems that are very different
from those we were taught, and that independent evolution suggests that the dis-
similarities to trading between turtles are always increasing.”29
A Turtle correlation chart paints another picture. The relationship is there to judge.
The data (Table 3.4) is the ultimate arbiter:
There is more to the story than correlation, however. Although correlations show
Turtles trade in a similar way, their returns differ due to their individual leverage
and portfolio choices. Some traders use more leverage, others less. TurtleTrader
Jerry Parker explains, “The bigger the trade, the greater the returns and the greater
the drawdowns. It’s a double-edged sword.”30
Correlation coefficients gauge how closely an advisor’s performance resembles an-
other advisor. Values exceeding 0.66 might be viewed as having significant posi-
tive performance correlation. Consequently, values exceeding –0.66 might be
viewed as having significant negative performance correlation.
Data is for Chesapeake Capital Corporation, Eckhardt Trading Co., Hawksbill Cap-
ital Management, JPD Enterprises Inc., and Rabar Market Research.
Zero Sum
The zero-sum nature of many markets is arguably the most important concept in
markets. Larry Harris, chair in finance at the Marshall School of Business at Univ-
ersity of Southern California: “Trading is a zero-sum game when gains and losses
are measured relative to the market average. In a zero-sum game, someone can win
only if somebody else loses.”31
Harris told me he was amazed at how many people came from my websites to
download his white paper on zero-sum trading—the topic left out of most strategy
discussions. It’s one winner and one loser.
Harris examines the factors that determine who wins and who loses in market
transactions. He does this by categorizing traders by type and then evaluating
speculative trading styles to determine whether the styles lead to profits or loss-
es: “Winning traders can only profit to the extent that other traders are willing to
lose. Traders are willing to lose when they obtain external benefits from trading.
The most important external benefits are expected returns from holding risky secu-
rities that represent deferred consumption. Hedging and gambling provide other
external benefits. Markets would not exist without utilitarian traders. Their trading
losses fund the winning traders who make prices efficient and provide liquidity.”32
There are those who absolutely do not accept that there must be a loser for them to
be a winner. They cannot live with the fact everyone can’t be a winner. Although
they want to win, many do not want to live with the guilt by their winning, someone
else has to lose. This is a poorly thought out yet all too common view of the losing
trader’s mindset.
Harris is clear on what separates winners from losers:
On any given transaction, the chances of winning or losing may be near even. In
the long run, however, winners profit from trading because they have some
persistent advantages that allow them to win slightly more often or occasionally
much bigger than losers win. . . .
To trade profitably in the long run, you must know your edge, you must know
when it exists, and you must focus your trading to exploit it when you can. If
you have no edge, you should not trade for profit. If you know you have no
edge, but you must trade for other reasons, you should organize your trading to
minimize your losses to those who do have an edge. Recognizing your edge is a
prerequisite to predicting whether trading will be profitable.33
Nobel Prize winner and cofounder of famed trend following incubator Commodi-
ties Corporation Paul Samuelson adds, “For every trader betting on higher prices,
another is betting on lower prices. These trades are matched. In the stock market,
all investors (buyers and sellers) can profit in a rising market, and all can lose in a
falling market. In futures markets, one trader’s gain is another’s loss.”
Dennis Gartman adds to the perspective: “In the world of futures speculation, for
every long there is an equal and opposite short. That is, unlike the world of equity
trading where there needn’t be equal numbers of longs versus shorts, in the world
of futures dealing there is. Money is neither made, nor lost, in futures; it is simply
moved from one pocket to the next as margins are swapped at the close of trading
each day. Thus, every time there is a buyer betting that prices shall rise in the fu-
ture, there is an equal seller taking the very opposite bet, betting that prices will
fall.”
These observations will save your skin if you’re willing to accept the truth, but as
you can see throughout this volume, many are either ignorant to zero-sum think-
ing, choose to ignore it, or refuse to believe it condemned to exist inside biases.
George Soros
The trading success of famed speculator George Soros is well known. In 1992 he
was labeled the man who broke the British pound for placing a $10 billion bet
against the pound that netted him at least $1 billion in profit.34
Yet even successful pros sometimes miss a key point. Years back, Soros appeared
on Nightline, an old-school ABC news program. This exchange between Soros and
then-host Ted Koppel goes to the zero-sum understanding—or lack thereof:
Ted Koppel:
As you describe it, the market is, of course, a game in which there are real
consequences. When you bet and you win, that’s good for you, it’s bad for
those against whom you have bet. There are always losers in this kind of a
game?
George Soros:
No. See, it’s not a zero-sum game. It’s very important to realize.
Ted Koppel:
Well, it’s not zero-sum in terms of investors. But, for example, when you bet
against the British pound that was not good for the British economy?
George Soros:
Well, it happened to be quite good for the British economy. It was not, let’s say,
good for the British treasury because they were on the other side of the trade
. . . It’s not—your gain is not necessarily somebody else’s loss.
Ted Koppel:
Because—put it in easily understandable terms—I mean if you could have prof-
ited by destroying Malaysia’s currency, would you have shrunk from that?
George Soros:
Not necessarily because that would have been an unintended consequence of
my action. And it’s not my job as a participant to calculate the consequences.
This is what a market is. That’s the nature of a market. So I’m a participant in
the market.
Soros opens a can of worms with his description of zero-sum. From a blog post
that incorrectly analyzes Soros’ interview: “Cosmetically, Koppel wipes the floor
with Soros. He’s able to portray Soros as a person who destroys lives and
economies without a second thought, as well as simplify, beyond belief, something
that should not be simplified.”35
This is nonsense. The fact Soros is a player in the market does not establish him as
a destroyer of lives. You might disagree with Soros’s political ideology, but you
can’t question his morality for participation in markets. You have a 401(k) plan de-
signed to generate profits from the market—like Soros. Others, such as Lawrence
Parks, a union activist, correctly state that Soros is in a zero-sum game, but Parks
then goes jealous by declaring zero-sum unfair and harsh for the working-man:
Since currency and derivative trading are zero-sum games, every dollar “won”
requires that a dollar was “lost.” Haven’t they realized what a losing proposition
this has been? What’s more, why do they keep playing at a losing game? The an-
swer is that the losers are all of us. And, while neither rich nor stupid, we’ve
been given no choice but to continue to lose. And every time one of these fiat
currencies cannot be “defended,” the workers, seniors, and business owners of
that country—folks like us—suffer big time. Indeed, as their currencies are
devalued, workers’ savings and future payments, such as their pensions,
denominated in those currencies lose purchasing power. Interest rates increase.
Through no fault of their own, working people lose their jobs in addition to their
savings. There have been press reports that, after a lifetime of working and sav-
ing, people in Indonesia are eating bark off the trees and boiling grass soup.
While not a secret, it is astonishing to learn how sanguine the beneficiaries have
become of their advantage over the rest of us. For example, famed financier
George Soros in his recent The Crisis of Global Capitalism plainly divulges: “The Bank of England was on the other side of my transactions and I was taking
money out of the pockets of British taxpayers.” To me, the results of this wealth
transfer are inescapable.37
Parks says his only choice is to lose. He loses, his union loses—it’s a pity party. It
seems everyone loses in the zero-sum game (even though Parks’ fund will of course
have their assets invested in the very funds he criticizes). Look, there are winners
and losers and he knows that. Yes, the zero-sum speculation game is indeed a
wealth transfer. The winners profit from the losers. Life is not fair. If you don’t like
being a loser in the zero-sum game, then it is time to consider how the winners
play the game.
Trying to understand Soros’s reasons for denying zero-sum would be speculation
on my part. Soros is not always the zero-sum winner, either. He was on the losing
side of the zero-sum game during the Long-Term Capital Management fiasco in
1998, in which he lost $2 billion. He also had severe trouble in the 2000 tech-
nology meltdown: “With bets that went sour on technology stocks and on Europe’s
new currency, the five funds run by Soros Fund Management have suffered a 20
percent decline this year and, at $14.4 billion, are down roughly a third from a peak
of $22 billion in August 1998.”38
These wins and losses took a toll on Soros: “Maybe I don’t understand the market.
Maybe the music has stopped but people are still dancing. I am anxious to reduce
my market exposure and be more conservative. We will accept lower returns be-
cause we will cut the risk profile.”39
Don’t Blame Zero-Sum
Long-time Federal Judge Milton Pollack’s ruling that dismissed class action suits
illustrates zero-sum confusion. He minces no words in warning whiners about
the game they are playing:
Seeking to lay the blame for the enormous Internet bubble solely at the feet of
a single actor, Merrill Lynch, plaintiffs would have this Court conclude that
the federal securities laws were meant to underwrite, subsidize, and encour-
age their rash speculation in joining a freewheeling casino that lured thou-
sands obsessed with the fantasy of Olympian riches, but which delivered
such riches to only a scant handful of lucky winners. Those few lucky win-
ners, who are not before the Court, now hold the monies that the unlucky
plaintiffs have lost, fair and square, and they will never return those monies to
plaintiffs. Had plaintiffs themselves won the game instead of losing, they
would have owed not a single penny of their winnings to those they left to
hold the bag (or to defendants).40
A 96-year-old judge bluntly telling plaintiffs to take responsibility for their own
actions was no doubt painful for those seeking an incompetence bailout. Pollack
flatly nails the losers for trying to circumvent the zero-sum market process via
the judicial process.
The harsh reality of speculation is you only have yourself to blame for decisions
you make with your money. You can make ongoing losing or winning decisions.
It’s your choice. David Druz, a longtime trend follower, takes Judge Pollack’s rul-
ing a step further spelling out the practical effects:
Everyone who enters the market thinks they will win, but obviously there are
losers as well. Somebody has to be losing to you if you are winning, so we al-
ways like to stress that you should know from whom you’re going to take
profits, because if you’re buying, the guy that’s selling thinks he’s going to be
right, too.
The market is a brutal place. Forget trying to be liked. Need a friend? Get a dog.
The market doesn’t know you and never will. If you are going to win, someone else has to lose. If you don’t like these survival-of-the-fittest rules, then stay out
of the zero-sum game.
Berkshire Hathaway
Amidst the recent celebration of Berkshire Hathaway’s 50 years of investment re-
turns, trend following trader Bernard Drury and his firm Drury Capital wondered if
a portfolio holding Berkshire (BRKA), already hugely successful, could nonetheless
be improved by combining holdings of BRKA with other assets. An ideal candidate
for investment alongside BRKA would be an asset with both positive returns on a
stand-alone basis as well as low correlation to BRKA.
In 1983, Dr. John Linter published the classic paper, “The Potential Role of Man-
aged Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of
Stocks and Bonds.” In this study he pointed to gains in risk-adjusted rates of re-
turn that potentially could be obtained by combining equity investment with man-
aged futures.
To examine a portfolio combination of stocks and managed futures (read: trend
following), Drury focused on Berkshire because of its legendary performance. On
the managed futures side, Drury’s trend following fund satisfies the requirements
of having both strong performance and almost-zero correlation to Berkshire.
While Drury cannot cite the same longevity as Berkshire, it has been in continuous
operation for almost 19 years. At least for these years, it is useful to examine Drury
in relation to Berkshire for a possible improvement of overall portfolio returns. The
two performance records, taken individually during this period, are broadly similar.
(See Table 3.5.)
TABLE 3.5: May 1997 to February 2015: Drury and BRKA
The correlation between the two return streams is 0.01. Despite the overall simi-
larity of returns, the paths to producing these returns have nothing in common.
Consequently, as modern portfolio theory would predict, the performance of a
portfolio holding Berkshire is potentially improved by adding a noncorrelated
Drury. (It is of course equally true a portfolio holding only Drury is potentially im-
proved by being coupled with a noncorrelated asset such as Berkshire).
A look at the efficient frontier for this two-asset portfolio suggests a blend of ap-
proximately 50/50 would have produced the highest ratio of ROR versus standard
deviation of returns:
The portfolio with 50 percent each in Berkshire and Drury raised the risk-adjusted
ROR to a level higher than either could achieve individually. For the holder of Berk-
shire, the diversification reduced the portfolio volatility by almost one-third and re-
duced the depth of the peak-to-trough drawdown by almost half. Finally, perhaps
even remarkably, the combination of Berkshire holdings with this noncorrelated
asset cut the length of the drawdown associated with holding Berkshire alone by a
whopping 43 months. This means instead of experiencing a 61-month period
(December 2007–January 2013) underwater, relative to the latest high price, while
holding Berkshire shares alone, the combined portfolio reduced the underwater pe-
riod to only 18 months. (By the same token, of course, the underwater period of
holding Drury alone is reduced from 55 months to the same 18 months).
Columbia University professor Benjamin Graham led academia and Wall Street
with pioneering work across value investing. Famously, Warren Buffett was one of
his students in the 1940s. And years later, the Nobel Prize–winning work of Harry
Markowitz explored the effects of combining noncorrelated assets to improve risk-
adjusted returns. Markowitz is credited with the often-repeated quip that “diversi-
fication is the only free lunch in finance.” Thus it’s not surprising that adding
Drury’s trend following as diversification to Buffett and Berkshire clearly enhances an overall portfolio return while reducing volatility.
Ultimately, performance data is the driver, the only truth we can take in for analysis.
If there is no data, no believable narrative can be used to explain anything. And
trend following data is a very clever way to illustrate human behavior with num-
bers—and it happens to also be proof of concept any skeptic would want before
jumping into the deep end to deploy their risk capital. Yet where does trend fol-
lowing performance data come from exactly?
Summary Food for Thought
•“F-You money”: If you trade for absolute returns you have the chance for
F-You money—the money it would take to leave your job and never work
again.
•Ewan Kirk: “When people ask: ‘What do you think is going to happen in
the future?’ We always say: ‘We don’t know.’ I can’t really project whether
next year will be a good year or a bad year.”
•Absolute return means trying to make the most possible.
•In a zero-sum game the total gains of the winners are exactly equal to the
total losses of the losers.
•George Crapple: “So while it may be a zero-sum game, a lot of people
don’t care. It’s not that they’re stupid; it’s not speculative frenzy; they’re
just using these markets for a completely different purpose [hedging].”
•The U.S. Army War College introduced the acronym VUCA to describe
general conditions post Cold War: volatile, uncertain, complex and am-
biguous.
•Mark Rzepczynski: “If a manager cannot explain what he does and his
edge in 45 minutes, you should not invest.”43
Bernard Drury graciously contributed for this section. Percentage change in stock
price month over month as of each month end across the period covered. BRKA
stock prices from Yahoo! Finance.
Note: You can review trend following performance going back decades. Send an
email for online sources: www.trendfollowing.com/contact.
Author note: The following quotations appear in the hardcover side
margins.
It is a capital mistake to theorize before one has data.
Sir Arthur Conan Doyle1
This ain’t clipping coupons. No risk, no return. No balls, no babies.
Anonymous
The class of those who have the ability to think their own thoughts is separated by an
unbridgeable gulf from the class of those who cannot.
Ludwig von Mises6
Volatility is the tendency for prices to change unexpectedly.7
Some suggested a few years ago that trend following had been marginalized. The an-
swer is we haven’t been marginalized—[trend following] has played a key role in helping
protect a lot of people’s wealth this year.
Mark Rzepczynski9
Trading is a zero-sum game in an important accounting sense. In a zero-sum game, the
total gains of the winners are exactly equal to the total losses of the losers.12
Larry Harris
Some people seem to like to lose, so they win by losing money.
Ed Seykota15
If you were to put all the trend following models side by side, you would probably find
that most made profits and incurred losses in the same markets. They were all looking
at the same charts and obtaining the same perception of opportunity.
Marc Goodman Kenmar Asset Allocation17
Dunn Capital Management’s documents include a summary of serious past losses. The
summary explains that the firm has suffered through seven difficult periods of losses of 25
percent or more. Every potential investor receives a copy: “If the investor is not willing to
live through this, they are not the right investor for the portfolio.”19
Obviously you don’t want to overhaul a program in response to one year just because
something didn’t work. That’s when you’re almost guaranteed that it would have
worked the next year had you kept it in there.
Eclipse Capital
The 25 or 50 biggest trend followers are essentially going to make money in the same
places. What differentiates them from one another are portfolio and risk
management.20
Unless you can watch your stock holding decline by 50% without becoming panic-
stricken, you should not be in the stock market.
Warren Buffett
Note: Since 1980 Berkshire Hathaway has had drawdowns of −51%, −49%, −37%, and
−37%. In addition, Charles Munger Partnership dropped −31.9% in 1973 and −31.5% in
1974.
We have not made any changes because of a drawdown. While we have made minor
changes since the program started trading in 1974, over the course of the years the basic
concepts have never changed. The majority of the trading parameters and the buy and
sell signals largely have remained the same.
Bill Dunn22
You have to keep trading the way you were before the drawdown and also be patient.
There’s always part of a trader’s psyche that wants to make losses back tomorrow. But
traders need to remember you lose it really fast, but you make it up slowly. You may
think you can make it up fast, but it doesn’t work that way.
David Druz23
Correlation coefficient: A statistical measure of the interdependence of two or more ran-
dom variables. Fundamentally, the value indicates how much of a change in one vari-
able is explained by a change in another.25
Campbell & Company, a trend following managed futures firm with almost [billions] in
assets under management, has returned 17.65 percent since its inception in 1972, prov-
ing that performance can be sustainable over the long-term.26
If an investor had invested 10 percent of his or her portfolio in the Millburn Diversified
Portfolio from February 1977 through August 2003 he or she would have increased the
return on his or her traditional portfolio by 73 basis points (a 6.2 percent increase) and
decreased risk (as measured by standard deviation) by 0.26 of a percent (an 8.2 percent
decrease).
Millburn Corporation
When I was young I thought that money was the most important thing in life; now that
I am old I know that it is.
Oscar Wilde
If they can get you asking the wrong questions, they don’t have to worry about answers.
Thomas Pynchon
The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price
Efficiency and Market Liquidity, see http://turtletrader.com/zerosum .pdf.
I was talking to myself, saying like, ‘Just relax, man. The comeback is so great already.
Let it fly off your racquet and just see what happens.’ I think that’s the mindset I got to
have, as well, in the finals. Sort of a nothing-to-lose mentality. It’s been nice these last
six matches to have that mentality. It worked very well so I’ll keep that up.
Roger Federer on pep talk he gave himself in the fifth set of his 18th grand slam
win
What objectivity and the study of philosophy requires is not an “open mind,” but an ac-
tive mind—a mind able and eagerly willing to examine ideas, but to examine them
critically.
Ayn Rand36
It’s all a matter of perspective. What some consider a catastrophic flood, others deem a
cleansing bath.
Gregory J. Millman41
If all it took to beat the markets was a Ph.D. in mathematics, there’d be a hell of a lot
of rich mathematicians out there.
Bill Dries42
If you have sound philosophy, and superior strategy, the day-to-day slows down. If you
don’t have such every distraction appears consequential.
Michael Covel
Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this
time...Valeant, of course, was a sewer.
Charlie Munger 2015, 2016
There are no facts about the future, just opinions. Anyone who asserts with conviction
what he thinks will happen in the macro future is overstating his foresight, whether out
of ignorance, hubris or dishonesty.
Howard Marks
Notes
1. Sir Arthur Conan Doyle, The Adventures of Sherlock Holmes (New York: A. L.
Burt, 1892).
2. Alexander M. Ineichen, Absolute Returns (New York: John Wiley & Sons, Inc.,
2003): 19.
3. “Disclosure Document,” John W. Henry & Company, Inc. (August 22, 2003).
4. “BMFR,” Barclay Trading Group (first quarter 2003).
5. “International Traders Research Star Ranking System Explanation,” International
Traders Research, http://managedfutures.com.
6. Ludwig von Mises, Human Action: A Treatise on Economics, 4th rev. ed. (Irv-
ington-on-Hud-son, NY: The Foundation for Economic Education, 1996).
7. Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners (New
York: Oxford University Press, 2003).
8. David Greising, “How Managed Funds Managed to Do So Poorly,” Businessweek,
November 23, 1992, 112.
9. Daniel P. Collins, “The Return of Long-Term Trend Following,” Futures 32, no. 4
(March 2003): 68–73.
10. Desmond McRae, “Top Traders,” Managed Derivatives (May 1996).
11. “Trend Following: Performance, Risk and Correlation Characteristics” (white
paper), Graham Capital Management.
12. Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners (New
York: Oxford University Press, 2003).
13. “Schroder GAIA BlueTrend,” Schroders Expert, Issue 1 (February 2016).
14. Ben Warwick, “The Holy Grail of Managed Futures,” Managed Account Reports,
no. 267 (May 2001): 1.
15. “The Trading Tribe” (forum response), The Trading Tribe,
www.seykota .com/tribe/.
16. “Drawdowns,” Institutional Advisory Services Group, www.iasg.com.
17. Laurie Kaplan, “Turning Turtles into Traders,” Managed Derivatives (May 1996).
18. “Marketing Materials,” Dunn Capital Management, Inc.
19. Carla Cavaletti, “Comeback Kids: Managing Drawdowns According to Com-
modity Trading Advisors,” Futures 27, no. 1 (January 1998): 68.
20. Michael Peltz, “John W. Henry’s Bid to Manage the Future,” Institutional In-
vestor (August 1996).
21. D. Harding, G. Nakou, and A. Nejjar, “The Pros and Cons of Drawdown as a
Statistical Measure of Risk for Investments,” AIMA Journal (April 2003): 16–17.
22. Cavaletti, “Comeback Kids.”
23. Ibid.
24. Thomas F. Basso, “When to Allocate to a CTA?—Buy Them on Sale” (1997).
25. InvestorWords. See http://investorwords.com.
26. “New Fans for Managed Futures,” Euromoney Institutional Investor PLC (Feb-
ruary 1, 2003): 45.
27. Julius A. Staniewicz, “Learning to Love Non-Correlation. Investor Support,”
John W. Henry & Company.
28. Ginger Szala, “Tom Shanks: Former ‘Turtle’ Winning Race the Hard Way,” Fu-
tures 20, no. 2 (January 15, 1991): 78.
29. Carla Cavaletti, “Turtles on the Move,” Futures 27 (June 1998): 79.
30. Laurie Kaplan, “Turning Turtles into Traders,” Managed Derivatives (May 1996).
31. Harris, Trading and Exchanges.
32. Larry Harris, “The Winners and Losers of the Zero-Sum Game: The Origins of
Trading Profits, Price Efficiency and Market Liquidity (Draft 0.911)” (Los Angeles:
University of Southern California, May 7, 1993).
33. Ibid.
34. Danny Hakim, “Huge Losses Move Soros to Revamp Empire,” New York Times,
May 1, 2000.
35. Enoch Cheng, “Of Markets and Morality . . .” Café Bagola (blog), August 27,
2002, https://web.archive.org/web/20041019121710/.
36. Ayn Rand, “Philosophical Detection,” Philosophy: Who Needs It? (Indianapolis,
IN: Bobbs-Merrill, 1998).
37. Lawrence Parks (presentation, Hearing on Hedge Funds before the Subcom-
mittee on Capital Markets, Securities, and GSEs; House Committee on Banking
and Financial Services, United States House of Representatives, March 3, 1999).
38. Hakim, “Huge Losses.”
39. Ibid.
40. “Merrill Lynch & Co. Inc. Research Reports Securities Litigation, 02 MDL 1484”
(Ruling by Federal Judge Milton Pollack dismissing class-action claims brought
against Merrill Lynch & Co. and its former analyst Henry Blodgett).
41. Gregory J. Millman, “The Chief Executive,” (January–February 2003).
42. Bill Dries, Futures (August 1995): 78.
43. Mark Rzepczynski, “The Weatherstone Approach to Hedge Fund Investing,”
Disciplined Systematic Global Macro Views (blog), October 13, 2016,
http://mrzepczynski.blogspot.com/2016/10/the-weatherstone-approach-to-hedge-fund.html.
4
Big Events, Crashes, and Panics
Of all the beliefs on Wall Street, price momentum makes efficient market
theorists howl the loudest.
—James O’Shaughnessy
Rare events are always unexpected, otherwise they would not occur.
—Nassim Taleb1
Remember the Gomer Pyle character from The Andy Griffith show? I can see
Gomer saying his classic TV line now:
“Surprise, surprise, surprise.”
To comprehend trend following’s true impact you must look at its performance
across the biggest events, bubbles and crashes of the last 50 years where it won
huge profits in the zero-sum game of surprises.
While world governments and Wall Street are notorious for country wipeouts,
central bank errors, corporate collapses, bank implosions, and fund blow-ups
that transfer capital from losers to winners, the winners are almost always miss-
ing from after-the-fact analysis. Like clockwork, the press is over-the-top fasci-
nated with the losers when surprises roll in. Following their lead, the public also
gets caught up in the losers’ drama, oblivious to: Who were the winners and why
did they win?
Sometimes they get close to the insight: “Each time there’s a derivatives disaster
I get the same question: If Barings was the loser, who was the winner? If Orange
County was the loser: Who was the winner? If Procter & Gamble was the loser:
Who was the winner?”2
Prominent finance academics searching for winners often come up short, as
Christopher Culp of the University of Chicago lamented: “It’s a zero-sum game.
For every loser there’s a winner, but you can’t always be specific about who the
winner is.”3
When big market events happen, smart people know the losers’ losses are going
somewhere, but time passes and they stop thinking about it or forget the original
goal. Reflecting on an implosion is not pleasant: “Fear is still in the bones of
some pension fund trustees—after Mr. Leeson brought down Barings Bank. The
failure of Barings Bank is probably the most often cited derivatives disaster.
While the futures market had been the instrument used by Nick Leeson to play
the zero-sum game and someone made a lot of money being short the Nikkei fu-
tures Mr. Leeson was buying.”4
Someone did make a lot of money trading short to Leeson’s long. But most of
Main Street and Wall Street look at it through the wrong lens. Michael
Mauboussin sees standard finance theory coming up short when explaining win-
ners during high-impact times: “One of the major challenges in investing is how
to capture (or avoid) low-probability, high-impact events. Unfortunately, stan-
dard finance theory has little to say about the subject.”5
The unexpected events so many bemoan are a source of outsized trend fol-
lowing profits. High impact and unexpected events, the black swans, have made
many in this book very wealthy. One trader explains trend following’s success
during uncertain times:
For markets to move in tandem, there has to be a common perception or
consensus about economic conditions that drives it. When a major “event”
occurs in the middle of such a consensus, such as the Russian debt default
of August 1998, the terrorist attacks of September 11, 2001, or the corporate
accounting scandals of 2002 [and the 2008 equity market crash], it will often accelerate existing trends already in place . . . “events” do not happen in a
vacuum . . . This is the reason trend following rarely gets caught on the
wrong side of an “event.” Additionally, the stop loss trading style will limit
exposure when it does—When this consensus is further confronted by an
“event,” such as a major country default, the “event” will reinforce the crisis
mentality already in place and drive those trends toward their final conclu-
sion. Because trend following generally can be characterized as having a
“long option” profile, it typically benefits greatly when these occurrences
happen.7
Said more bluntly: “Even unlikely events must come to pass eventually. There-
fore, anyone who accepts a small risk of losing everything will lose everything,
sooner or later. The ultimate compound return rate is acutely sensitive to fat
tails.”8 However, big events also generate plenty of inane analysis by focusing
on the unanswerable like questions posed by Thomas Ho and Sang Lee, authors
of The Oxford Guide to Financial Modeling9:
1.What do these events tell us about our society?
2.Are these financial losses the dark sides of all the benefits of finan-
cial derivatives?
3.Should we change the way we do things?
4.Should society accept these financial losses as part of the “survival
of the fittest” in the world of business?
5.Should legislation be used to avoid these events?
It is not unusual to see market wins and losses positioned as a morality tale to
be solved by government. This drama absolves the losers’ guilt for poor strate-
gies (i.e., Amaranth, Bear Stearns, Bernard Madoff, LTCM, Lehman Brothers,
Deutsche Bank, Valeant, etc.). Yet the market is no place for politics or social
engineering. No law will ever change human nature. As Dwight D. Eisenhower
noted: “The search for a scapegoat is the easiest of all hunting expeditions.”
Bottom line, trend following performance histories during the 2016 Brexit event,
the 2014–2016 oil implosion, the 2008 market crash, the 2000–2002 Dot-com
bubble, the 1998 Long-Term Capital Management (LTCM) crisis, the 1997 Asian
contagion, and the 1995 Barings Bank and 1993 Metallgesellschaft collapses an-
swer the all-important question: “Who won and why?”
Event 1: Great Recession
The world changed as stock markets crashed during October 2008. Millions lost
trillions of dollars when buy-and-hold-tight strategies imploded. The Dow, S&P,
and NASDAQ fell like stones, with the carnage carrying over into 2009. Everyone
felt it: jobs lost, firms going under, and fear all around. No one made money dur-
ing this time. Everyone lost. That was the meme.
Hold on—is that true? It is not. There were winners during October 2008 and they
made fortunes ranging from +5 percent to +40 percent in that single month. And
trend following strategy was the winner. First, let me state how it did not win:
1.Trend following did not know stock markets would crash in October
2008.
2.Trend following did not make money from only shorting stocks in
October 2008.
Trend following made money from many different markets; from oil to bonds to
currencies to stocks to commodities, markets that trended up and down. It always
does well in times of wild and extended price swings, in part because systems pro-
grammed into computers make calculated, emotionless buys and sells.
“We are not going to be the first to get in or the first to get out, but we are generally
able to capture 80 percent of the trends,” opined a Superfund associate. For exam-
ple, consider performance from January 2008 through October 2008:
•January: –2.21 percent
•February: 14.17 percent
•March: 1.59 percent
•April: –1.23 percent
•May: 6.52 percent
•June: 9.88 percent
•July: –10.26 percent
•August: –8.36 percent
•September: 2.59 percent
•October: 17.52 percent
This was not the only trend following trader winning big. Consider others during
the period:
•One fund run by John W. Henry was up 72.4 percent through Octo-
Octo- 2008.
•TransTrend, a Dutch-based trend following trader managing more than
$1 billion in assets, saw one of its funds go up 71.75 percent from Jan-
uary through November 2008.
•Clarke Capital Management saw its $72.2 million fund gain 82.2 per-
cent through October 2008. As but one example of his winning bets,
Clarke shorted crude oil when it was around $140, and then stayed with
the trade down to $80 before exiting, thereby collecting the bulk of the
trend.
•Trend following trader Bernard Drury started selling S&P 500 index fu-
tures short in November 2007. The index went down about 36 per-
cent and the largest Drury fund roared up 56.9 percent through Octo-
ber 2008.11
•Paul Mulvaney, another trend following trader who has used a much
longer timeframe in his trading (weekly bars), saw his fund post a
45.49 percent return for the month of October 2008—yes, in one
month.
Note: Berkshire Hathaway dropped −51% over 2007–2009.
Another trend follower provided insights into his 2008 performance: “October
2008 provides a prime example of how [we] can produce gains in volatile and
otherwise adverse market conditions. During this month and preceding months,
[our] trading system not only profited from trends that were gaining momentum, but also responded to historic volatility by reducing or eliminating positions, and
thus risk exposure, in markets in which trends were growing stale.”
How did they do it? “In February 2008, a sustained downward trend in the U.S.
dollar against various currencies accelerated. This coincided with a significant rally
in gold and energy markets. Many trend following trading systems . . . profited
from short positions in the U.S. dollar [see Figure 4.1] and long positions in gold
and energies.”
FIGURE 4.1: U.S. Dollar Short Trade
They described the unfolding market chaos: “At the same time, several world
stocks indices exhibited signs of weakness. By June, however, gold stumbled nearly
$200 from recent highs above $1,000 per ounce [see Figure 4.2]. [We were able] to
continue capturing gains in the U.S. dollar, energies, and stocks while reducing its
long exposure to gold as returns in this market faltered.”
FIGURE 4.2: : Long Gold Trade
They clarified how events led to October 2008:
During July and August, profitable trends in the U.S. dollar, energies, and grains
exhausted themselves. It was at this juncture that the our system repositioned
itself for results in October despite short-term drawdowns during these two
months. While speculative traders may have viewed the precipitous drop in
energies and other commodities as an opportunity to add to their long posi-
tions, we identified the end of sustained trends in these markets and signif-
icantly reduced its positions, and therefore its risk, particularly in the U.S. dol-
lar. Meanwhile, our system began identifying emerging trends in world treasury
markets [see Figure 4.3], as well as meats and industrial metals.
FIGURE 4.3: :Long Five-Year Notes Trade
Figure 4.3 shows the patience trend following had to endure in the face of extreme
volatility:
As October 2008 unfolded, my associate offered a behind-the-scenes take: “Ap-
proaching October, we were ready to take advantage of changing market conditions
both because of positions we no longer held as well as positions we had entered
during the subpar return periods of July and August. For example, we had avoided
the potential for substantial losses from an 18.3 percent decline in gold futures and
a 32 percent collapse in crude oil [see Figure 4.4] by reducing long exposure to
these markets before their substantial October declines.”
FIGURE 4.4: Crude Oil Short Trade
Trend following also captured a major trend in the Nikkei 225 (see Figure 4.5)
But this is not about predictions, so when trends changed, the gears switched:
“After having been short the U.S. dollar for most of the first half of 2008, by Octo-
ber, we had established positions designed to profit from the reversal of the U.S.
dollar trend in July and August. At that point, currencies such as the British pound
began to decline against the dollar [see Figure 4.6].”
FIGURE 4.6: British Pound Short Trade
Trend following realized the bulk of October profits as a result of the ability to capi-
talize on different market conditions while limiting losses based on a combination
of diversification, flexibility, risk management, and discipline. While a substantial
portion of trend following’s October profits were derived from short positions in
the stock indices and world currencies, trend following also realized profits from
long bond positions. It avoided major losses by reducing exposure to gold and
energies as well.
Although not as large as some trend following traders in terms of assets under
management, another trader offered insights into his 2008 performance. He took
me through his trades where he saw monster returns while other market players
gasped for air.
First he outlined a European interest rate trade (see Figure 4.7): “In the midst of
the global financial crisis, we received signals on many short-term interest rates.
The Euribor is a short-term interest rate futures contract traded at the EUREX. We
bought on October 7 and are still long (through December 2008). Central banks
around the globe began dropping interest rates to ward off equity market declines.
Lower interest rates mean higher Euribor futures prices. Fundamentals did not
drive our decisions.”
FIGURE 4.7: Long December 2008 Euribor Trade
He further explained how he profited from a short-term interest rate, the EuroSwiss
(see Figure 4.8): “The EuroSwiss is another short-term interest rate futures con-
tract. We entered this position well before the global equity market crash.”
FIGURE 4.8: :Long December 2008 EuroSwiss Trade
Consider his explanation about trading hogs (see Figure 4.9): “The Hog position
was one of the most beautiful trends that I’ve seen in years. As the U.S. dollar ral-
lied, nearly every commodity tied to the dollar moved violently. Although our larger
portfolio gains happened in October, this position profited throughout the fall of
2008.”
FIGURE 4.9: Short December 2008 Lean Hogs Trade
Sure, people love to focus on stocks, but lumber of all things offered huge gains
(see Figure 4.10): “Lumber was another great market over the fall of 2008. Lumber
fell due to the housing crisis in the U.S. Lower demand means lower lumber
prices. We sold the market short in the late summer and held the position until
mid-November. However, it is important to keep in mind that we went short based
off of price action, not fundamentals.”
FIGURE 4.10: Short January 2009 Lumber Trade
For you Starbucks connoisseurs, the coffee market fall 2008 was another major
move (see Figure 4.11): “Although traded in London, Robusta Coffee is denom-
inated in U.S. dollars. The move up in Robusta Coffee was helped in large part
from a strengthening U.S. dollar. A higher dollar means less purchasing power in
other currencies, pushing Robusta lower. My fundamental views once again mean
little, we just followed the trend.”
FIGURE 4.11: Short January 2009 Robusta Coffee Trade
Perhaps no other market than the U.S. dollar was more consequential for trend fol-
lowing. It did not matter whether the strategy made money in the dollar going long
or going short—it was agnostic to direction (see Figure 4.12): “The trend up in the
U.S. dollar was cut into two segments. We saw more volatility in this contract than
others, simply due to the U.S. equity markets. Although our entries and exits are
tied to highs and lows in the U.S. dollar futures, moves in the U.S. equity markets
influenced the price as well. The rise of this contract created opportunities in many
of the other markets we trade, because they are so closely tied to the price of the
dollar.”
FIGURE 4.12: Long December 2008 U.S. Dollar Trade
All you can do with trend following is take what markets give you. The goal is to
make money in whatever market is trending and not fall in love with one particular
market to the exclusion of another, better market opportunity.
Day-to-Day Analysis
The market crash of 2008 offered fantastic evidence showing trend following
as vastly different than the passive index mindset. Figure 4.13 shows daily data
from trend follower Salem Abraham and lets you see day-to-day performance dif-
ferences between his trend following fund and the S&P. For those who hear
about trend trading wins in October 2008 and immediately want to scream lucky,
look closely at the Abraham data. It is a great proxy for the other trend following
traders as well.
FIGURE 4.13: Abraham Trading Compared to the S&P
Even though gains by the likes of Abraham and Mulvaney might make logical
sense, in hindsight their performance is not easy to accept for indoctrinated
EMT minds. Consider feedback from a reader attempting to sell his firm on
trend following benefits:
I have been in discussions with trend following trader Mulvaney Capital Man-
agement since the summer for a company in which I was the COO. The board
thought my ideas were too risky and that I tried to hit too many homeruns by
potentially hiring Mulvaney. This particular [firm I was with] lost $30 million
in September and October [2008]. I showed them the Mulvaney performance:
$15 million invested in 1999 equated to $71 million today and $30 million over the same period equated to $142 million. After my presentation at a board
meeting, I returned to my office and was told [that] next week . . . I was being
eliminated as I was too big of a risk taker. My only other investment in my
short tenure was with Abraham Trading and the returns equated to nearly
positive 12 percent for the same time period. This was the only positive in-
vestment for the organization over that period. So much for my risk taking.
Logically, it is difficult to keep saying trend following is risky especially in the face
of those risky leveraged, long-only buy and hold approaches that cratered in
2008, but Wall Street is not logical.
Event 2: Dot-com Bubble
The period from 2000–2002 was littered with volatile up-and-down markets. Al-
though the prime story for that three-year period was the Nasdaq meltdown, sev-
eral subplots unfolded, ranging from the September 11 surprise to the Enron deba-
cle to major trend following drawdowns and subsequent recoveries to new highs. It
is interesting to note how trend following performed, for example, compared to the
2002 S&P and NASDAQ (see Table 4.1).
TABLE 4.1: 2002 Performance Histories for Trend Followers
FIGURE 4.14: Trend Followers and the S&P Chart, January 2002–December
2002
Source:Barchart.com
Drawdowns and Recoveries
It’s no secret for the majority of 2000, trend following as a strategy was in a
drawdown. It went down significantly heading into the last few months of the
year (Figures 4.14 through 4.21). Some press and skeptics were eagerly calling
the strategy finished, kaput.
I was not surprised when a Barron’s reporter contacted me for my opinion given
the popularity of my trend following site at the time. She appeared to have it in
for Henry and Dunn and was looking for confirmation that trend following was
dead. I pointed out drawdowns had occurred in the past, but that over the long haul trend following has made tremendous amounts of money. She ignored
those facts:
“John W. Henry isn’t alone in experiencing hard times. But the firm’s losses are
among the most staggering . . . The company’s hardest-hit trend following trad-
ing program, called Financial & Metals, was down 18.7 percent in 1999 . . .
Henry, whom one rival calls ‘our industry’s Dave Kingman,’ definitely swings for
the fences. (Kingman hit 442 home runs during his 16 seasons in the majors,
but he also struck out more than 1,800 times.) It’s unclear whether John W.
Henry will make changes to his trading program, one he cooked up decades ago
while on a vacation to Norway.”14
You have to wonder if this Barron’s reporter had taken the time to read Henry’s
speech from November 2000 before writing her December article. Henry was
hinting at new success around the corner: “Unfortunately, markets do not step
to a drummer we control. The period we have just been through has been terrif-
ically painful for investors, brokers, general partners, and trading advisors. Draw-
downs affect everyone emotionally, psychologically, and physically when they
persist. It becomes very easy to envision a scenario in which things never get
better. However, experience tells us that things inevitably look bleakest before
the tide turns.”15
The tide was indeed turning. On January 10, 2001, this same reporter sent me an
e-mail to say she was doing a follow-up story and wanted a comment. I was im-
pressed she was willing to set the record straight because Dunn made 28 per-
cent in November 2000 and 29 percent in December 2000. Henry made 13 per-
cent in November 2000 and 23 percent in December 2000. Here’s her follow-
up:
Wall Street’s biggest commodity-trading advisers posted a dramatic turn-
around in the fourth quarter, turning last year’s heart-stopping losses into
gains for the year. “This rebound is not a surprise,” says Michael Covel, of
TurtleTrader.com, which tracks trend followers . . . Henry, a high-profile
commodities-trading firm in Boca Raton, Florida, profiled by Barron’s last
month, posted a 20.3 percent return last year in its largest trading program
which was down 13.7 percent for the first nine months of the year, powered
back 39.2 percent in the fourth quarter.16
How was Henry able to power back 39.2 percent in the fourth quarter of 2000
after posting a loss of 13.7 percent for the first nine months of the year? What
trends did he ride? Where was his target of opportunity? The answers can be
found in Enron, California, and natural gas.
Enron, California, and Natural Gas
If you examine the natural gas market during the last few months of 2000 and al-
most all of 2001, you can see obvious trend trading opportunity. For trend fol-
lowing, the natural gas market’s massive trend up and down were the source of
immense profit.
The losers of course were Enron and the State of California. Enron’s collapse is a
classic case of greed, fear, and ultimately incompetence on an epic scale. From
Enron’s upper management’s manipulation of the facts, to the employees who
purposefully ignored the manipulations, to the State of California’s inept at-
tempts to play energy markets, everyone should have been accountable for fool-
ishness. That said, in the zero-sum game everyone is responsible, whether they
admit it or not.
The Enron debacle is stunning when you consider the losers. The number of in-
vestors who deluded themselves into thinking they were on a path to quick rich-
es is incalculable. Portfolio managers of pension funds, university endowments,
individual investors . . . everyone was caught up in the exhilaration of a company
that seemed to go in only one direction—up. Owners of Enron stock never
stopped seeing the pot of gold. They looked the other way and suspended their
disbelief to celebrate the zooming share price.
However, there was a gargantuan misstep: They had no strategy to sell when the
exit time arrived as the Enron trend turned hard the other way. That Enron crash
chart (see Figure 4.22) is now famous. And there was only one piece of data
needed to judge Enron: the share price. At its peak the company’s stock traded at
$90 a share, but it collapsed to 50¢ a share. Why would anyone with a pulse
hold onto a stock that goes from $90 to 50¢? Even if Enron was the biggest
scam ever propagated, hopeful investors who held on all the way down to 50¢ a
share are as responsible as Jeff Skilling. Blind investors bear responsibility for
not selling and losing their money. The chart was telling anyone who cared that
the trend had not only changed, but Enron was going to zero and fast.
Not only were there massive winners and losers in Enron stock, but huge losses
were also seen in natural gas during the 2000–2001 California energy crisis.
Enron was a primary supplier for California natural gas. And California, bound by
its own flawed deregulation schemes, freely signed long-term contracts with en-
ergy trading firms buying Enron natural gas for their electricity.
Not surprisingly, with inexperienced players and bad agreements in place, Enron
and the State of California forgot natural gas was just another market. Like any
market it was subject to go up or down for any number of reasons. Eventually
natural gas spiked up and then down in ferocious trends. Unfortunately, neither
Enron nor the State of California had a plan in place to deal with price changes.
Feeling abused, California complained loudly. California Senator Diane Feinstein
maintained they had no culpability in the game: “I am writing to request an addi-
tional hearing to pursue what role Enron had in the California energy crisis with
respect to market manipulation and price gouging. Enron’s ability to deal in
complex unregulated financial derivatives in the natural gas market while con-
trolling a tremendous share of the gas trading market provided Enron the ability
to manipulate market prices. This was very likely a key factor in driving up gas
and electricity prices leading to the California energy crisis.”
It has been said the Enron crisis cost California $45 billion over two years in
higher electricity costs and slowed economic growth. When you look at the
charts of natural gas (see Figure 4.23) and Enron (see Figure 4.22), you have to
question Feinstein’s basic understanding of markets:
Why did California lock itself into stringent agreements with firms like Enron?
Why did California, through its own deals, trade outside typical market struc-
tures? Why couldn’t they deal with a changing natural gas price? The State of
California alone is at fault for its inept decisions.
Anyone at any time can trade natural gas. Anyone can hedge a natural gas posi-
tion. The opportunity to speculate and hedge is there for everyone. It is not a
novel concept. Trend following traders were playing the natural gas game, too,
riding it up and down for profit, as Table 4.2 demonstrates.
One Enron employee lashed out at the sordid affair: “My fellow (former) col-
leagues have no one to blame other than themselves for allowing such disas-
trous losses to occur in their retirement accounts. An abdication of personal re-
sponsibility should not be rewarded. It is a sad consequence, but it is reality.”20
From private mutual fund companies like Janus to retirement funds managed by
State governments, none of them had a plan for exiting Enron. They all bought
the stock assuming it would only go up, but walking away was never part of their
plan. “Hold on forever” was the mantra. Yet the Enron story is more profound
than the tale of one company’s disaster. It is the all too typical story of inept indi-
viduals managing billions of retirement wealth. Losses in Enron were staggering:
•Japanese banks lost $805.4 million.
•Abbey National Bank lost £95 million.
•John Hancock Financial Services lost $102 million.
•British Petroleum retirement lost $55 million on Enron debt.
David Brady, a Stein Roe Focus Fund manager: “Where did I go wrong? If I
learned anything, I learned the same old lessons . . . The numbers just didn’t
add up. If you had looked at the numbers the balance sheet would have showed
you the real problems.”
Notice he blames balance sheets and not his choices. Public retirement ac-
counts led by essentially DMV workers recklessly bet on Enron to go up forever
as well:
•The Kansas Public Employees Retirement System had about $1.2 mil-
lion invested in about 82,000 shares of Enron stock. “It was based
on (Enron’s) spectacular earnings growth and many analysts recom-
mended it as a hot stock,” said David Brant, Kansas Securities Com-
missioner.
•The retirement fund for the City of Fort Worth lost nearly $1 million
in Enron.
•The Teacher Retirement System of Texas first invested in Enron in
June 1994. It realized a net loss of approximately $23.3 million from
its Enron stock holdings and $12.4 million in net unrealized losses
from its current bond holdings in Enron. Jim Simms of Amarillo, a
board member for six years and chairman of the board, said: “We’re
human beings—when you’re investing money you’ll have some win-
ners and some losers . . . You can’t protect yourself when you’re
being fed inaccurate information . . . We had all the precautions in
place.”
There were no precautions in place. No fail-safes. No stops. Enron’s fall from
grace was no different than any other corporate implosion, although the losers
(such as those in Table 4.3), as this quote reminds, always need to call it new to
rationalize losses. However, the game never changes, even if the company
names do.
TABLE 4.3: Largest Shareholders in Enron (Percent Fund in Enron Shares)
An interesting aspect of the Enron fiasco was the close relationship between the
Enron share price and natural gas. To lose money in Enron stock was to lose
money in natural gas. They were connected at the hip. Enron acted as a deriv-
ative for natural gas. The company presented mutual funds and pension funds
an opportunity to get into natural gas speculation even if their mission statement
had them limited to stocks. Using Enron as a proxy, mutual and pension funds
were able to ride natural gas to the top without ever taking a position in natural
gas. Not only was everyone buying and holding Enron; they were, for all intents
and purposes, buying and holding natural gas. The data makes the case:
September 11, 2001
September 11, 2001 demonstrates unpredictable on a grand scale. How could
anyone know in advance where the safe place to be was? Before considering Sep-
tember 11 specifically, consider Ed Seykota’s words in general: “A surprise is an
event that catches someone unaware. If you are already on the trend, the sur-
prises seem to happen to the other guys.”23
No one predicted a terrorist attack would close Wall Street for four days. Al-
though it was difficult to stay focused on the rigors of everyday life, trend fol-
lowing maintained. It confronted markets as it always had—with a plan set in
motion long before the unexpected event happened.
Trend following was short stocks and long bonds ahead of the attack because
those markets were already headed in that direction. For example, Sunrise Cap-
ital Partners noted how lucky they were to be positioned ahead of the attack. Fur-
ther, Campbell & Company made the case that currency markets had followed
through with continued trends. “The U.S. dollar had already begun to weaken be-
fore the attacks, hence Campbell was short that market.” Campbell had been
long bonds and short a number of global stock index futures contracts ahead of
the attack because of established trends.24
Although Enron, the California energy crisis, and September 11th are vivid illus-
trations of the zero-sum game with trend following as the winner, the story of
Long-Term Capital Management in the summer of 1998 is an even better case
study.
Event 3: Long-Term Capital Management
Long-Term Capital Management (LTCM) was a hedge fund that went bust in 1998.
The story of who lost has been told repeatedly over the years; however, because
trading is a zero-sum game, exploring the winners was the real story. LTCM is a
classic saga of the zero-sum game played out in grand fashion with trend following
again as the winner.
Trillion Dollar Bet, a PBS special, described how LTCM came to be. In 1973, three
economists—Fischer Black, Myron Scholes, and Robert C. Merton—discovered an
elegant formula that revolutionized modern finance. This mathematical Holy Grail,
the Black–Scholes option pricing formula, was sparse and deceptively simple. It
earned Scholes and Merton a Nobel Prize and attracted the attention of John Meri-
wether, the legendary bond trader of Salomon Brothers.
LTCM promised to use complex mathematical models to make investors wealthy
beyond their wildest dreams. It attracted the elite of Wall Street’s investors and ini-
tially reaped fantastic profits managing money. Ultimately, theories collided with
reality and sent the company spiraling out of control.25
This was not supposed to happen: “They were immediately seen as a unique enter-
prise. They had the best minds. They had a former vice chairman of the Federal Re-
serve. They had John Meriwether . . . So they were seen by individual investors, but
particularly by banks and institutions that went in with them, as a ticket to easy
street.”26
To understand the LTCM fiasco you again need to look at modern finance’s
foundations. Merton Miller and his colleague Eugene F. Fama launched what be-
came the efficient market theory: “The premise of the theory is that stock prices are
always right; therefore, no one can divine the market’s future direction, which in
turn, must be ‘random.’ For prices to be right, of course, the people who set them
must be both rational and well informed.”28
In other words, Miller and Fama believed perfectly rational people would never pay
more or less than any financial instrument was worth. As a fervent supporter of the
efficient market theory, Myron Scholes was certain markets could not make mis-
takes. His associate, Robert Merton, took it a step further with his continuous-time
finance theory, which essentially wrapped the financial universe into a supposedly
tidy ball.29
Merton’s markets were as smooth as well-brewed java, in which prices would flow
like cream. He assumed . . . the price of a share of IBM would never plunge directly
from 80 to 60 but would always stop at 79¾, 79½, and 79¼ along the way.30
If LTCM’s universe was supposed to be in a tidy ball, it might have been because
academic life—where Merton and Scholes pioneered their theories—was tidy.
LTCM’s founders believed the market was a perfect normal distribution with no
outliers, no fat tails, and no unexpected events. Problems began the moment these
assumptions were accepted.
After Merton, Scholes, and Meriwether had Wall Street convinced the markets were
a nice, neat, and continuous normal distribution and there was no risk and the
party was on, LTCM began using mammoth leverage for the soon to come risk-free
returns.
Approximately 55 major banks gave LTCM financing including Bankers Trust, Bear
Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill
Lynch, Morgan Stanley, and Dean Witter. Eventually, LTCM would have $100 bil-
lion in borrowed assets and more than $1 trillion worth of exposure in markets
everywhere. This type of leverage was not a problem initially—or so it seemed.
Merton was even said to have remarked to Miller, “You could think of LTCM’s
strategy as a gigantic vacuum cleaner sucking up nickels across the world.”
However, it was too complicated, too leveraged, and devoid of anything remotely
resembling trend following risk management. The Organisation for Economic
Co-operation and Development outlined a single trade example that uncovered
LTCM’s overall trading strategy. It was a bet on the convergence of yield spreads
between French bonds (OATs) and German bonds (bunds). When the spread be-
tween the OATs and the bunds went to 60 basis points in the forward market,
LTCM decided to double its position. That deal was one leg of an even more com-
plex convergence bet, which included hedged positions in Spanish peseta and Ital-
ian lira bonds.32
The result of all these complex convergences was no one had a clue what LTCM
was up to risk-wise, including LTCM itself. Its professors ran a secretive and
closed operation so convoluted that regulators and investors had no idea what,
when, or how much they were trading. Not being able to price an instrument or
trade freely in and out of it on a daily basis ignores what Wall Street calls trans-
parency. Jerry Parker sees the differences between LTCM and his trading:
We’ve always had 100 percent transparency . . . The good thing about CTAs is
their strategies are usually straightforward, not something that only a few people
in the world can understand. We’re trend following and systems-based, some-
thing you can easily describe to a client . . . People who aren’t willing to show
clients their positions are in trouble . . . One of the problems was that people
put too much money in these funds such as Long-Term Capital Management.
We ask for just 10 percent of risk capital, and clients know they may make 10
percent one month and lose 10 percent the next month. The ultimate error is to
put a ton of money with geniuses who never lose money. When all hell breaks
loose, those guys lose everything.33
Even more than LTCM’s lack of transparency, the larger failure involved lightning as
one critic noted: “I don’t yet know the balance between whether this was a random
event or whether this was negligence on theirs and their creditors’ parts. If a ran-
dom bolt of lightning hits you when you’re standing in the middle of the field, it
feels like a random event. But if your business is to stand in random fields during
lightning storms, then you should anticipate, perhaps a little more robustly, the
risks you’re taking on.”35
The Black–Scholes option pricing formula did not factor in the randomness of
human behavior—only one example of the negligence that ultimately would cause
lightning bolts to zap LTCM in August and September 1998. When lightning struck
LTCM, trend following was assessing the same markets—playing the zero-sum
game on the other side. In hindsight, the University of Chicago professors were
clearly aware of the problem as Nobel Laureate Professor Merton Miller noted:
“Models that they were using, not just Black–Scholes models, but other kinds of
models, were based on normal behavior in the markets and when the behavior got
wild, no models were able to put up with it.”36
If only the principals at LTCM had remembered Albert Einstein’s quote that ele-
gance was for tailors, part of his observation about how beautiful formulas could
pose problems in the real world. LTCM had the beautiful formulas, but they were
not for the real world. Eugene Fama, Scholes’s thesis advisor, had deep reser-
vations about his student’s options pricing model: “If the population of price
changes is strictly normal [distribution], on the average for any stock . . . an obser-
vation more than five standard deviations from the mean should be observed
about once every 7,000 years. In fact, such observations seem to occur about once
every three to four years.”37
LTCM lost 44 percent of its capital, or $1.9 billion, in August 1998 alone. In a letter
to LTCM’s 100 investors dated September 1998, John W. Meriwether wrote: “As
you are all too aware, events surrounding the collapse of Russia caused large and
dramatically increasing volatility in global markets throughout August. We are
down 44 percent for the month of August and 52 percent for the year to date. Loss-
es of this magnitude are a shock to us as they surely are to you, especially in light
of the historical volatility of the fund.”39
At the time of Meriwether’s letter, LTCM’s history consisted of only four short
years, and although its “losses of this magnitude” might have shocked LTCM, its
clients, and the lender banks to whom it owed over $100 billion, those trading
losses became the source of profits for trend following. Amazingly, years later, Sc-
holes still seemed to have a problem with accepting personal responsibility for his
action in the zero-sum game: “In August of 1998, after the Russian default, you
know, all the relations that tended to exist in a recent past seemed to disappear.”40
Ultimately, the Fed, along with major world banks, most of which were heavily in-
vested in LTCM, bailed the firm out. I believe if this bailout was not allowed to hap-
pen there would have been no precedent for the October 2008 bailouts, which
made LTCM look like a walk in the park. The LTCM bailout stopped normal market
forces. It set in motion the events of the next 10 years culminating in the fall of
2008. And the fixing of 2008, tracing back to LTCM’s fixing, brings the world up to
today—waiting for the next one.
The Losers
CNN outlined LTCM losers:
•Everest Capital, a Bermuda-based hedge fund, lost $1.3 billion. The
endowments of Yale and Brown Universities were invested in Ever-
est.
•George Soros’ Quantum Fund lost $2 billion.
•High Risk Opportunity Fund, a $450 million fund run by III Offshore
Advisors, went bust.
•The Tiger Fund run by Julian Robertson lost $3.3 billion in August
and September of 1998.
•Liechtenstein Global Trust lost $30 million.
•Bank of Italy lost $100 million.
•Credit Suisse lost $55 million.
•UBS lost $690 million.
•Sandy Weill lost $10 million.
•Dresdner lost $145 million.
The Winners
As dramatic as the LTCM blowout story is, the real lessons you can learn are
from the winners. Campbell & Company was candid:
If you look back to the early part of 1998, you will see it was a similar period in
terms of industry returns. It was a very sad time all the way through July. And
then out of nowhere it came, the collapse or the near-collapse of Russia in Au-
gust and the LTCM crisis. All of a sudden, August was up 10 percent and Sep-
tember and October were up 4 percent or 5 percent, and many CTAs pulled
down an 18 percent or 20 percent year out of nowhere. It’s very hard to put your
head back where you were three months before that and say it looked like a very
gloomy business without much of a future and all of a sudden we’re the place
it’s all at. The hedge fund world had fallen apart, equities had gone into the toi-
let, and managed futures were king and on the front page of The Wall Street
Journal. So some of this is the psychology of what we do.41
Trend following performance data for August and September 1998 looks like one
continuous credit card swipe from LTCM to trend following—a zero-sum trans-
fer swipe. During the exact period that LTCM lost $1.9 billion in assets, the
aggregate profits (see Table 4.4) of Bill Dunn, John W. Henry, Jerry Parker, Keith
Campbell, and Man exceeded $1 billion dollars.
TABLE 4.4: Trend Following Profits August–September 1998
FIGURE 4.25: Trend Followers and U.S. T-Bond, May 1998–December 1998
Source:Barchart.com
FIGURE 4.26: Trend Followers and German Bund, May 1998–December 1998
Source:Barchart.com
FIGURE 4.27: Trend Followers and S&P, May 1998–December 1998
Source: Barchart.com
LTCM’s failure lessons are now taught by all prominent business schools, but
they leave out the winning lessons trend follower Jerry Parker teaches:
•Transparent—By and large, trend followers trade markets on regu-
lated exchanges. They are not cooking up new derivatives in base-
ments. Trend followers typically trade on freely traded markets where
a price that everyone can see enables anyone to buy or sell. Trend
followers have nothing in common with the derivatives fiascos that
damaged Orange County or Procter and Gamble.
•Understandable—Trend following strategies can be understood by
anybody. No high-level math only PhDs can comprehend.
•No rock stars—There are individuals who not only want to make
money, but also want a rock star as their portfolio manager. They
want to think that the strategy being used to make them money is
exciting and state-of-the-art. Trend followers are not in the game for
notoriety, only to win.
I always wonder what would have happened and how much more money trend
following models would have made if LTCM had been allowed to implode with-
out preferential government interference. And I asked Dunn Capital whether they
thought LTCM’s bailout was proper. They replied with a one-word answer: No.
Bill Dunn responded with even more clarity:
I believe the Long-Term Capital Management collapse was caused by:
1.Their trading approach was based on the theory prices and relation-
ships between prices tend to vary, but they also tend to return to
their mean value over long periods of time. So in practice, they
probably looked at a market (or a spread between markets) and
determined what its mean value was and where the current price
was in relation to their estimate of its “true mean” value. If the cur-
rent price was below the mean, a “buy” was indicated, and if it was
above the mean, a “sell” was indicated. (I don’t know what their exit
strategy was.)
2.The main problem with the above is that as market prices move
further against your position, you will be experiencing losses in
your open positions and your above trading approach would sug-
gest that adding to the current position will prove to be even more
profitable than originally expected. Unless this market very quickly
turns and starts its anticipated return to its mean, additional losses
will be suffered and the potential for profit will seem to become
even greater, although elusive.
3.This problem can only be overcome by either adopting a strict entry
and exit strategy that is believed to promote survivability or by hav-
ing a nearly unlimited amount of capital/credit to withstand the occasional extreme excursions from the mean, or better yet, adopt
both of these ideas.
4.But the situation became even more unstable when LTCM ventured
into highly illiquid investment vehicles and also became a very
major part of these very thin markets.
5.In the end, they became overextended and they ran out of capital
before any anticipated reversion to the mean could bail them out.
Those who cannot or will not learn from the past always set themselves up for
another August–September 1998 lightening bolt. Another LTCM fiasco is always
in the offing since the Black–Scholes way of life, where the world is a normal dis-
tribution, is still considered a viable approach to investing in 2017. Philip Ander-
son, joint winner of a Nobel Prize in Physics, sees the dangers in normal distri-
bution thinking: “Much of the real world is controlled as much by the ‘tails’ of
distributions as by means or averages: by the exceptional, not the mean; by the
catastrophe, not the steady drip; by the very rich, not the ‘middle class.’ We need
to free ourselves from ‘average’ thinking.”46
And breaking out from average thinking starts with hitting home runs (i.e., trend
following) instead of hitting supposed sure-fire singles (i.e., LTCM).
Footnotes to LTCM
•Myron Scholes went on to form a new fund, Platinum Grove, after
LTCM’s demise. With Scholes as chairman, Platinum Grove lost
$600 million dollars during 2007–2008.
•A great story about LTCM hiring Goldman Sachs to assist raising
cash during the crisis: “LTCM gave their derivatives positions to
Goldman Sachs as part of their due diligence: ‘Goldman Sachs
traders stayed up all night using the LTCM data to front-run their
clients in markets around the world. Goldman, led by Jon Corzine,
was in similar spread trades as LTCM, and was losing billions itself.
With the LTCM data, Goldman unwound trades like a precision guid-
ed missile instead of a machine gun firing indiscriminately. Ultimately
Goldman failed to raise money for LTCM, but it was mission accom-
plished in terms of gaining inside information. If Goldman could not
save the system, it would at least save itself.’”47
Event 4: Asian Contagion
The 1997 Asian Contagion was another event where trend following won out. To this
day in 2017 if you drive around Bangkok, Thailand or Kuala Lumpur, Malaysia, you
can still see unfinished skyscrapers left as artifacts of yet another financial implo-
sion. One of the biggest losers during this meltdown was infamous trader Victor
Niederhoffer. Always opinionated, bombastic, and for most of his trading career,
exceptionally successful, Niederhoffer’s trading demise was swift.
Niederhoffer played a big game, whether at speculating, chess, or squash. He chal-
lenged grandmasters in chess and he won repeated titles as a national squash
champion. He regularly bet hundreds of millions of dollars and consistently won
until Monday, October 27, 1997. That day he lost an estimated $50 million to $100
million, and his three hedge funds, Limited Partners of Niederhoffer Intermarket
Fund L.P., Limited Partners of Niederhoffer Friends Partnership L.P., and Nieder-
hoffer Global Systems S.A., bellied up.48
Imagine receiving this letter faxed from Niederhoffer on Wednesday, October 29,
1997:
To:
Limited Partners of Niederhoffer Intermarket Fund, L.P.
Limited Partners of Niederhoffer Friends Partnership, L.P.
Shareholders of Niederhoffer Global Systems, S.A.
Dear Customers:
As you no doubt are aware, the New York stock market dropped precip-
itously on Monday, October 27, 1997. That drop followed large declines on two
previous days. This precipitous decline caused substantial losses in the fund’s
positions, particularly their positions in puts on the Standard & Poor’s 500
Index. As you also know from my previous correspondence with you, the funds
suffered substantial losses earlier in the year as a result of the collapse in the
East Asian markets, especially in Thailand.
The cumulation [sic] of these adverse developments led to the situation
where, at the close of business on Monday, the funds were unable to meet min-
imum capital requirements for the maintenance of their margin accounts. It is
not yet clear what is the precise extent (if any) to which the funds’ equity bal-
ances are negative. We have been working with our broker-dealers since Mon-
day evening to try to meet the funds’ obligations in an orderly fashion. How-
ever, right now, the indications are that the entire equity positions in the funds
has been wiped out.
Sadly, it would appear that if it had been possible to delay liquidating
most of the funds’ accounts for one more day, a liquidation could have been
avoided. Nevertheless, we cannot deal with “would have been.” We took risks.
We were successful for a long time. This time we did not succeed, and I regret
to say that all of us have suffered some very large losses.51
Niederhoffer seems unable to acknowledge that he, alone, was to blame for his
losses in the zero-sum game. He did it. It was his strategy. No one else did it for
him and using the unexpected as an excuse is no excuse. It is interesting to note
his trading performance was long heralded as low risk. He made money almost
every month. Compared to trend following drawdowns he was the golden boy mak-
ing money as consistently as a casino. Who would want to place money with trend
following and potentially tolerate a steep drawdown when they could put money
with Niederhoffer, who seemed to combine similar performance with what ap-
peared to be far less risk and almost no drawdown? That’s how the narrative
looked before Niederhoffer’s flame out.
But the idea Niederhoffer was devoid of risk disappeared quickly with his trading
firm’s 1997 demise. Examine his performance numbers during that year (Table
4.5):
TABLE 4.5: Niederhoffer Performance52
When reviewing Niederhoffer’s performance meltdown (see Table 4.5), keep in
mind in the last issue of The Stark Report where his performance was still listed,
his ranking was as follows:
Return: four stars
Risk: four stars
Risk Adjusted: four stars
Equity: five stars54
The star rankings gave the impression Niederhoffer was risk-free. However, his
trading, like LTCM’s, was predicated on a world of normal distributions. Measuring
him with standard deviation as the risk measure gave an imperfect view of Nieder-
hoffer’s true risk. Some observers were well aware of problems in Niederhoffer’s
contrarian style long before the flameout. Frank J. Franiak spoke out six months
earlier: “It’s a matter of time before something goes wrong.’’55
But Niederhoffer loyalists were concerned only with whether the profits were con-
tinually coming in even if his strategy was deeply flawed and potentially dangerous.
His clients were enamored: “Whatever voodoo he uses, it works,” said Timothy P.
Horne, chairman of Watts Industries Inc. (and a Niederhoffer customer since
1982).56
The vast majority of Niederhoffer clients did not realize until after their accounts
were toast that voodoo doesn’t work.
Niederhoffer on Trend Following
Five years after his blowout, Niederhoffer began ripping trend following:
“Granted that some users of trend following have achieved success. Doubtless
their intelligence and insights are quite superior to our own. But it’s at times like
this, when everything seems to be coming up roses for the trend followers’ theo-
ries and reputations, that it’s worthwhile to step back and consider some funda-
mental questions: Is their central rule; is the trend is your friend valid? Might re-
ported results, good or bad, be best explained as due to chance?” He added:
“But first, a warning: We do not believe in trend following. We are not members
of the Market Technicians Association or the International Federation of Tech-
nical Analysts or the TurtleTrader Trend Followers Hall of Fame. In fact, we are
on the enemies’ lists of such organizations.”58
Niederhoffer continued: “No test of ‘the trend is your friend’ is possible, be-
cause the rule is never put forward in the form of a testable hypothesis. Some-
thing is always slippery, subjective, or even mystical about the rule’s interpre-
tation and execution.”59 Even though the market is the ultimate arbiter (it’s al-
ways right), Niederhoffer still didn’t let go:
In my dream, I am long IBM, or priceline.com, or worst of all, Krung Thai
Bank, the state owned bank in Thailand that fell from $200 to pennies while I
held in 1997. The rest of the dream is always the same. My stock plunges.
Massive margin calls are being issued. Related stocks jump off cliffs in sym-
pathy. Delta hedges are selling more stocks short to rebalance their positions.
The naked options I am short are going through the roof. Millions of in-
vestors are blindly following the headlines. Listless as zombies, they are liqui-
dating their stocks at any price and piling into money market funds with an
after tax yield of –1 percent. “Stop you fools!” I scream. “There’s no danger!
Can’t you see? The headlines are inducing you to lean the wrong way! Unless
you get your balance, you’ll lose everything—your wealth, your home!”60
Many smart players to this day view Niederhoffer as brilliant, and I see his wis-
dom in some work and hope to have him on my podcast one day. But markets
are unforgiving. Get the risk wrong, and it’s obituaries.
Event 5: Barings Bank
The first few months of 1995 go down as one of the most eventful periods in the
history of speculative trading. The market events of that period, by themselves,
could be the subject of a Harvard PhD finance course. But twenty years later, de-
spite the enduring significance, the events have been forgotten and no Harvard
class ever materialized.
What happened? A rogue trader, Nick Leeson, overextended Barings Bank in the
Nikkei 225, the Japanese equivalent to the Dow, by speculating that the index would
go higher. It tanked instead, and Barings—the Queen’s bank, one of the oldest,
most well established banks in England—collapsed, losing $2.2 billion.
Who won the Barings Bank sweepstakes? That question was never asked by any-
one—not The Wall Street Journal nor Investor’s Business Daily. Was the world inter-
ested only in a story about failure and not the slightest bit curious about where
$2.2 billion went? Trend following was sitting at the table devouring Leeson’s mis-
takes.
The majority of traders do not have the discipline to plan 3, 6, and 12 months
ahead for unforeseen changes in markets. However, planning for the unexpected is
an essential ingredient of trend following strategy. Huge moves to profit from are
always on the horizon if you are reacting to the market and not trying to predict it.
Sadly, most market players only know to make decisions based on their percep-
tions of what the market direction will be. After they make their directional choice,
they are blinded to any other option. They keep searching for validation to support
their analysis even if they are losing colossal money—like Nick Leeson. Before the
Kobe earthquake in early January 1995, with the Nikkei trading in a range of 19,000
to 19,500, Leeson had long futures positions of approximately 3,000 contracts on
the Osaka Stock Exchange. After the Kobe earthquake of January 17, his buildup of
Nikkei positions intensified and Leeson kept buying as the Nikkei sank.64
Who Won?
Observe the Nikkei 225 (see Figure 4.32) from September 1994 until June 1995.
Barings’ lost assets directly padded the pockets of disciplined trend following
traders.
A few months after Barings, John W. Henry’s performance (see Table 4.6)
made the case clear:
Note: Total money under management in millions with monthly percent returns.
Dean Witter (now Morgan Stanley) was Henry’s broker at the time: “I have over
$250 million with Henry . . . I have been pleased to see how well the Original
[Henry] Program has done so far in 1995: up over 50 percent through April 18
[1995].”65
Other trend followers brought home huge gains in February and March of 1995
(see Table 4.7). However, their winnings arguably were more from the Japanese
yen trend up and down:
Note: Total money under management in millions with monthly percent returns.
There might be slight differences in leverage and signal timing, but even a quick
glance makes clear: Immense trends equaled monster profits for almost all trend
followers. Henry confirmed in 1998, albeit cryptically, his massive zero-sum Bar-
ings win:
The inflation story, of course, is not the most dramatic example. More re-
cently Asia is another example of how one-time big events can lead to trends
that offer us opportunity, and really shape our world. Whether you believe the
causal story of banking excesses in Asia or not, there was a clear adjustment
in the Asian economies that has been, and will continue to be, drawn out.
Under these situations, it’s natural that trends will develop, and recognizing
these trends allows us to capitalize on the errors or mistakes of other market
participants. Because, after all, we’re involved in a zero-sum game.67
Henry and Leeson were indeed involved in the age-old zero-sum game—like in
so many other historical examples. They both bellied up to the table, but there
was one big difference—Henry had an actual strategy. What Leeson had nobody
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