I was forwarded this quote that addresses the idea of technical analysis and where trend following fits into the grand scheme:

“From John Murphy’s book technical analysis is defined as the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. There is the key difference. Predictive vs following. A lot of the “tools” in technical analysis books are centered around prediction v. following. A classic example of this concept would be the idea of a price target off a head and shoulders top. A true market technician would set a price target based on the size of the formation and forecast the most likely next “leg” the market would go to. A true trend follower would never set a price target, they prefer to let a trailing bar stop take them out of the market when prices start to reverse against them or some other similar method. You can use technical analysis “tools” to help you follow the price movement and act more like a follower or you can use technical analysis tools to help you predict, the choice is yours. Another important point is that if someone told you they were a trend follower, that would imply that they are that type of trader. Technical analysis is a wide concept that would need to be refined in order to generate a particular trade system.”

I agree with all except the idea that prediction may be an option. Technical analysis for so-called prediction is fool’s gold.

Richards J. Heuer, Jr. wrote the free online book Psychology of Intelligence Analysis for the Center for the Study of Intelligence at the United States Central Intelligence Agency. The relevance to great trading and great traders is straightforward.

Here is the table of contents:

Author’s Preface
Foreword by Douglas MacEachin
Introduction by Jack Davis
PART I–OUR MENTAL MACHINERY
Chapter 1: Thinking About Thinking
Chapter 2: Perception: Why Can’t We See What Is There to Be Seen?
Chapter 3: Memory: How Do We Remember What We Know?
PART II–TOOLS FOR THINKING
Chapter 4: Strategies for Analytical Judgment
Chapter 5: Do You Really Need More Information?
Chapter 6: Keeping an Open Mind
Chapter 7: Structuring Analytical Problems
Chapter 8: Analysis of Competing Hypotheses
PART III–COGNITIVE BIASES
Chapter 9: What Are Cognitive Biases?
Chapter 10: Biases in Evaluation of Evidence
Chapter 11: Biases in Perception of Cause and Effect
Chapter 12: Biases in Estimating Probabilities
Chapter 13: Hindsight Biases in Evaluation of Intelligence Reporting
PART IV–CONCLUSIONS
Chapter 14: Improving Intelligence Analysis

I have noticed the CIA’s web server can be iffy so be patient.

Yesterday I mentioned the recent research “Investment Behavior and Negative Side of Emotion” published in Psychological Science. You can purchase that article online here for $26. I make no money from this and have no relationship with the publisher or authors.

From Bloomberg today comes an article that firmly backs the importance of the emotional component needed to be a great trend follower (or any trader for that matter):

“Functional psychopaths” make the best investment decisions because they can’t experience emotions such as fear, a study by researchers at Stanford Graduate School of Business showed. Fear stops people from taking even logical risks, meaning those who have suffered damage to areas of the brain affecting emotions, and can suppress feeling, make better decisions, the report showed. The ability to control emotion helps performance in business and the financial markets, the researchers found.”

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I wrote recently about having seen Jim Cramer’s TV show Mad Money for the first time. Yesterday traveling down to South Florida, I saw his show again on the plane’s TV. It’s one thing for Cramer to do this show circa 1999, but today in 2005 it’s almost criminally insane broadcasting. I notice that many people are justifying the show since it has a large audience. So even though the entire show is useless by any measure of investor sophistication, it’s alright since so many people watch it. Here is a good take on the show.

A good quick read (PDF) about how rather than shrinking risk, the behaviour of following the herd by investors adds to it.

Today I received:

“As a UK resident, I’ve just read the excellent book on Trend Following. To cut things short, re. the advice on p. 246, can you advise me how to find a trend following trader to trade for me.”

Sure, here is a good tracking service for trend following fund managers.

The Benefits of Managed Futures 2005 Update from the Center for International Securities and Derivatives Markets.

The Risk Matrix: Speed v. Impact (PDF) is from Choice Alternative Investments.

Of course an exceprt like the following should be read as “food for thought”, but there are some good insights:

“A new discovery may help explain where boneheaded investment ideas and get-rich-quick schemes come from. Researchers say two different brain regions may be involved in making risky vs. conservative investment mistakes, a finding that may eventually help economists build better models of people’s investment behavior. “Overall, these findings suggest that risk-seeking choices (such as gambling at a casino) and risk-averse choices (such as buying insurance) may be driven by two distinct [brain regions],” write Camelia Kuhnen of the Stanford University School of Business and colleagues in the Sept. 1 issue of Neuron.”

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From a reader today:

“Dear Michael, I wanted to say that “Trend Following” is now on my top three trading books list. I agreed with it so much that I ordered another copy that I sent to my brother-in-law the “skeptic”. More importantly, it inspired me to start my own business, called xxx. I’ll be using my software background to build custom trading systems, trade and risk management systems and other software for traders. The idea came to me when I read about Ed Seykota’s program that he runs everyday. I ended up building a trading system for myself based on some principles I had written out months ago on an index card. Then I started thinking that there may be other people who could use this as well. Again, excellent book — it really was a great read and one I’ll end up re-reading several times again I’m sure. Best Regards, Lou B.”

A reader writes:

“Just read Trend Following book and most comments revolved around commodity trading. I have been mostly trading pullbacks in momentum stocks, but it seems that I have been making more money on the up trending stocks. Where can I receive some info on trend following stocks?”

What is a momentum stock? What is a pullback? What exactly, down to numbered precision, is an up trending stock? This is just all jargon.

The term commodity is confusing when used by most. When the word is used, most people mean the futures markets and futures markets cover all markets across the globe including stocks. Trend followers don’t care what they trade and they surely don’t limit themselves to so-called “commodities”.

In this excerpt from Managed Account Reports the most successful Turtle offered:

“I think another mistake we made was defining ourselves as managed futures, where we immediately limit our universe. Is our expertise in that, or is our expertise in systematic trend following, or model development. So maybe we trend follow with Chinese porcelain. Maybe we trend follow with gold and silver, or stock futures, or whatever the client needs. It’s called managed futures because that was the profit center at the FCMs. We’re trading these great systems, and testing, and making sure what we do has worked in the past. And being disciplined, and unemotional, and applying our methods to the futures markets. But limiting our trading to this one group of markets. We need to look at the investment world globally and communicate our expertise of systematic trading. You have Big Blue beating the world chess champion, and everybody saying yeah, that makes sense, I can understand that. We’ve not been able to maximize our opportunities with systematic trading. People look at systematic and computerized trading with too much skepticism. But a day will come when people will see that systematic trend following is one of the best ways to limit risk, and create a portfolio that has some reasonable expectation of making money. We’ve got to be there and ready to take advantage of the opportunity. I think we’ve miscommunicated to our clients what our expertise really is. Systematic trading is going to be better for everyone in the long run. Our methods will work on lots of different markets. The ones that are hot today, the ones that are not hot today. We don’t want to pigeon-hole ourselves as managed futures or commodities.”