Michael Covel: News & Info.

From TheStreet.com today:

“The rally that began this year was so strong that you have to give the bulls the benefit of the doubt and assume the rally could continue. It’s still early to get extremely pessimistic, but the bulls should view the overnight selloff as a warning signal. The groundwork is being laid for a move to the bottom of the channel.”
Ken Tower, Chief Market Strategist with CyberTrader

I have met Ken. He comes from a technical perspective and we have talked ‘trend following’ as he has read my book. I know his comment is most likely the quick response to a deadlined reporter, but I have to disagree. Trying to give a historical accounting to one day of market action has no real purpose. One day of market action, unless it is a major market crash, is nothing but noise. There is no concrete way to divine market directions from one day. Yes, perhaps it is a small bone to pick with Ken, but I feel it is an important one.

Here is a discussion I had with a trader the other day. We were talking about the 5 questions presented in Chapter 10 of my book Trend Following. He forcefully responded:

“…here are my methods in order of the five questions:

1. I only trade stocks…most of my money is in IRA’s, I rarely go short.
2. I always buy an equal dollar amount on each trade.
3. I use technical analysis for buy & sell signals. Trend lines, etc.
4. Same answer as #3.
5. Same answer as #3.”

Let me restate the 5 questions:

1. How do you determine what market to buy or sell at any time?
2. How much of a market should you buy or sell at any time?
3. How do you determine when you enter a market?
4. How do you determine when you exit a losing position?
5. How do you determine when you exit a winning position?

This trader has a blind spot. That blind spot lets him believe that his answers comprehensively address the 5 questions. His answers need to go further.

Feedback today:

“Mr. Covel: I’ve been trading since 2003 and have devoured many trading books. Trading with the trend is not a new concept which makes me wonder why anyone, such as yourself, would write a book entitled Trend Following. That’s like reinventing the wheel. Any idiot with an understanding of technical analysis, good eye for bullish price patterns (in an uptrend) and bearish price patterns (in a downtrend) and a disciplined approach to risk management can make money in the markets. After successfully trading the uptrend of 2003, I stumbled over the sideways markets of 2004 & 2005. This has become a hard and expensive lesson for me. Real brilliance is attributed to the trader who can make money in the sideways and choppy markets and I have yet to find anybody who has written a good book on how to do that. Rich O.”

Some points to consider:

1. Great traders don’t make big money in sideways markets. Great traders use risk management during sideways markets to stay in position (and preserve capital) to catch the next up or down trend.

2. Great traders do not use predictive technical analysis, they use reactive technical analysis.

3. I have not seen evidence that any “idiot”, as you say, can trade successfully. Greatness in all pursuits takes hard work. Hard work is not something that all people want in their lives.

4. The book Trend Following has sold over 50,000 copies. It fills a void in a marketplace inundated with books about finance and trading but lacking any resource or, for that matter, practically any reference to trend following trading.

More Feedback:

“I am a great believer in trend following and have found your book to be most useful and informative. I also enjoy reading some of the trend following excerpts that you pass on in these emails. With that said, might I make one suggestion? On occasion, you seem to have a need to go ‘toe-to-toe’ with the naysayers of trend following. I think, perhaps, that entering into these verbal ‘wars’ only ends up lending some credence to their position by even acknowledging their existence.Trying to change the minds of these ‘buy-and-hold’ and CNBC puppets is like the old story about trying to teach a pig to sing - it accomplishes nothing and it really pisses off the pig. Just a thought for consideration: continue to promote and educate those who are just trying to get into investing about the benefits of trend following. Stick with the positive promotion of trend following and leave the ‘naysayers’ alone on their meaningless battlefield. Don’t waste your energy fighting people who have already made up their minds. Save your energy to help those who have not yet been brainwashed. Getting down in the dirt with those who put down trend following may tend to discredit the very important message you really want to get across to those who need it most.”

A question that came in today:

“Dear Michael, I am a young trader and have developed a passion for the markets over the last three years. I am also extremely interested in your research and frequently refer to your book/websites for insight. It is always inspiring to hear about successful traders, and I look forward to reading more of their stories through your work in the future. I have a question about pursuing trading as a career. Currently, I am a first-year MBA student, and many of my colleagues are searching for internship opportunities for the summer. It would be exciting to gain some experience with a professional trader, although I understand that positions at hedge funds are extremely difficult to come by. Still, I wanted to see if you had any suggestions or ideas that might be worthwhile to pursue, either with an up-and-coming trader or a fund willing to extend an opportunity to someone new to the business. Any information would be very much appreciated. Sincerely, Jeff M.”

Good question. Unless you have a contact through friends, family, etc., an intern position is hard to come by. If you only need 20 employees to run a billion dollar fund that doesn’t leave many spots for interns - especially in an industry that stays ‘low profile’. You may also consider the mind set of many great hedge fund managers: they often started with little money as one man shops. If you really want to be “them”, working for them might not be the way to get there. If you want to be them it might be best to emulate them.

A good reminder (PDF) worth reading. An excerpt:

“Imagine an unbiased coin is flipped three times, and each time the coin lands on heads. If you had to bet $1000 on the next toss, what side would you choose? Heads, tails or no preference? Anyone calling tails is suffering from the gambler’s fallacy - a belief randomness mean reverts. Of course, it doesn’t. The coin has no memory, on each flip it is just as likely to come up heads or tails. How does this relate to the equity market? Well, year on year returns in equities are essentially a random process, just like the coin toss. So saying markets can’t go down four years in a row is just like calling tails in the coin tossing example…”

I do know the article was written in 2003, but does that make a difference to the author’s overall lesson?

James Montier of Dresdner Kleinwort Wasserstein in London wrote Emotion, Neuroscience and Investing - Investors as Dopamine Addicts. An excerpt:

“Under emotional distress, people shift toward favouring high-risk, high payoff options, even if these are objectively poor choices. This appears based on a failure to think things through, caused by emotional distress…When self-esteem is threatened, people become upset and lose their capacity to regulate themselves. In particular, people who hold a high opinion of themselves often get quite upset in response to a blow to pride, and the rush to prove something great about themselves overrides their normal rational way of dealing with life…Self-regulation is required for many forms of self-interest behaviour. When self- regulation fails, people may become self-defeating in various ways, such as taking immediate pleasures instead of delayed rewards. Self-regulation appears to depend on limited resources that operate like strength or energy, and so people can only regulate themselves to a limited extent…Making choices and decisions depletes this same resource. Once the resource is depleted, such as after making a series of important decisions, the self becomes tired and depleted, and its subsequent decisions may well be costly or foolish…The need to belong is a central feature of human motivation, and when this need is thwarted such as by interpersonal rejection, the human being somehow ceases to function properly. Irrational and self-defeating acts become more common in the wake of rejection.”

A recent piece of research titled Research Reveals Why Some Stocks Keep Winning, While Others Keep Losing (PDF) outlines new academic thought on momentum trading. An excerpt:

“A new study suggests that investor psychology plays a big role in why stock prices show strong momentum - the tendency for prices to continue in the same direction, either rising or falling. Theoretically, with the information in this model, investors could measure price momentum more efficiently and earn more in the stock market, [Bing] Han said, [assistant professor of finance at Ohio State University's Fisher College of Business].”

How in the world is this news? Have trend followers not been taking advantage of momentum for decades to make money? This professor is only at the “theoretical” stage, when trend followers have been living these concepts to the tune of billions in profits for some time. Don’t get me wrong, I have not yet read the research and do not mean to denigrate the professor, but when the press is pushing this “angle” it makes me wonder how they can imply “new” or “breakthrough” with this research.

Trend following doesn’t care about the market. Stocks, bonds, currencies, commodities - no matter. For example, view this chart. Does the name of the company have any bearing on your trading decisions? Or could you have not known the business of that company and traded it successfully? Does it make any difference in how you would trade that “chart” to know what the firm even does?

I apologize for the server outage. Technology even at peak performance, can go belly up!

Trend Following’s translation into Complex Chinese was published Fall 05 by Pearson Education Taiwan. The Complex Chinese version of Trend Following can be purchased here.

View full Complex Chinese book jacket here. Other sellers of the book can be found by searching Google for the local ISBN 9861542035.