Michael Covel is the author of the internationally bestselling book Trend Following

Clustering Illusion

March 31, 2005

The clustering illusion is good food for thought.

Anatomy of Give and Take

March 29, 2005

"Economic theory goes only so far in explaining why people buy, sell, save or trust. Scientists are looking inside the mind for answers." Read LA Times article (PDF).

Aspect Capital

March 28, 2005

Aspect Capital: London based trend following trader (PDF). With roots to some of the great trend following trading firms, Aspect Capital has become a major player in the managed money arena.

Fundamental Switch

March 27, 2005

Do all trend followers start as trend followers? No.

Recently I spoke with a top trend follower who spent the first 15 years of his career trading, following and providing analysis on one market alone. He did not focus on other markets. How did he change?

His wakeup call came from another trader who was trading trends over multiple markets and spending little time to do it. How could this trend trader be doing other things during the day and not be focused on the constantly changing news and fundamentals. His lesson took quickly -- trend followers are not glued to screens during the day watching quotes. They trade systems and systems give flexibility.

A few years later, and after a bunch of hard work, the transition from trading one market was made. He now trades multiple markets relying on the "price" as his trading trigger for entry, exit and position sizing.

Tapioca Starch Trading

March 26, 2005

Consider:

"Thailand's commodities futures exchange launched tapioca starch futures trading on Friday but turnover was very thin as most tapioca dealers do not understand futures markets, the exchange's president said. "We did not expect very high volume on the first day as players need time to be informed about futures trading," said Napaporn Kurupasutachai, president of the Agricultural Futures Exchange of Thailand (AFET). Tapioca starch, which is used in the food, paper and toothpaste industries, became the third futures product on the fledgling exchange, behind rubber futures started in May last year and rice futures in August."
Daily Times, Pakistan

It sounds like there is not enough liquidity to yet trade Tapioca starch, but once the volume is established and traders trust the exchange, trend followers have another potential market to apply speculation.

You know nothing of Tapioca starch? Trend followers don't either. They also know little about the fundamentals of stocks, cattle, oil, euros, etc. It's not about having mastery of each market, the trick is to treat every market the same and you do that by trading the "price".

Trend Following Conversation II

March 25, 2005

Building on yesterday's conversation with a top trend follower, today in New York City I spent over half the day with one of the great trend following pros of all time. His trading career has spanned 30 years with many twists and turns. He is one very wise man - he gets it. This was the first time I had met this trader, but I did use a few of his quotes in my first book.

Why is he special? He is able to break down the complicated processes of life into chunks to better avoid the typical reasons people fail to accomplish their goals. He uses extreme focus on whatever entrepreneurial task he sets his mind too.

He also compares so many other aspects of life to trend following. One great example involved searching for oil. You will drill many wells with many of them coming up dry, but some will produce that black gold. If you know from the beginning that there will be many aborted attempts at success and that those attempts are a necessary part of finally finding oil, then you can accept the game as it is and deal with it.

It all gets back to a mindset of portfolio management. Not everything in a portfolio always makes money. Maybe once in a while everything will turn positive, but more often than not you will have the winners paying for the losers. Why do it this way? Like this great trader pointed out -- he can't predict and nor can anyone else.

Trend Following Conversation

March 24, 2005

I had a face to face conversation today in New York City with one of the best trend followers out there (trading many hundreds of $ millions). Like I mentioned the other day with another interview, this too is a man who I had never met before nor was he mentioned in my first book Trend Following.

What did I learn in a big picture sense? This man was influenced by a host of factors, but ultimately he came to his understanding of producing above average returns through his own detailed research. He pointed out that when he first started 10 years back he had no idea who the best trend followers were. He came to his aha moment through a series of small steps ultimately leading to the big idea: How can I capture those big moves, that arrive at unpredictable times, over a broad array of markets? His answer, now demonstrated with a track record exceeding +20% a year, was trend following trading.

The Tape

March 23, 2005

There is a VHS tape out there about a very famous trader from many moons ago. It's not my job to name it, but if you can find a copy, it sure is inspirational. The context and time period is somewhat dated (especially the fashion), but the men covered in the tape show a passion and energy that was the obvious key to their success. True entrepreneurs starting out whom today are legends. Great stuff. And no, I am not talking about gurus (Larry Williams, etc.) at retail seminars. This guy on the tape is still a player and a big one at that.

LTCM: The Zero Sum Game

March 22, 2005

Yesterday I picked up the phone and called a top trend follower. His firm no longer reports their performance data, but they continue to trade billions making as much money as any one.

I had never talked with this man before and he was not in my first book Trend Following. Once his firm stopped reporting their performance data I forgot all about them -- until yesterday.

This trader was at first uneasy talking with me. "How did you find me?" "Why are you calling?" But he had a good sense of humor, even though he quickly said that he did not want to be quoted on the record. We talked for 45 minutes.

His insights:

1.) He backed up the idea that many more Long Term Capital Management's are ready to implode today. He said to look at the numbers of the arbitrage guys. He pointed out that for the last 4 years the arbitrage ("stat arb, convertible arb") guys are using more and more leverage to generate less and less return ("too much gearing"). He added, "They think they have found the Key to Rebecca and they have not found anything."

2.) He acknowledged that his billion dollar plus fund was on the other side of LTCM's (Long Term Capital Management) losses in the zero sum game: "We were the other side...they were an accident waiting to happen...now 7 years later the risks for these types of traders are just as great."

3.) Wall Street investment banks only want 35 year old traders. You get to be 50 and they don't want you. What's his point here? Wall Street ignores experience like Richard Donchian trading into his nineties. I know great trend followers ranging in age from 30 to 70. That's his point.

4.) "When people's emotions drive their decision making, systems traders have the luxury of being able to stick with it."

Trends Exist?

March 21, 2005

There are a few guys out there arguing away with the concept of trend following. Their argument goes something like this:

"No one has shown me a single accepted statistical test that proves the existence of a trend. Our tests indicate randomness in most every market series...What I'm looking for is a formulation of method aside from the luck that keeps the rare practitioner of an essentially random system from going broke."

If you bring up the track records of numerous trend following traders, they attribute any and all success to "luck". Sure is a whole bunch of luck!

The bottom line? They really don't want to know that trend following works. If trend following works, they look bad. If you spend a good part of your adult life yelling that something is not true and it turns out to be true, you lose face. I compare these guys to Mark McGwire's recent steroids testimony. By all accounts McGwire is a decent guy facing terribly hard choices. The anti-trend following crowd faces the same bad choices. If they admit it works, they look real bad. But if they continue to say trend following doesn't work, they look bad too. People and their egos don't change.

Entrepreneurial Zeal

Recent months of in-person interviews with great traders have only reinforced what I believe to be the essential ingredient of success: entrepreneurial zeal. Whether soft-spoken and retiring or crazy-men, these guys are self-made, often several times over. And it's not the genius of a Trend Following system that makes them wealthy. It's their self-discipline, willingness to be responsible for what they do, and their hard work. Trend Following rules are the easy part. It's playing by them that is difficult. Frankly it all comes down to defining what you really want. Most people don't want to become rich, they just want to be rich. That's no definition. That's a dream. To become anything you need entrepreneurial zeal. I met with a well-established trend following trader the other day who has become rich (in terms of money) but more important, has created a rich life in terms of family, community and place.

Trend Following Feedback

March 20, 2005

Since the release of Trend Following 11 months ago, feedback ranging from the average retail trader to the world class fund managers has been overwhelmingly positive. There appears to be a small minority unable to accept trend following trading, but the vast majority of market players have taken to the book:

Dear Michael, I bought your book on trend following, and while I am not even to close to finishing it, I can tell that I like it very much. What a great read, what an inspiring book! Thanks for writing it! Warmest regards from Amsterdam, Albert
Feedback 1

Mr. Covel, I purchased your book when it was hot off the press. As a market participant for over 15 years, and having read a lot of books on the markets, your work is excellent. Congrats on the success of your book. Thanks, David L., CFA
Feedback 2

I just finished reading "Trend Following" today. It is AWESOME! I am very greatful to you for writing it. In the mess of hundreds of useless investing/trading books, yours stands out with about 5 - 7 books that can actually help people make money! While reading your book I actually felt for the first time in my life that I could run a fund! I am 36 years old and it has been a life long dream of mine to work for or run a successful hedge fund. I always felt to uneducated to do it until now.
Feedback 3

Hi Michael, My name is Jack M. and I've just finished reading your book "Trend Following". What an excellent and informative read. I have been researching this method of trading and this book helped me immensely. A little bit about me, I finished an Engineering degree in Queensland, Australia two years ago, but I haven't found any job or career path that really interests me. I find it fantastic to find Trend Following...I hope to learn and use this method of trading in my life. Thanks again for your excellent book, Jack M.
Feedback 4

I just purchased the Michael Covel book Trend Following and have started reading it with much interest. As I was plowing through the first chapter, it began to occur to me that I am a closet trend follower, as are many of my value oriented colleagues. How did I arrive at that conclusion? Let's go back to the answer that was given about fundamental analysis. That answer would certainly dispel any myths about trend following being better than fundamental analysis if it were truly the case that one ran the numbers, bought a stock and forgot about it. Trouble is, it doesn't work like that. You get new information about your purchase at least every quarter. At that point, any money manager worth his salt is re-evaluating his holdings in light of this new information. Sometimes you revalue your holdings upwards, other times, downwards. Some change very little. Next look at current price versus the newly calculated valuation. If the risk/reward ratio is sufficient, buy more. If it's not, hold what you have. If the valuation has gone down enough or the price risen sufficiently, you sell. It is interesting to note that, currently, most of the Graham and Dodd investors are holding a significant portion of their assets in cash (myself included). This is because there is nothing that meets our value criteria to buy and, of the holdings that we held, they have become overvalued enough to take profits on. So trend following and fundamental analysis are not mutually exclusive as some of you might think. If things are done properly, good fundamental analysts will follow a trend. As for your argument on position sizing ('fundamental analysis won't tell you how much to buy'), you are correct in that statement. But trend following won't tell you that either. Position sizing is a personal choice and is a necessary part of ANY competent investment program. The decision to add to positions that offer better rewards and sell out of positions with declining or negative rewards is critical. I look forward to finishing Mr. Covel's book. I am still intrigued by trend following techniques. I do not argue with the successes of those who follow the techniques. Sincerely, Alan M., CFA
Feedback 5

Neighborhood Brokers

March 19, 2005

So do you have the typical neighborhood broker (Merrill, Smith Barney, etc.)? I recently met someone looking into trend following for the first time. She is doing her due diligence and asking all the right questions of the trader she wants to hire to manage her money. The problem? She has a typical neighborhood broker already. I am sure her broker is a perfectly fine guy, but all he can say about trend following trading to her is that it is "risky".

Of course her broker doesn't attempt to define "risk", he just throws the term around. He also doesn't bother to acknowledge that all trading and investing is risky if you have no plan. I wonder if he thinks buying and holding the Nasdaq since 1998 is "risky"?

The good news is that this lady sees her broker's weak argument. Over time more people will come to see her smart choice. Just as many will never get it.

Geography is Not Important

March 18, 2005

I just finished a trip to meet with another great trend following trader who just happens to live and work nowhere near a major city. With a track record of 17 years (+20% a year), his performance alone is quite impressive, but his ability to do his "thing" on his terms is truly inspirational.

You have to also wonder about those people that attribute this man's performance (and other trend follower's performance) to "luck". If you think a trader is lucky, but you have not taken the time to sit down and personally meet with him (doing all the needed quantitative and qualitative homework), you miss the point. Great traders are NOT lucky over time. Their "secret" is hard work. That is their enduring edge.

Long Volatility Report

March 16, 2005

Long Volatility (trend following) white paper (PDF) from Anders Kulp, Daniel Djupsjöbacka, Martin Estlander, & er Capital Management Research. Published in AIMA Journal.

Shorter-Term Feedback

March 15, 2005

A reader wrote in recently to complain that trend following doesn't really work and that all trend followers are using "new" techniques today. He also expressed his view that shorter term methods are superior.

He believes this white paper (PDF) is the future of trading.

My comments:

1.) Jim Simons has no peer. He is the best. There are no other traders like him. The costs to do what he does, however, and no one really knows what that is exactly, are huge. His PhD staff, data, & technology far exceed the costs of a trend following operation. I have met no one that does not have the utmost respect for Jim Simons. The question really is: "Is it better to try and be Jim Simons or invest with Jim Simons?"

2.) How can you easily tell trend followers have not changed their style of trading? Trend followers by and large have strong correlations of performance returns. They make and lose in the same months. They trade VERY similar styles. There now exists a nice population of trend followers, trading for some years, to analyze. The idea that they have all "changed" is simply not true when you examine all quantitative and qualitative evidence.

Hedge Fund Introduction

March 14, 2005

Hedge Fund Introduction: Read PDF Brochure

Pearl of Wisdom

March 13, 2005

From a recent Financial Times story comes a pearl of trend following wisdom:

"David Harding at Winton Capital Management says his managers adjust the model systematically every month, no more, no less. "What you do not want to do is wait until you are in a beastly draw-down when you are having lots of problems with clients and say: 'What we have discovered is a new thing that fixes the problem'. That's what the marketing people tend to want but that is not the correct thing to do," says Mr Harding."

When you are on a losing streak, don't start trying to reinvent the wheel. That's David's strong point.

Korean Translation

March 12, 2005

The book Trend Following has now been signed for a Korean translation.

CNBC Twilight Zone

March 11, 2005

I accidentally flipped to CNBC today. It is like watching an episode of the Twilight Zone. How does Maria Bartiroma, 5 years after the bubble burst, with a straight face ask "analysts" for opinions on stocks? It is strangely bizarre. After seeing this odd TV spectacle, I decided to search Google to see if there were stories on CNBC ratings. From Bill Mann I found some fun insight that quickly backed my gut impression of CNBC version 2005. It doesn't appear people watch:

"The past two years have been pretty positive for the markets. If CNBC's ratings were tightly correlated with market direction, one would think that the ratings would have rebounded in sympathy, rather than continue to tank. CNBC was perfectly constructed to be the voice of record while the bull market raced ever higher. Many people compared CNBC with Disney's (NYSE: DIS) sports broadcasting juggernaut, ESPN. But viewing sports and viewing stocks aren't even comparable: The cost of rooting for the wrong "team" on CNBC is far, far higher. What CNBC was not constructed to do was offer up much in the way of useful, contrary information. It's as if the network's programming manager goes daily up onto the roof, checks the prevailing winds, and constructs the program to respond. The problem, of course, is that following the prevailing winds doesn't help the viewers who come to the station to hear something useful. That's overstating it. But the executive shuffle and the comments among NBC brass, along with the decline in viewership, however it is properly defined, are fairly conclusive pieces of data showing that CNBC in its present form is struggling...CNBC needs to matter. The network has the same talking heads on now that it did in the late 1990s. In the '90s, they hyped dot-coms, in 2000 optical networking, and so on to today, when commodity and energy companies can do no wrong. The result is that CNBC viewers, if they count on you for information, are doing nothing but chasing the thing that has just happened. That's exhausting, it's counterproductive, and in the long run, it's expensive. I've said this for years: Who cares what analyst on Wall Street raised or lowered guidance?"

Another Interview

March 10, 2005

I am in the middle of an extensive set of informational interviews with some of the great traders of today. I just finished a meeting yesterday with the President of a trend following firm who manages over $3 billion dollars for clients. A very down to earth guy, his most direct advice was for people to focus on their plan and not stay preoccupied with others' plans. He drove home the point that if you dare to be great, in whatever your chosen profession, standing outside the crowd is where the great rewards will be found. If you only want to work for the man, you can't be the man.

Buffett Says Sorry

March 08, 2005

Read:

"In his highly popular annual letter to shareholders, America's second-richest man expressed regret that his bet against the dollar had been so profitable, and urged the US administration to take action to deal with its widening trade gap and budget deficit. Mr Buffett, 74, one of America's most successful businessmen for the past half century, said: "In no way does our thinking about currencies rest on doubts about America."
Independent News & Media (UK) Ltd.

Read more:

"Warren Buffett, the world's second-richest person, last year increased his bet against the U.S. dollar 78 percent to $21.4 billion, resulting in a $1.84 billion gain. He also said he would be happy if his bet were to fail."
Reuters

I understand he is the richest guy out there, but this kind of talk is disingenuous. Do you really think he is "sorry" he made money shorting the dollar? I am sure the loyal buy and holders will ignore all of this and just blindly pretend that Buffett is still the "folksy" hero to the "everyman". Why can't Buffett just admit, "I made a great trade on the dollar?" This "I feel guilty" routine is just that - a routine.

NOTE: Please don't ask whether I think Buffett is a success. Of course he is - a monster one. That is not my point.

Buffett Annual Letter

March 07, 2005

The greatest "investor" Warren Buffett is trading like a trend follower these days:

"Mr Buffett's bet against the dollar also grew. Foreign exchange contracts - mostly short positions against the US dollar--nearly doubled over the year to $21.4bn, generating $1.8bn in gains as the greenback fell against other major currencies. These currency profits were partly responsible for a sharper than expected rise in fourth quarter earnings from $2.39bn to $3.34bn, although Berkshire earnings are notoriously volatile due to the timing of investment gains."
FT.com
March 5, 2004

That is some serious profit for Mr. Buffett! Buy and hold out the window!

NOTE: Please don't ask whether I think Buffett is a success. Of course he is - a monster one. That is not my point.

Men Behaving Badly

"Men Behaving Badly" whitepaper explains "irrationality in decision making when defeat becomes hard to accept."

Download now.

Trading System Consistency

March 06, 2005

Food for thought:

"What kind of risk are you willing to take to get this profitability? Consider whether you are willing to suffer the occasional large loss in return for consistent small profits. For example, risk arbitrage as a trading strategy has lots of small profitable trades but the size of the average winning trade is overshadowed by the size of the losing trade. Do you need to make modest profits but take little risk? Do you need to make huge profits but can afford to take sizable risks? I usually start interviews with potential clients by asking them how much risk they are willing to take. Can you afford a loss of 5%? How about 50%? Defining the amount of risk usually defines the type of system that is required. Don't forget that it is very easy to acquire risk. One of the keys of profitable trading is controlling and managing the risk that is acquired. One of the key risk elements to look at is the risk of catastrophe. For example, it may be that two systems have identical returns but one has a higher risk of catastrophe. I remember in the early days of system trading how moving average crossover systems were all the rage. The basic concept is to buy the instrument when the, say, 10-day moving average of price crossed over the 40-day moving average of price, and short when the reverse occurs. In fact, this is a profitable system. But one of the problems is that moving averages are, by definition, behind the market. It is quite possible for an instrument to lose 90% of its value before the sell signal is triggered! Of course, it won't happen very often, but the mere potential of this risk must be considered in the system selection process."
Courtney Smith
Chairman, Courtney Smith & Co.

Bledsoe Forgets System

March 05, 2005

Great trend followers don't debate their signals when they arrive. They know that they have done their homework. They know their success comes from the discipline to follow their rules - no matter what. Trend followers don't get entry or exit signals and apply some extra layer of "human judgment". They don't try to be smarter than the "system".

Now think about this "football coaching" excerpt, keeping in mind the importance of following a system:

"A very significant story for the future of Drew Bledsoe in Buffalo happened, of all times, during the coin flip before the season's last game against Pittsburgh. Big game for Buffalo. Very big. A win over Pittsburgh, which would be resting some of its stalwarts, and the Bills were still in the playoff hunt. Winds were whipping up pretty strong that day -- 17 mph. Before he walked out to midfield for the flip, Bledsoe was advised by coaches to choose to defend the east goal if Pittsburgh won the toss and elected to receive. That way, the Steelers wouldn't be wind-aided when they took the ball. Pittsburgh won the toss. Pittsburgh elected to receive. Bledsoe said Buffalo would defend the west goal. West? We told him east! The Bills sideline was stunned. What is God's name was Bledsoe doing? Bledsoe explained that when he got to midfield, it seemed to him the wind was whipping around differently than the way the coaches thought, and so he picked the opposite goal to defend. There was some anger toward Bledsoe on the sideline, and maybe it was just coincidental, but the Steelers scored 23 of their 29 points going from west to east that day -- and Bledsoe's decision backfired. Sometimes, coaches don't want players to think. They want players to do what they're told. Bledsoe defied the Buffalo staff that day, a sort of subtle defiance that began to irritate the Bills coaches the same way it had irritated Bill Belichick's staff four years earlier. That simple act didn't get Bledsoe unemployed. Three very big Bills losses this year (at New England, at Baltimore, and that Pittsburgh game), in which he threw zero touchdowns and eight interceptions, helped Mike Mularkey decide he'd be as well off playing J.P. Losman, a kid he knew had some mobility and, more important, would follow instructions."
ESPN
Better without Bledsoe
Patriots built dynasty by sticking with Brady
Sunday February 20, 2005

Competition

March 04, 2005

As you trade, no matter the style employed, you need to be aware of the competition. And when you think of the competition, you better think how their trading affects you. You can't just sit back and ignore the world. From the ground up your trading philosophy needs to be aware of other market participants and specifically other market participant's varying time horizons. Trend followers might be fine with the belief that price analysis already factors the competition, but shorter-term systematic traders better be aware of Jim Simons.

Trend ID

An excerpt to ponder:

Question: Besides the obvious of price determining trend formations...What key factors would one look for in order to reinforce the belief that a trend is in fact developing?

Ed Seykota: Your focus on "trend formation" and "trend developing" indicates a desire to anticipate trends. Such attempts to "pick the bottom" are things fundamentalists attempt. Trend Followers simply wait for trends to appear.

Trend Following in New York

March 02, 2005

I finished an interview today with a trend follower based in New York City. He has been at it for 30 years. His firm, like my recent Caribbean interview, also manages over $1 billion in client capital. In a wide-ranging conversation about trend following's lack of acceptance in some quarters, he pointed out that for many people "investing with skill" is hard to understand. Trend following is a skill. You can learn that skill or you can hire a trader who has the skill. But either way skill does matter when you are aiming to beat market averages. More to come in the near future...

Seykota on Short Term

March 01, 2005

Ed Seykota was recently asked in his forum:

"I am new to trend following and wish to ask you what your favorite chart is for determining a given market's trend? Daily, Weekly, Yearly, Hourly?"

Ed responded:

"Hmmm...your list seems to lack scaling options for minute, second, and millisecond. If you want to go for the really high frequency stuff, you might try trading visible light, in the range of one cycle per 10-15 seconds. Trading gamma rays, at around one cycle per 10-20 seconds, requires a lot of expensive instrumentation, whereas you can trade visible light "by eye." I don't know of even one short-term trader, however, who claims to show a profit at these frequencies. In general, higher frequency trading succumbs to declining profit potential against non-declining transaction costs. You might consider trading a chart with a long enough time scale that transaction costs are a minor factor - something like a daily price chart, going back a year or two."

I agree with Ed's pithy wisdom, but he is not saying short term is impossible.

There do exist shorter term systematic traders who have done quite well (Toby Crabel, Jim Simons). They would agree with Ed that their style is hard. The shorter you go the more you need great execution, fantastic data and multiple systems. To be a great shorter term mechanical trader is a different animal than trend following, but it is a style that a select few have mastered.