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

Why Turtles Matter

September 30, 2005

Steven Gabriel, M.D. offers a take on Why the Turtles Matter.

More on the Turtles.

Wild Feedback

September 29, 2005

Feedback from today:

"All these website gurus are BS. It is rather simple actually. Market is so dynamic. It depends on (1) supply and demand, and (2) manipulation. These 2 are in turn depend on a host of factors, which are dynamic in nature:

The strength of the supply and demand (buyers and sellers) and the market manipulators (who know how to get around the rules) are therefore so dynamic. The strength of buyers for a particular stock should reach a critical mass before the other investor would turn to buyers and sparks a rally. As confidence grows, more and more stocks rally and the broader market turns to a bull market. A critical mass volume of buyers to spark a rally in a stock and the momentum of the rally are also dynamic in nature. Therefore some price of stock moves up and fall back down as a result of not achieving a critical mass. At other times, only a brief rally as the buying momentum fizzles out. While at other times, a surprising rally as buyers continue to buy at higher and higher levels. These price movements more often than not, are guided by market manipulators who buy at lower level and try to ignite a rally and later cash out. If they are successful, they may cash out at 200 or 300% their cost. If they are not that successful, i.e. their attempt to draw buyers is futile than they may cash out at 5% above their cost or at breakeven. They also sometimes even have to cut their losses at minus 5 to 10% if the dynamic of the market unexpectedly moves against them. Note that the word 'sparks' in the phrase 'sparks a rally' means the movement is not planned and therefore impossible to predict. So the technical ability of the so-called 'timing the market' is therefore a bunch of BS. The only way is one has to closely, if not continuously, monitor the stock market and make a calculated guess based on the dynamic of the various factors, most importantly the current investors sentiment. It boils down to a guessing game."

This reader's diatribe on the "whys" of the market seems to be a clever explanation for his own inability to profit from his own buying and selling. In his mind he has it "all" figured out, but to all of us observing his words carefully, the disconnect is clear. Once again, people always ask where do the market losers who supply the market winners come from...

Surviving Speculation

September 28, 2005

Surviving Speculation by Adam Hamilton is food for thought.

Capitalism or Not?

I just watched an interview between Bill O'Reilly and Congressman Charlie Rangel. Keeping in mind that the United States of America spends record amounts on entitlements today, O'Reilly said to Rangel (and I paraphrase):

"You can't help everyone. Some people elect not to compete in a capitalist society no matter how much we spend on entitlements. You can't make people compete and some people don't want to compete. That's the bottom line."

True.

Panic

September 27, 2005

I regularly receive emails from Innerworth and sometimes they do provide insights to pass along:

"Jake thought that he had it all figured out. He would buy 500 shares of a stock when the price hit 50, and sell when it reached 51. Maybe it wasn't the most thorough trading plan but it was a plan. When Jake tried to execute the plan, however, the trouble started. The stock opened at 51. Jack waited for it to go down to 50, which it did around noon. He tried to buy it as he had planned, but he got a poor fill. He decided to go with what he had, but the stock price went up and down, between 49 and 50 until the close. Throughout the day, Jake felt frustrated. He couldn't think straight. He hadn't anticipated how the price might fluctuate as it did. He was caught off guard, and thrown into a state of anxiety and panic."

Continue reading Panic »

Risk, Reward & Margin

September 26, 2005

A good white paper on risk, reward and margin from David Harding and Winton Capital.

Lack of Moral Reasoning

This study by Sharon Stoll tackles the subject of a lack of moral reasoning among athletes. Her work, if you ponder for a moment, is relevant to populations well beyond "jocks" however. Take for example my book Trend Following. I have seen legitimate criticism that debates trend following trading. Criticism from the likes of James Altucher attacks trend following on the merits. I disagree with him strongly, but I never question his morality. From others, however, I have seen personal attacks that never address the substance of trend following (or my writings). Interestingly the personal attacks come from those who seem to have the deepest moral flaws.

I have always found that there are immoral individuals who succeed in the short-term in whatever they pursue, but in the long run these people always implode. Stoll's work is thought provoking.

Hedging Real Estate

September 25, 2005

They have been all the vogue, but many of the new markets opening up will most definitely change what we think of as a market "to trade". The Wall Street Journal chimes in:

Once, a home was a castle. Now it is looking more like Fort Knox -- a pile of money in need of protection. Amid warnings from economists that real-estate values in some parts of the country may drop eventually, there is a nascent movement to offer new investment products designed partly to hedge against falling property prices. The goal: Offer limited protection against the risk of riding real-estate prices back down again after the record run-up in recent years. In recent months, Merrill Lynch & Co. and other investment banks have started offering investment products that will rise in value if a basket of housing- related stocks declines. Already, nearly $400 million of these investments have been sold, according to Daniel Carrigan, vice president for new-product development at the Philadelphia Stock Exchange. The Chicago Mercantile Exchange also is preparing to announce plans to introduce in the second quarter of next year futures contracts based on home prices in each of 10 cities. It will also offer a composite contract covering all 10 cities. That plan follows the introduction last May by HedgeStreet Inc., based in San Mateo, Calif., of financial contracts called Hedgelets that let investors bet on a rise or a fall in home prices in six individual cities."

Continue reading Hedging Real Estate »

Exchange Traded Funds

September 24, 2005

A good introduction/commentary on exchange traded funds from Wharton.

Style Drift

September 23, 2005

In doing some research I came across the following excerpt. The date of the article has no relevance for my point:

"A key failing of equity managers in 2003 had been their inability to capture the upside when markets bounced. That had happened largely because managers were still licking their wounds from 2002 and an environment that had penalised risk-taking. But managers were not being paid to hold cash; they were paid to put it to work. Getting the risk profile right meant investors understanding how drawdowns happened and being able to distinguish between "good" and "bad" drawdowns. "Style drift is a bad drawdown...Breaching limits is a bad drawdown. But an investment decision that was part of the strategy and went wrong is not a bad drawdown. You need to take on more risk without scaring the hell out of investors."

The whole concept of style drift is very important. Put simply it means jumping from one trading strategy to the other. Kind of like chasing your tail (if you happened to have a tail).

A good drawdown is one that happens because you expect it. A good trading strategy will have drawdowns from time to time. You can't avoid them. They are not unexpected. A bad drawdown, on the other hand, is one where the losses pile up as you chase the latest hot manager or hot investment tip. Bad drawdowns stem right from impatience and greed.

Sample Too Small

September 22, 2005

In a Yahoo news piece the other day I noticed this bit of writing which has tossed around for seemingly decades:

"Larry Williams is noted for winning the World Cup Trading Championship by the largest percentage gain of all time. He turned $10,000 of real money into $1.1 million in less than a year during the contest."

In the article, Larry Williams is asked about the contest:

"Sure, I won the Robbins World Cup trading championship, I took $10,000 of real time money, not paper trading, in 12 months up to $1.1 million. That is an accomplishment, I guess...What I did was maybe lucky, who knows..."

I am glad Williams decided to use the word "luck" for his effort. While perhaps impressive, his effort has not been repeated. And that's the rub for me. Why do all these people keep touting this contest win, this one year only performance, still to this day over 15 years later?

David Harding, a man with a track record exceeding 15 years not just one year, has noted the problems with short-term results and short-term thinking:

"It is very dangerous to read too much into short-term results," said Winton Capital Management's founder and managing director David Harding, who was a co-developer of AHL, along with Aspect Capital founders Michael Adam and Martin Lueck.

An even better story of perhaps too small of a sample (and sheer luck) can be found here.

Predict v. Follow Feedback

September 21, 2005

Feedback from author of Predict v. Follow:

"Hello Michael, I just wanted to let you know that it was my quote you used. I'm glad to further the discussion on your website since it has helped me greatly. Thought I would take the opportunity to let you know what I thought of your book and comment on it. Your book has caused me to do some soul searching to what kind of trader I want to be, how I will enter markets and how and why I will exit. It forced me to define an approach to trading, to carefully pick markets to trade, and to think how I would choose risk management levels. No book can be all things to all people, but your book forced me to rethink my trading strategy and attempt to trade like a professional trader would trade. By the way, technical charts do serve a great purpose, they are the records of missed markets of most fundamentalist's and guru technician's. Why do they miss most markets? p. 140 of your book answers this question (I think the best concept in your book). Thank You."

Kelly Formula, Bell Labs, Data Transmission and Optimal Bet Size

Read the new book Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone.

Review of book at BusinessWeek.

More on the Kelly formula.

Predict v. Follow

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.

Intelligence Analysis

September 20, 2005

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.

Negative Side of Emotion

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.

Functional Psychopaths

September 19, 2005

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."

Continue reading Functional Psychopaths »

Jim Cramer Redux

September 17, 2005

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.

Shrinking Risk - No.

September 16, 2005

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

Where to Go?

September 15, 2005

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.

Benefits of Managed Futures

September 12, 2005

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

Risk Matrix: Speed v. Impact

September 11, 2005

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

Brain Regions Blamed for Bad Investment Ideas

September 10, 2005

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."

Continue reading Brain Regions Blamed for Bad Investment Ideas »

Index Card Thinking

September 09, 2005

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."

Stocks v. Commodities

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."

Risk v. Volatility

Some feedback just received:

"Greetings, just a thought from another trend follower. I hear the term risk used by investors/traders all the time. They are rightly concerned about risk, yet most do not know the source of risk, and, therefore, how it must be handled. For instance, I spoke with an experienced trader today. One statement really stuck out, "...oil stocks are too risky just like the internet stocks from a few years back..." He then used this reasoning as justification for why he currently won't trade oil stocks. I tried to explain he was really talking about volatility - not risk. Stocks are not risky, they are volatile. Risk [on the other hand] is a part of one's trading system. How much capital does one allocate to the oil sector? When does one open a position in the oil sector? When does one close that position? If you know the answer to these questions before your trade, you have already taken steps to reduce your risk. Refusing to trade certain stocks, futures, commodities, indices, options, currencies, etc. will not accomplish this."

Jim Cramer's Mad Money TV

September 08, 2005

Got a call last night from a friend who told me to turn on CNBC. I did. I watched in amazement Jim Cramer's TV show "Mad Money". I specifically saw a feature called "Jim's Call: Buy or Sell." I can put it no blunter: if you watch this and you think this is useful, you need a mental examination.

More on Jim Cramer.

More on Jim Cramer's Mad Money from Sfgate.com.

TradingMarkets.com Covel Articles

Here is an archive of my articles that I have placed on TradingMarkets.com.

Emotional Feedback

September 07, 2005

Feedback received today from a client:

"Dear Michael, this is more of a commentary than a question. I just want to express my recent experiences and place a large exclamation point on being ready to accept losses prior to opening a trading account. My experience has been that due to the nature of any trading that cuts losses short and allows winners to run, a great percentage of the initial trades could very well show up as losses and upset a traders psyche..."

Continue reading Emotional Feedback »

Fibonacci Turning Points?

Consider a recent email received:

"T-3 Fibs ProTrader day trading software is the most accurate predictive methodology ever produced for professional traders who wish to apply complete Fibonacci time and price predictions to their day trading in an effort to pinpoint HIGH probability turning points in price and time before they happen."

Prediction is folly.

No Oil Prediction

September 05, 2005

This excerpt came across my desk the other day:

"One cannot escape making an oil-price forecast. The demand-supply factors are still strong for oil and natural gas markets, leading some analysts to predict continued high or even higher prices over the next several years quite the opposite of what Mr. Gignac thinks will happen. With economists disagreeing and investment advisors no better at forecasting than anyone else, it is really up to investors to choose their own path. A complicating factor is the loose linkage between oil and gas stocks and commodity prices. Even if oil prices slip from the $60-a-barrel range into the $50-a-barrel range, it may be that oil and gas stocks would still be higher a year from now especially if enough market participants believe the oil price will stay high for some time. A recent commentary by Greg Pardy, an oil and gas analyst at Scotia Capital, noted that the stock prices for large oil and gas integrated and exploration companies in Scotia's coverage universe were discounting only $45 oil. That means the market was not assigning any value to the share prices for the rise in the oil price above that level."

How does one use this type of commentary to know when to buy? Or sell? Or how much to buy or sell? How does this type of fundamental analysis help answer the important questions? Do you really believe an oil forecast or prediction is possible?

Winton Capital

September 03, 2005

From the most recent Winton Capital newsletter, comes a trend following performance update:

"The Winton Futures Fund gained 7.60% in August to bring the year to date performance to 17.38% and the compound annual average rate of return in 95 months of trading to 21.48%.

Continue reading Winton Capital »

Van Tharp Wisdom

September 02, 2005

Dr. Van K. Tharp speaks to a "state of mind":

"Many traders start out using a state of mind that focuses on "having." Rather than focus on how to trade in concert with the markets, they are obsessed with profits, and what they can purchase with those profits."

Continue reading Van Tharp Wisdom »