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

Risk Capacity?

December 30, 2005

I came across a "risk capacity" survey online. One of the questions with answer choices:

How would you rate your knowledge about investing in general and more specifically, the relationship between risk, return, and time?
A. significantly below average
B. below average
C. average
D. above average
E. expert

How does it help to pose this question to investors? The firm that poses the above question also makes these assertions on their website:

1. It is virtually impossible to beat a market over time through active investing.
2. Indexing is backed by Nobel laureates who have provided unbiased, rigorous, empirical research, most notably the Modern Portfolio Theory.
3. Stock pickers are analogous to gamblers who rely on feelings and emotions when making bets.
4. Time pickers or market timers move money in and out of different investments in an attempt to profit from short-term cyclical events, which is a futile endeavor.
5. Manager picking is not a reliable practice because the past performance of money managers does not predict their future performance. Star money managers fall from their stature sooner or later, since their stellar performance is attributed to Lady Luck rather than skill.

Whomever wrote the above 5 points has not read Market Wizards, Fortune's Formula or Trend Following.

Adding Risk to Reduce Risk

December 29, 2005

Trend follower Campbell and Co. from their web site offers this graphic with this explanation:

"The Effect of Adding Campbell Composite to a Hypothetical Portfolio Consisting of Stocks and Bonds Quarterly Returns from January 1972 - October 2005 (estimates)"

From a portfolio level perspective, many have a hard time digesting the fact that a "risky" investment added to an existing portfolio of stocks and bonds can actually increase return and reduce risk.

Taming the Lion Excerpt

This audio excerpt (MP3) is from the new book Taming the Lion by Richard Farleigh.

'Train-to-Failure'

December 27, 2005

Brett Steenbarger outlines an interesting aspect of bodybuilding called 'train-to-failure' (PDF). An excerpt:

"The vast majority of people live their lives the way uninformed athletes train: they take on too many demands, none of which are sufficiently intense to take them to failure. Theirs is the equivalent of lifting a twenty-pound barbell for hours on end. They become tired, but not strong. By the time they get old, they are chronically tired, and then retire from all demands. For many, retirement is an exercise in mental, physical, and spiritual deconditioning."

Download PDF.

Australia Trend Following

Feedback:

"Hello Michael, I have just finished reading your book and have found it to be very informative and would recommend it to anyone as one of my top 3 trading books. The trend following method I currently use is essentially a combination of two methods discussed in Appendix A of your book ("Trend with Pattern Entry" and "Donchian Channel"). On the very last page of the book there is a coupon to fill in to get a free trend following CD ROM. Is this available for people located overseas (I am located in Australia)? Once again, thanks for writing a terrific book. Have you / do you ever intend to come to Adelaide, South Australia? Regards, John Porton."

Yes, the free coupon offer in the new edition of Trend Following is available for everyone across the planet. I have not been to Australia yet, but will be making the trip in the near future!

Rebalancing Confusion

December 26, 2005

I was forwarded an article on year-end portfolio "rebalancing". First it said:

"Lighten up on longtime winners like small stocks, gold shares and real-estate investment trusts."

Then it said very next line:

"Make sure you have a full weighting of growth stocks, blue chips and Japanese shares -- and don't be too quick to trim your positions if they roar ahead."

These statements contradict each other. How and why should you lighten up on longtime winners (I assume they are still winners), but also at the same time not trim positions that are roaring ahead?

Daily and Weekly Data?

December 23, 2005

Feedback from today:

"...what do you think of using weekly and daily data to ensure that a trend is happening?"

Trend following is definitely practiced using daily bars. I know some past and current trend followers who use weekly bars too. However, isn't the real key still to answer the 5 questions first?

More on 'Shorter' Trends

December 22, 2005

Feedback today:

"Wanted to add a comment to the 12/20 comment on shorter trends. I can relate. In my opinion, and with 7+ years experience, I believe what constitutes "a trend" is much like beauty, it's in the eye of the beholder. It is very subjective...I, for instance, perceive markets in terms of "trends" that generally last from several days to several weeks. While I may trade a particular market 12 to 15 times in a year, the LT trend followers may only trade it once of twice."

Short term trading is doable, but you better be Jim Simons or Toby Crabel. And you better figure out how to handle commissions and execution costs that will always be there to eat away profit. I add a brief new comment on this in the new edition of Trend Following in the appendix.

Which Moving Average?

December 21, 2005

Feedback received today:

"Hi, I was just experimenting using different moving averages to react to price movement in equities and futures. I notice that in your book, you mention only exponential moving averages of different time lengths. What do you think of using moving averages with different calculation methods (say exponential and triangular or time series) in order to track recent price movement in a stock as opposed to price movement in the past? It seems like that would be a pretty good way to track breakouts. Thanks. Joe."

I look at these issues in a different way. The key is answer the 5 questions presented in Chapter 10 of my book:

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?

If after testing you determine that your variation or choice of moving average works to help you answer those 5 questions (to meet your personal goals of profitability, drawdown, etc.), then you are on to something. If it doesn't work, lesson there too. But don't get fixated on the entry indicator...

Feedback on Shorter Trends

December 20, 2005

Feedback on "shorter-term" trends:

"Michael: I have read the older version of Trend Following and am working to apply the knowledge you conveyed so well in it. I am a definite believer in trend following and its benefits. With that being said, I would like to offer one piece of 'information' that I have acquired through reading a couple of dozens books on trading and my somewhat limited experience trading. For some reason, perhaps that I am 55 and my brain isn't as fast as it used to be, I came away from reading your book with the following phrase in my mind: "Long-term trend following." Admittedly, your book does not really use this phrase. You simply recommend 'trend following.' The reason I raise this issue is that, trend following does not, by definition, have a specific time frame inherent with in its' 'methodology.' It does not have a defined length, or even an intoned length of trade. My mistake in interpreting 'trend following' as 'long-term trend following' caused me to stay in trades after a seemingly 'short-term trend' (meaning less than a few months) had run its course. Because I had the concept of 'long-term trend following" in my mind, I was looking/expecting trades to last for many months and perhaps into years. While there are trends that will meet these criteria, there are many, profitable, 'trend-following' trades that last only a few days or a few weeks depending upon the future/stock that is being traded. Once I recognized this 'long-term' definition error in my thinking, I have been exiting some 'trend-following' trades more quickly than before, and have, as a result, often 'saved' substantial profit that I was previously letting slip away while I waited for the 'long-term' time period to pass. I share this with the hope that it might help others who might suffer from the same misconception that 'trend following' has some pre-defined aspect of time built into it. It doesn't. Just follow the trend over the time period for which one's analysis applies, and get out when that trend says it is done. And, of course, cut losses short. Thanks for sharing your knowledge with others. Sincerely, H. Richardson"

How do you determine the "time period for which one's analysis applies"? The trend followers that I have written about and the trend following I describe is thought of as long-term trend following. That's how they define themselves and their trading. There are the few super traders (i.e., Simons, Crabel) who can trade very short time frame trends with success, but the average trader has no shot in my opinion in so-called "shorter trends". Shorter trends require much more in terms of execution and commission for success.

On Stress

December 19, 2005

Brett Steenbarger in a recent article titled Coping With Risk and Uncertainty offers:

"What constitutes a source of stress is highly dependent upon our perception. If we define something as a threat, we will experience it as threatening, and that will trigger a stress response. For some people, public speaking is an everyday activity, not to be feared at all. It might even be something enjoyable. Others view public speaking as a potentially humiliating event. Their perception of threat triggers the stress response that we call performance anxiety. Cognitive psychologists, however, remind us that it is not the public speaking event itself that is generating the anxiety, but rather our processing of that event. Take away the perception of threat and the anxiety diminishes."

This paragraph struck me. How many times have you ever heard someone say, "that's too risky", when talking about trading? Traders will have different perceptions of risk depending on their "processing" or "understanding". Saying that something is "risky", without further explanation or discovery, is plain lazy. Thanks to Dr. Steenbarger for the pearl of wisdom!

James Altucher: Critic

December 18, 2005

Even though James Altucher refuses to recognize trend following as viable, I do appreciate and thank him for his mention of my blog and book Trend Following in his 'RealMoney.com Blog Watch' for December 17, 2005.

Doesn't Like Trend Following

December 17, 2005

Feedback recently posted about the book "Trend Following":

"This book is another pie-in-the-sky book. Technical analysis is not the end all to investing in markets. Sure, the author has empirical data but...so what. He fails to mention the enormous DD's one has to endure in order to make money. It is proven that mechanical trading systems do not hold their weight in gold. By and by, they become obosolete [sic] because...they were curtailed to a selective time frame that no longer supports their viability in the wake of present time. Relying solely on mechanical trading systems that are derivatives of technical analysis is futile to longevity investing in the markets unless you have a lot of money you can use to weather the storm with. This strategy is best suitable for CTA's and hedge funds...people who have the money to put up and stay in the game with...if the situation gets kind of murky."

1. I wonder if this reader read p. 6-10 of the book?
2. I wonder if this reader read p. 246 of the book (last paragraph)?
3. I wonder if this reader understands that the Nasdaq is in a 55% drawdown spanning 5.5 years?
4. I wonder where it is proven "that mechanical trading systems do not hold their weight in gold?" What does that mean exactly?
5. I wonder what "By and by, they become obosolete because...they were curtailed to a selective time frame that no longer supports their viablilty in the wake of present time" actually means? If readers can interpret for me, send in an email.

In terms of trend following becoming obsolete, that cry has been screamed by skeptics for over 30 years. I know some very wealthy trend followers who must wake up every day dreading their "obsolescence"!

Risk Equalization

December 16, 2005

The Market Technicians Association's December 2005 Newsletter Technically Speaking leads with an article of mine titled Risk Equalization (PDF).

Feedback from Client

"I want to say again what a great benefit this course and your website have been to my trading. I am trading with calm and tempered enthusiasm that I attribute directly to the lessons I have learned through your materials. Drawdowns are expected and therefore of little concern as my stops are in place if the market reverses against my positions. I no longer calculate every dollar that I could have 'won' if I had only picked the top or gotten in at the very start of the move. I still have colleagues that agonize over the 'what if's', and then over-optimize their systems based on recent occurrences. I have thankfully learned to stay the course, and stay true to my decision making process. A process that is un-altered by the news and views of the community and the press. A process that focuses simply on price. When to get in, when to add more, with how much, and when to get out are all rock solid non discretionary rules, regardless of the market, the cycle or the funnymentals."

3000 Book Order

December 14, 2005

I just learned that a trend following fund bought 3000 copies of the new and expanded edition of Trend Following.

Following Gold

Jason Wells sent me feedback on "gold":

"The question that everyone seems obsessed with is, "Why is gold rising when the dollar is also near a high and inflation is tame?" The answers given by financial pundits in the mainstream press are varied and no one agrees what the true answer is. A recent article in the Washington Post seemed to hit the nail on the head: "Gold’s New Luster Puzzles Traders." Might I suggest that the proper response (from an investor's standpoint) to this question is as simple as it is straight-forward: Who cares?"

Jason also forwarded a comment from Clif Droke:

"Whatever trend-following devices you use, if you follow the longer-term trend you're almost bound to come out ahead over time. This approach is always better than the hand-wringing approach that leaves the investor impotent to act and forcing him to ask over and over the "why" of a market trend along with trying to second-guess what the market trend is clearly telling him. It is not in vain that it is said, "The trend is your friend." The investor's job is not to know the "why" of a market trend, but simply to recognize it and act accordingly. And isn't that what technical analysis (and investing) is all about?"

Patton and Cool Hand Luke

December 13, 2005

A great MP3 from the movie Patton and another great MP3 from the movie Cool Hand Luke (with help from Guns N' Roses).

Blackstar Funds Update

December 12, 2005

We recently posted a white paper from Blackstar Funds, LLC. Unrelated another reader wrote in to mention Fund X. Today, Cole Wilcox of Blackstar funds emailed me:

"We compared the Blackstar Diversified Equity program vs. the FUNDX flagship mutual fund which was launched in 2001 and employs the strategy mentioned in your readers comments. Attached is a chart comparing the returns and drawdown of the two strategies."

Here is Cole's graphic.

5 Year Performance Chart

Here is a MarHedge performance graphic for notable trend followers over the last 5 years. It includes the following trend followers: Superfund, Winton Capital, Transtrend, Abraham Trading, Graham Capital and Clarke Capital.

Minneapolis Star Tribune Quote

December 11, 2005

I was quoted today in The Minneapolis Star Tribune. The article was titled Computer Algorithms Increasingly Call Shots in Stock Trades. While the article may come off as a little simplistic, we should all appreciate this reporter tackling a subject still foreign to most traders and investors. [source]

Market Flow and Worry

Van Tharp forwarded me (2) other good reads: The Flow of the Markets (PDF) and Stop Worrying Yourself out of Profits (PDF).

An excerpt:

"Imagine yourself flowing down a river, only you don't know that you are. You do, however, notice that when you move in one direction, with the flow of the river, you move rapidly. When you move in another direction, against the river, you move slowly or not at all. In fact, when you go in that direction, you seem to put out a lot more effort just to stay in place. Your life becomes a struggle. It just seems to push you in another direction. Feeling miserable, you fight against it. But it doesn't help. You still seem to move only in one direction--with the flow of the river. Most people prefer to struggle against the river. They try everything they can think of to go upstream. All solutions like this-going against the flow-have the same result: frustration. If you were in the river, what could you do to make your life easier? One solution would be to get out of the river. But that would be giving up. There is only one easy solution-to acknowledge or accept that the problem has nothing to do with the river. The river just is. And it moves downstream and nothing you do can change that. When you realize that the problem stems from you, then the solution becomes obvious - just relax and flow with the river."

Barry Ritholtz of The Street.com

December 09, 2005

In his 'Apprenticed Investor' series, Barry Ritholtz of the TheStreet.com offers feedback on Trend Following:

"My favorite of the new TA [Technical Analysis] books is Trend Following by Michael Covel. Straightforward, easy to read, this book is rich in details about why trend following is such a successful strategy amongst some of the world's best-performing hedge funds."

PDF of article.

Van Tharp on Trading Systems

December 08, 2005

Van Tharp, thinking appropriate for my audience, emailed me one of his white papers (PDF) regarding "trading systems". Take a read!

Easan Katir on "Average Indicators"

December 07, 2005

Easan Katir, a member of Ed Seykota's Trading Tribe, emailed me some of his current research (PDF) titled "Investigating Optimal Parameters in a Moving Average Crossover Method".

Experts v. Novices

December 05, 2005

Brett Steenbarger authors an interesting article on Experts, Novices, and Trading Performance (PDF).

No Load Fund X

"Hello Michael, I found the article on the Blackstar Funds report very interesting, about whether or not trend following works for stocks. They offer some great proof but there is even better proof that trend following absolutely works for stocks. Hulbert Financial Digest, which tracks performance for many stock market newsletters, rates as the number one performer for the past 25 years a newsletter called "No Load Fund X." It constantly outperforms most other market letters. And what method do they use? A trend following system! They take the strongest performers among all mutual funds and ETFs (which are, of course, made up of stocks) and invest in them. Once they stop moving up, they exit and move into the new strongest performers. They simply follow the trend. I don't know how anyone can possibly deny that trendfollowing works, here's documented proof that blows away the competition...I'm certainly not a professional investor, I just use it in my retirement account but it works great! So when I read your book, it really hit home and I realized that trend following is the only way to navigate the market. You're information has been very helpful. Thanks, Mike Galiatsatos"

Skill-Based Return, or Alpha

December 04, 2005

Skill-based return, or alpha (i.e. generate alpha) is what trend followers are aiming to achieve. However, many believe that a skill-based return is impossible. They believe the only return to be had is from following the "index". The New and Expanded Edition of Trend Following includes performance reports for numerous trend followers. It is quite clear, from the performance reports, that generating alpha is very doable.

George Crapple

December 03, 2005

George Crapple of trend follower Millburn Ridgefield offered wisdom in a Barclay Group publication:

"A futures fund traditionally invests its underlying assets in Treasury securities, some of which are deposited as collateral or margin for futures and forward positions. These positions typically have a face value of three to seven times the net asset value of the fund as in the case of Millburn Ridgefield Corporation's funds. The substitution of individual equities for a portion of the underlying Treasury bill asset base would reduce the non-correlation of managed futures with equities, unless the manager adopted a methodology of hedging the equity exposure in bear markets. Regardless of the level of substitution of equities for Treasury bills, the leverage in a futures portfolio will still make the portfolio substantially managed futures, and the arguments for including such a strategy in a total portfolio remain intact. Since investors often look at each of their investments on a stand alone basis as well as on the basis of what they contribute to an overall portfolio, the inclusion of some equities in a futures portfolio can enhance rate of return and, in many situations, reduce volatility due to the non-correlation of the strategies."

Interview Down the Tube

December 02, 2005

I was forwarded the following interview request:

"What to Do with 2005 Winners/Losers -- Wall Street Journal (US) I'm looking for investment strategists, money/portfolio managers, financial planners and professors to discuss what investors should do with the big stock winners and losers they hold from 2005 as 2006 approaches. This is for a Sunday Wall Street Journal article. Need leads by: 02:00 PM US/Central DEC 02 >>> xxx xxx [xxx@dowjones.com] Phone: 201-xxx-xxxx"

I called this reporter and said if you have winners, don't exit. Keep riding the trend. I said that you don't get rich taking profits, so if the trend is still on, stay with the trend.

She immediately said that she could not write that since it was not true. She wanted to know how I could say such a thing. I tried to explain the basics of following the trend. She did not "get" it. I was surprised for a moment that this reporter would not listen, but then again was it really a surprise?

Winton Capital Update

December 01, 2005

The Winton Futures Fund gained 7.02% in November to bring the year to date performance to 14.43% and the compound annual average rate of return in 98 months of trading to 20.38%. David Harding continues to push his London-based trend following firm forward.

From the Front Lines

I received a call today from a key player at a trend following firm with a track record exceeding 15 years. They had a great November after a tough most of 2005 (November recouped much of the year). And we both agreed that is the hard part! Meaning can you sit there in the midst of choppy markets waiting for the trend? That's the life of the great traders. That's the life of those who make the millions. Bottom line.