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

Simplicity

January 31, 2006

Great feedback from a reader on "simplicity":

"I found your interview dated November 7, 2005 interesting and enjoyed it very much...I personally know quite a few trend followers that adhere to the idea that systems drift over time and need to be tweaked. Such traders sow the seeds of their demise. They lack the tendency to idealize, and instead pay attention to small features and choose to ignore clarity and simplicity. Their ideas (not methods) are not scientific. Such traders lack the ability to translate their ideas into firm trading rules. They add complexity and noise when they should be doing the exact opposite. Science is about principles and principles that can be dated are not principles. The supreme task of a trader is to arrive at a broad principle that addresses the trading process - the profit generating mechanism. And such a 'principle' can be assimilated, validated, corroborated and verified. From this principle, a system that will not be dated can be built by pure deduction. Many have difficulty understanding how one can make money through a disciplined use of a simple volatility based money management system. They are conditioned to think in linear terms where cause and effect are clearly linked. They don't realize the simpler the theory the less it will look anything like the world they see. The key to really understanding the profit generating process is not system optimization, endless estimation, and blind number crunching. While facts reside in the real world, principles reside in the mind. These traders attempt to start by looking at the data and try to 'warm the general principle out of the system.' And as the data drifts over time, the supposed principle gets dated. To find principles that stand the test of time requires a leap into the unknown, into the darkness of our mind and feelings where imagination and intuition hide. It is cognition resting on sympathetic emotions which hopefully lead to the first principle. Only then do we test the validity of the evidence by observing how well it fits the theory - the first principle...P.S. Kudos is due you for your brilliant work on trend following."

I found this one of the best emails I have ever received. To the point and on the money.

Holy Grail Promises

January 29, 2006

This chart supplied by a reader is pure Holy Grail. It is emblematic of the types of "feel good" stories people will push to "explain" market movement. Steer clear.

Sugar Explosion

January 27, 2006

Take a look at the sugar trend for the last year:

View Chart

Sugar is one of those markets that can rocket on a whim. Veteran traders will easily recall the years when markets like Sugar or Coffee or Cocoa traded substantially higher or lower - the big trends out of nowhere. Often sparked by an assortment of third world concerns, these markets have a tendency to produce large trends in a short period of time.

Look at sugar now. It has exploded to recent highs, highs not seen in more than a decade. But how could you have taken advantage of a move like this? How could you have been ready for the next world event to shoot sugar to the moon? You need to trade with rules. You need to have a system. You need to be ready, with a market like sugar on your watch list, ready to enter on breakouts as it is making new highs or lows. You have no idea when you enter if it will go to the moon, but you still need to have a method that will get you "in" to be on board so if it does rocket up - you don't miss it.

This Sugar move is even more proof of the theorem that trend following exploits "worldwide events". Trend followers had ample time to position in Sugar while it was trading around 8.00 - long before the market blew through 12, 14 or even 18. What technical signal would not have had you squarely into the Sugar trend?

Trend following entry into the Sugar happened long before Brazil began to emphasize more and more sugar to make more Ethanol. Or you could possibly argue that the fundamental reason for Sugar's rally is tied to Crude Oil. However, the fundamentals didn't matter if you were trading to take advantage of this incredible move. Sugar began moving higher long before the public knew about Brazil's re-emphasized energy policy. Traders who waited on the fundamentals to "explain" the rationale for the Sugar trade missed the initial breakout, and the big profits that resulted.

Why do people have such a hard time just accepting the sugar trend (or any other trend) and just riding it? Why do people feel the need to explain "why" the move happened?

Accept Reality or Pretend: Your Choice

January 25, 2006

Feedback today that sums "it" up nicely:

"I believe that most people prefer to think that a 'business approach to investing' just makes sense - plain and simple. Though if you bring the discussion further, and really delve into what that means, and specifically, how it's reliant upon prediction, then you get a lot of blank stares. People have told me that they might not know the ins and outs of how their money manager is making decisions, but they know he is using 'sound investment principals' and they feel safe with that. When I bring up price being the real-time determinant of value, when I bring up money management and systematic trading decisions, as a clear way to be actively involved in your chance of turning your nest egg into an eagle, I get a lot of negative responses. The feedback I get is that people want to think that you need to be a hard working detective to really dissect these companies, understand the businesses, know the management, read the economy and then make an investment based on these 'facts'. They really would rather have that, and pay for that, and buy into that - then work on themselves and take responsibility. I certainly don't think everyone is that way, but it seems that the majority is."

"Charting" Confusion

January 24, 2006

This post from yesterday brought this feedback:

"The problem with [these] statements [is] that [they] totally downplay the use of 'technical charting' as a means of trading. My question...would be, if you believe in [a] Trend Following methodology, how do you answer the five questions in Chapter 10 [of Covel's book] without looking at a chart or at least at a table of numbers? Do you peruse astrology tables or consult a Ouija board? No, of course not. You look at a chart just the same as does someone who does 'technical analysis.' What if a true novice who is trying to learn about [trend following] were to read [these] statements as his or her first exposure to the concept? They might easily deduce that they should never consult a chart. Charting is not the enemy. Stochastics, RSI's, moving averages, et al are the components of 'technical analysis' that are the culprits. But, let us not confuse charting with technical analysis."

I don't know what a true novice or anyone for that matter would do with a "chart" exactly. Trend followers use price data to make decisions. They look at the raw numbers for their signals and bet sizing. They don't "read charts", whatever that means exactly.

In terms of "technical analysis", I have tried to make clear the case in my book that there are two popular ways to view the subject. One involves prediction (useless) and one involves reaction (employed by the great traders). I cringe when I hear the term "technical analysis" as the term has no universal defintion and means so many things to so many different people.

Perhaps the feedback above about yesterday's post and my comments in retort will provide clarification to a subject area riddled with never-ending jargon.

Ken Huck of Edge Ware, Inc

January 23, 2006

Ken Huck of Edge Ware, Inc. produces software for trend following. He wrote me the other day with an excerpt from John Mauldin's writings quoting Dr. Gary Hirst of Hirst Investments:

"I had heard about technical analysis and chart patterns and, looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools - stochastics, RSI chart patterns, Elliot Wave, and so on-just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don't realize it: the distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure I found things that work over the short term, systems that work for five or ten years, but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."

Doug Fabian Radio Show

January 22, 2006

Here is an interview (MP3) I did recently with Ed Foster of the Making Money with Doug Fabian radio show. The interview is nearly 70 minutes long.

Barry Ritholtz: The Big Picture

January 20, 2006

Barry Ritholtz of The Big Picture writes today at his site:

"I have to emphasize again: I don't believe in forecasting. I don't know what's going to happen next year; Neither do you, nor does anyone else, for that matter. Bull or Bear are irrelevant labels."

Nice sum up on a volatile market day. And he is not being sound-bitish, just real.

Little Book That Beats the Market

January 19, 2006

From Morningstar.com today:

"What makes Greenblatt's [book: The Little Book that Beats the Market] message valuable is its focus on investing as opposed to speculating. Investing involves risk, but it is not buying something with the hope that you'll be able to sell it to someone else for a greater price later. Investing is financing the operations of a business, and it involves trying to understand if that business is healthy enough and profitable enough to give you an adequate return on your capital from its operations, based on the price you've paid for your interest in those operations. This is what Warren Buffett has called a "business" approach to investing, and it's the one we favor at Morningstar both when we analyze stocks and when we evaluate the investment processes of mutual fund managers. Our stock analysts prefer free cash flow yield instead of earnings, as they believe free cash flow is a more accurate measure of the amount of cash that can be lifted out of a business without disturbing its operations. They also use something called a discounted cash flow analysis to value the stocks they cover, but the principles are the same as Greenblatt's."

Is it easier for the average person to wrap their arms around the idea of "financing the operations of a business" or simply trading based on daily price action? Is it more realistic for the average person to be an "investor" or "trader"? Thoughts on the subject? Email me.

Gambler's Fallacy?

From the Post:

"Let's start with the good news: You are about to win $500. No, it's not 100 percent certain, but frankly, it looks pretty darn good. All you need to do is drive to New York, buy a lottery ticket and play the number 686. Hello 500 smackeroos! It's basically a lock and you want to know why? Well, Roy Siano is glad you asked. "Double sixes are our best bet for the next issue," he says. That would be the next issue of 3 + 4 Digit Lotto Stats, one of two biweekly publications owned, edited and published by Siano and his business partner for the past five years, Stephen Allensworth. Each issue of Lotto Stats and its sister magazine, Lotto News, purport to do what any mathematician will tell you cannot be done: teach you how to win the lottery. For $2.95 per issue, you get 32 black-and-white pages stuffed with reams of data, dozens of charts and erudite-sounding advice from a handful of columnists, each offering strategies to gamble your way to Fat City courtesy of the New York lottery. Plenty of these columns come off as -- what's the polite phrase here? -- utterly cockamamie. One is based on astrology, another on interpreting dreams. Readers in a recent issue who saw a door in their REM sleep, for instance, were advised to play 271. Why? Unclear. But that's the more fanciful stuff. Siano and Allensworth claim that solid logic undergirds the "hit frequency charts" and "pattern tables" crammed into their magazines. It boils down to this: If you flip a coin nine times and it keeps coming up heads, what should you bet will happen in the next flip? "Tails, of course," says Siano, who at the moment is sitting at the dining room table in Allensworth's apartment in Port Chester, a suburb of New York near the Connecticut border. "We use gambler's math," says Allensworth, who is sitting on the other side of the table. "What it does is track events. Sometimes numbers are out for a long time," which is to say, they fail to show up in winning combinations. "Generally speaking, after they've been out for a while, they tend to make up lost ground."

Huh?

Ken Tower Comment

January 18, 2006

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.

Blind Spot

January 17, 2006

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.

Not Happy About Book

January 16, 2006

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."

Intern with Hedge Funds?

January 15, 2006

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.

Gambler's Fallacy

January 14, 2006

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?

Investors as Dopamine Addicts

January 13, 2006

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."

The Academics Chime In

January 11, 2006

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.

Up and Up

January 10, 2006

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?

Server Outage

January 08, 2006

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

Complex Chinese Translation

January 06, 2006

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.

Aver and Aversion

Michael J. Mauboussin of Legg Mason Capital Management outlines the topic "Aver and Aversion (PDF)" in a recent whitepaper.

An excerpt:

"One of prospect theory's most important contributions to finance is loss aversion, the idea that for most people, losses loom larger than corresponding gains. The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. Loss aversion is a clear-cut deviation from expected utility theory. What gives? The decision frame shows one significant difference between expected utility theory and prospect theory. Expected utility considers gains and losses in the context of an investor's total wealth, while prospect theory considers gains and losses versus isolated components of wealth, like changes in a stock price. Investors tend to make decisions based on reference points, not the big picture."

Audio Excerpt

January 05, 2006

Audio (MP3) about new edition of 'Trend Following' book released November 05.

Bob Pardo of Pardo Capital

Bob Pardo of Pardo Capital was profiled in the book Market Beaters. Here is an excerpt (PDF) from the book. He also wrote an informative book titled Design, Testing, and Optimization of Trading Systems.

The Fed Speaks

January 03, 2006

From today:

"NEW YORK (Reuters) - U.S. stocks extended gains on Tuesday, with both the Nasdaq Composite and the S&P 500 index rising above 1 percent, as minutes from a December U.S. Federal Reserve policymakers' meeting signaled the central bank's 1-1/2 year campaign of rate increases was likely near an end. The Dow Jones industrial average jumped 80.85 points, or 0.75 percent, at 10,798.35. The Standard & Poor's 500 Index was up 14.11 points, or 1.13 percent, at 1,262.40. The technology-laced Nasdaq Composite Index advanced 29.06 points, or 1.32 percent, at 2,234.38."

Is this the trigger to enter? Is that the point of this news tidbit? Get in now? If you do get in now, when do you exit? If you do get in now, which market? If you get in now, how much do you bet of your limited bankroll?

Are You an Expert?

January 02, 2006

Michael J. Mauboussin of Legg Mason Capital Management outlines the topic "Are You an Expert? (PDF)" in a recent whitepaper.

Winton Capital Wisdom

January 01, 2006

David Harding of Winton Capital was recently asked: Because recent performance has been good, does that necessarily mean that future performance will be bad? His answer:

"Au contraire. There is a danger of people over extrapolating recent good performance into the future and being too optimistic about what we're going to achieve. But, equally, there is no evidence of mean reversion, in the sense that whenever we have a good period that's inevitably followed by a bad period or that when we have a bad period that's followed by a good period. It's a biased coin tossing exercise. It's like tossing coins. Luckily we strongly believe our coin will land profit side up, rather than loss side up, 60 per cent of the time. But there is no forecasting the future of our returns from our recent performance. However much your feelings tell you something, your gut tells you something, the gut is very misleading in this context."