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

Even Neurosurgeons Can Miss "It"

September 30, 2006

A trading friend of mine emailed me:

"Hi Michael - An old friend called me yesterday. He is a very successful neurosurgeon and a very good person as well. His only downfall in his mind is his lack of success in the trading world. After we exchanged pleasantries he asked me what I thought about the stock market. After a brief pause I responded, "I think the stock market is going up!" He then mentioned he subscribed to a couple of very expensive forecasting services one of which is run by a live "guru" who won a big trading contest several years ago. His next question was how could I disagree with the guru? I then responded, "You asked me what I thought about the stock market and I told you it is going up because it IS going up right now. Look at the chart!" We laughed as I was not being mean but simply offering him an observation of what the market is doing right now not what I think the market is going to do. I then told him I don't ever have a clue what the market is GOING to do and anyone who says they know is either a very big liar or an idiot. I simply respond to a set of rules for trading and I guess I am dumb enough to just keep following them to the best of my ability. I then reminded him of two very important lessons that he should be learning right now.

#1: No one really KNOWS what a market is going to do although many profess to know.
#2: If you follow the beliefs and more importantly the advice of others you and you alone are responsible for your results be they good or bad. Van Tharp calls this phenomenon "respondability." The only person responsible for your results is in the mirror.

Who Are the Winners?

September 28, 2006

Amaranth loses...so who wins? This blowout has the smell of a few big winners - maybe one big winner. It reminds me of Barings Bank. One dumb bet (Nick Leeson is now played by Brian Hunter) with some smart winners on the other side. Think the winners will be on the front of Time Magazine?

Mean Reversion Lesson

A reader, Chris Dugan, forwarded me this comment on Amaranth from Bernie Schaeffer:

"It's amazing to me that Amaranth seems to have relied on the same "principle" as did the disgraced managers of Long-Term Capital, "stewards" of what was (until Amaranth) the biggest blow-up in hedge-fund history. Simply put, this "principle" holds that various historical relationships between various markets will "mean revert" once they begin to diverge significantly from the norm. The mean reversion principle has become an article of faith among many of the major hedge funds. Given the alleged sophistication of these supposedly risk-savvy players, it is shocking that a principle that thumbs its nose at the "fat tail" events that are far, far more common than any modeling ever suggests continues to have holy-grail status. And then, when funds like Long-Term Capital and Amaranth blow up, the ready excuse is "who would have thought such a 'highly remote' event would ever occur?"

He added:

"The lesson here is that these models that are so avidly followed by those who should know better have been dead wrong and continue to be dead wrong about the odds of so-called rare events. The equity markets have been in a derivatives-induced coma for several years now, and my sense is that the upcoming fourth quarter is about as ripe a period as I can imagine for this coma to come to an abrupt end. Regardless of which way the break goes, we will likely have derivatives pain, which almost certainly means more hedge fund pain. An upside breakout can blow away those who've been heavily overwriting calls; a downside break creates potentially huge liability for those who have sold a massive quantity of very low delta puts that have thus far been "free money," month after month. In other words, market moves may begin to feed on themselves rather than mean revert, and some players will pay - big time - for this."

Now that is a great view from Bernie Schaeffer.

God Wants You to Be Rich

A recent article PDF about religion and money. An excerpt:

In a recent survey of people with at least $25 million to invest, "hard work, smart risk-taking and God" were credited for wealth accumulation. Last week, Time magazine's cover story asked "Does God Want You To Be Rich?"

This is all, quite literally, a Holy Grail IMHO. That's not me professing a religious view one way or the other. I just see it difficult for rational investment choices to blend with 'faith' - whatever it might mean to whoever.

Amaranth Conference Call

September 27, 2006

Here is a copy of a recent Amaranth conference call (PDF).

Loss and Hope

September 25, 2006

Janice Dorn (site) submitted this article:

Pain is what you walk through. Misery is what you sit in. Take an old pair of jeans and cut a hole in one of the front pockets. Now, start pouring sand into that pocket. What happens? Sand runs down your leg and to the ground. What do you do? Keep pouring until the sand is up to your ankles? Your knees? Your waist?

Continue reading Loss and Hope »

At Least They Are Honest

From the wires today:

"Oil exporting countries may consider a cut in output after crude prices fell below $60 a barrel on Monday for the first time in six months...The oil price fall over the past month has been accompanied by investor selling in oil and other commodity markets, mainly on concerns that economic growth in the US is slowing. “There is a concern by hedge funds that oil and commodities are no longer the one-way bet they once were,” said an Opec official."

No longer a straight line up? Nothing a little manipulation can't fix. At least they are honest about the lack of a free market, eh?

Short Now

From the Associated Press today:

"Oil prices have dropped 23 percent since the middle of July, attributed to ample global inventories, eased worries about supply threats from Iran and Nigeria, receding fears about this year's Atlantic hurricane season and as signs of economic weakness in the U.S. point to a possible softening in demand for energy. "The hedge funds and investors have been bailing out because geopolitical tensions have eased and they also realize that inventories are high during this period of seasonably weak demand at the end of summer," Shum said."

The funds I know have not "bailed." They are just short energy now - making money on the down trend.

More Amaranth Feedback

September 24, 2006

Brian Cypher writes:

"The reason I wanted to write to you is your posting on Amaranth. When I read that, I thought “Amaranth must have made a huge directional trade or continually scaled into long positions as gas went down. They totally disregarded any portfolio risk analysis measures.” I couldn’t believe that a firm like this, which had attracted “smart” money, could make such a grossly over-weighted trade not only in monetary terms but in ego as well. Even if they would have just limited their total portfolio exposure to 5% (approx. $475 million) to the Natural Gas market, the loss would have been limited to that or at best 50-60% loss of that 5% or $250,000,000 or so. I don’t get it but then I do and it makes my personal goals that much more attainable. This is just one more example of how trends will continue to persist in markets."

Amaranth Feedback

From a reader:

"Strangely now Amaranth is saying they are "eliminating energy trading from our strategy". I wonder how that will help? Wouldn't the same style of crazy leveraged bets be ruinous in another market as well? Amaranth went on to say "liquidity dried up so quickly that the fund was not able to unwind its energy positions." WHAT?? NG contracts are not liquid? Something is wrong here. Could Amaranth have had such a large position that they were a significant percentage of the entire open interest? Michael, I think this is a better chart than the one you posted on your blog."

"It clearly shows a downtrend in 2006. Why would somebody bet that prices would go even higher when they peaked last year and hadn't really come off that much since? That is, if one is looking for weather correlation, shouldn't there be a tighter spike with rapid decline after Feb? To me, if you weren't in on the 2005 uptrend, it appears that one should have put on a small short position in Feb 2006 with a wait and see attitude and a stop order. Was Amaranth buying all the way down expecting an even higher price than December 05 peak at $11.20? Maybe hindsight is 20/20, but it sure looks like a downtrend to me."

Amaranth's Conference Call

September 22, 2006

From a reader today:

This is one sentence from a Bloomberg story on Amaranth's conference call this afternoon:

Amaranth founder Nicholas Maounis, speaking on a conference call with investors today, said his firm considered the market moves that caused the losses a 'highly remote' possibility. (Emphasis mine) The firm's energy investments were 'fully consistent' with its strategy, he said.

First of all, we know that 'highly remote' events are not that remote after all. Long-Term Capital learned the hard way, but by now everyone else should know that 'remote' stuff happens!

Second, he claims that the energy investments were fully consistent with their strategy? How is that possible? They were supposed to be a multi-strategy fund, but they had 50% of their capital in energy trades. In fact, it looks like they had 50% of their capital in ONE trade. How is that consistent with 'multi-strategy'?

'Pigweed'; Food for Thought

September 21, 2006

I received a call today from a well-known trend following firm. My friend wanted to vent/laugh a little at the irony in the definition of Amaranth:

1. Any of various annuals of the genus Amaranthus having dense green or reddish clusters of tiny flowers and including several weeds, ornamentals, and food plants. Also called pigweed.
2. An imaginary flower that never fades.

But he quickly turned serious about the $4.6 billion dollars transferred in the zero sum game of the markets. He noted that Morgan Stanley had declined to invest with his firm due to perceived 'riskiness', but that same Morgan had lost their shirts in Amaranth.

He went on to question the blind sheep plowing money long only into "commodity funds." He then told me that 21 of their 26 positions in their portfolio are "shorts." Market is down - follow the trend.

So how bad was the 'Pigweed' fund blowup?

"Many investors, meantime, want out. Some are so anxious to exit their positions that they're willing to sell their stakes in the fund for less than half what they were worth at the end of August, according to Hedgebay, which operates a secondary market for hedge fund holdings. For example, people who had $1-million (U.S.) invested in the fund a few weeks ago are now willing to sell their position for $400,000, said Hedgebay co-founder Jared Herman in an interview from Connecticut. Investors are now willing to pay $300,000 for that stake."

Put all your eggs in one basket (one market) and allowing a young thirty something to pull the trigger with no risk management...and none of this is a surprise. The surprise to me is who was invested in this donkey show.

Hedge Funds World Japan

I will be speaking at Hedge Funds World Japan. The event is 5-7 December 2006 at The Four Seasons Hotel in Tokyo.

Chicken Little

September 20, 2006

From today:

"NEW YORK (AP) -- Stocks dropped suddenly Tuesday after Thailand's military launched a coup against the country's prime minister. While the major indexes recovered most of their losses in late afternoon, all closed lower. Tech stocks smarted from Yahoo Inc.'s news that slower ad sales would depress its third-quarter results."

With a headline like that, would you have not expected to see a Dow drop of more than -0.12%? That's right, that headline is for a one tenth of one percent drop. BTW, the AP writer who penned that is paid a salary.

A Chart That Buried a Hedge Fund

Natural Gas Down Move.

$4 Billion Dollar Silent Praise

I received an email today from a non-US hedge fund that manages $4 billion out of the UK. They wanted to know when the Korean version of Trend Following will be released. They are not mentioned in my book. Interestingly, they declined to participate in one of my new books underway. My view? They want no association and want no comment, but they obviously find the book useful for their marketing even though the book profiles their competitors.

I thank them either way.

A Bet on a Hurricane - Unreal

September 19, 2006

I find the excerpt below...simply amazing:

"Amaranth, started in 2000 by former Paloma Partners' hedge fund guru Nicholas Maounis, was up nearly 30 percent before management fees this year, and its asset base had grown to a whopping $9.5 billion. At the firm's Greenwich, Conn., offices, four security guards and local police kept a close watch over the building. After studying weather patterns and other data, Amaranth made an enormous wrong-way bet that a Katrina-like hurricane would cause the difference between summer and winter natural gas prices to widen dramatically. Instead, a mild hurricane season caused that spread to collapse, wiping out about $5 billion in value. "I can't believe they bet the whole fund on a hurricane," said one energy trader. Maounis dropped the bomb to his investors in a letter yesterday saying the firm's losses could be "in excess of 35 percent" for the year. Officials at Amaranth - whose name comes from the Greek word amarantos, meaning "unfading" - declined to comment. The losses are especially painful for Amaranth's large institutional investors, including several pension funds, university endowments and fund-of-funds managed by big brokerage houses, including Morgan Stanley, Deutsche Bank and Credit Suisse. Morgan Stanley's Institutional Fund of Hedge Funds gave $94 million to Amaranth in November 2004, which represented more than 5 percent of its fund, according to regulatory filings. Maounis will have to navigate some difficult seas in the next month, when some investors can begin pulling money out of the fund. Sources said Amaranth had devised so-called gates - which restrict client withdrawals to up to two years after investment. That will probably stave off a rush for the doors that would collapse a smaller fund. Still, about $1 billion worth of lock-up agreements will expire in the next two months, sources said. "I think Amaranth is going to die a slow and painful death," said one source. Amaranth's blow up marks the second hedge fund in the last month to be shaken by the volatile energy markets. Last month, MotherRock, a $400 million fund run by former New York Mercantile Exchange President Bo Collins, lost all of its investors' capital when the natural gas markets turned against it. Ironically, Amaranth bought a portfolio of MotherRock trades from ABN Amro's futures unit, which was left holding the bag after MotherRock collapsed."

Amaranth Spin

September 18, 2006

David Faber in reporting about the Amaranth hedge fund losses said today (they went from +23% YTD to -35% YTD), "It will have no impact on other funds." Oh really? It is a zero sum game! Those losses of $3 to $4 billion at Amaranth went to winners on the other side of the coin in Natural Gas.

From MarketWatch:

"Hedge fund Amaranth Advisors LLC said Monday that it has suffered heavy losses related to in its investments in natural gas and it could report a year-to-date decline in the fund of more than 35% when it finishes unwinding its positions. The firm said it has met every margin call to date on the positions, and has nearly completed disposing of its natural gas exposure. "We are in discussions with our prime brokers and other counterparties and are working to protect our investors while meeting the obligations of our creditors," the company said in a prepared statement issued Monday."

From Dealbreaker.com:

So who is this Brian Hunter we mentioned in the previous item about the huge losses at Amaranth Advisers? We haven’t been able to track down a picture of him yet but we’ve collected some details on young man who came to head his fund’s energy trading desk at the age of thirty-two. Earlier this year, Trader Magazine ranked him at 29 in its list of top one hundred traders. He’s said to have made $800 million for the fund in 2005—much of it from the skyrocketing price of natural gas in the wake of hurricane Katrina—and was paid somewhere between $75 and $100 million. When he decided he wanted to leave New York for his native Calgary, Amaranth set up an office there for his team. Hunter’s role in the losses his fund expects to suffer as it unwinds its natural gas position is not yet known. One source familiar with the market for energy trades told DealBreaker he believed Hunter had made trades this year similar to his winning 2005 bets and got caught out when 2006 produced a much calmer hurricane season and new oil discoveries in the Gulf of Mexico.

From TheStreet.com:

"Based in Greenwich, Conn., Amaranth employs more than 360 people, including 115 traders. The fund's Web site tabs its assets at $7.5 billion, and the firm has offices in Houston, Toronto, London and Singapore. Sources say assets under management may have been more than $9 billion going into September. "We have met every margin call to date," the letter continues. "We are in discussions with our prime brokers and other counterparties and are working to protect our investors while meeting the obligations of our creditors." A person familiar with Amaranth says the fund was up a little more than 20% for the year as recently as mid-August. Using that figure, a back-of-an-envelope calculation means Amaranth at one point was up $1.5 billion for the year. But in recent weeks it may have lost as much as $4 billion. The fund, assuming it is down 35% for the year, now has about $5 billion in assets under management. A trader with another hedge fund says the news of the big loss at Amaranth may explain some unusual trading in certain stocks last week. The trader speculated that Amaranth may have been liquidating positions in some of its equity holdings to satifisy the margin calls from its prime broker. Amaranth wouldn't comment beyond its letter to investors. The hedge fund reported having $2.3 billion invested in U.S. stocks as of the end of June. Several of Amaranth's big investments were Humana , Goldcorp and Sprint. A broker gives a margin call when an investor or trader does not have adequate collateral to support the amount of money it has borrowed."

Why Can't You Add Fundamentals?

September 16, 2006

Last Friday after giving a presentation to a mostly fundamental crowd, there was a question and answer session. One of the questions was essentially, "That sounds very promising, but why can't you add a fundamental perspective for entries and exits on top of the trend following approach and do even better?"

The question was not meant to be negative to trend following as the questioner seemed genuinely interested in the subject, but rather I thought it was an attempt to cling to what someone knows best. I have yet to find any mechanical trend follower with a discretionary fundamental overlay. The closest I would know of someone who fits that category would be Paul Tudor Jones.

Losses? Who Has Losses?

September 14, 2006

An old pro trader sent in a funny story about his days at Commodities Corporation:

"Back in the early 90's Commodities Corporation (CC) brought a few Japanese traders in for some in-house "training". Of course the ultimate and true goal was to capture some big Japanese money. I was still in their good graces and [CC] asked me to have lunch with a couple of these gentleman. They were new to the program and I hoped to give them some insight into how I handled the process of trading. I told them they had to come up with a method or system that fitted who they were. Then I told them I thought it was great to find a mentor and I was available anytime they had questions or issues and that is still me today. I then began to discuss how important risk management was and that I was willing at that time to risk only 1% per bet in dealing with public money. I am more aggressive today but that was then. I told them that losses were part of the process in finding winners. I will never forget as long as I shall live the youngest trader looked me square in the eye and with a very puzzled look asked "You have losses?" I knew right then these birds had a very long way to go and I often wonder what happened to them."

What Separates Them?

Yesterday I made the case at a presentation here in Hong Kong that the difference between those great traders who make it and those who don't is drive. The ability to stick with, to never quit is the Maginot line between winning and losing. One person in the audience said it couldn’t be that easy. Who said mental toughness is easy? It's not.

A Chart to Ponder

September 12, 2006

View this chart. Some might recognize the performance, some not. Either way it is a great reminder about how it is impossible to make money every month. Making money every month should never be the objective.

To me, the real relevance here is not whose performance it is, but rather that the performance exists.

CLSA Investors Forum

i will be speaking at the CLSA Investors Forum Wednesday and Friday in Hong Kong at the Grand Hyatt. Not sure how what appears to be a fundamentally driven crowd will react to the message of trend following.

No Secrets

September 09, 2006

Someone asked Ed Seykota about 'market secrets' that will be revealed at a conference that Ed is speaking at in Singapore. He responded:

I do not know what secrets the other speakers intend to reveal as these are, well, secret. I can tell you a couple "secrets" about purveyors of secrets:

1. There are no secrets.
2. They don't want you to know that.

Recording Tools?

A completely unrelated to trading question came in:

Michael, I've been listening to some of your podcasts (great stuff, by the way!) and I wanted to find out what audio equipment do you use to create the files? Your voice sounds very clear. I'm particularly looking for suggestions on sound card, microphone, etc. Thanks so much! Rahim

Real straightforward.

1. Macintosh workstation.
2. Neumann TLM 103 Microphone.
3. Mbox.
4. Audio Hijack.

That's it!

More Commission Please!

September 08, 2006

Some feedback today:

Michael: I recently received a phone call which I would like to share with you in the hope that you will find the contradiction as entertaining as I did. Apparently my personal commodities account which is “self directed” isn’t generating enough commissions to make someone happy, so I got a call suggesting that I convert to an “advised” account. I would still make all my own decisions, but, for “a few bucks more” per trade, I would have access to a “market strategist” (the guy on the phone calling me) and some free copies of research reports from Hightower. His chief qualification, which he mentioned several times during the conversation, was that his father had made his living in the corn pit. I grew up in Chicago and still live nearby. Pit traders that I have met and pit traders that I have read about seem to all be trend followers. Granted, their idea of “long term” might be measured in minutes and a “big move” means more than two ticks. But they generally use ideas that would be familiar to people mentioned in your book. They hold while the trend is continuing and when it might be running out of steam, they are out in a heartbeat. No grand “market strategy” to be seen. Regards, Chuck

I do want to emphasize that pit traders while perhaps chasing very short-term daily fluctuations - which by some may be called trends - don't resemble the traders in my book in terms of strategy. They are worlds apart. I don't believe that was Chuck's point, but I thought a clarifier was needed.

Iran's President Mahmoud Ahmadinejad

September 06, 2006

Tonight I saw this flash at the Drudge Report:

"Islamic Republic News Agency reports that Ahmadinejad intends to travel to NYC, hopes to speak at UN on Sept. 19 at 7 PM; same day as Bush [whose speech is set for 11:30 AM] and day before Hugo Chavez."

I found these comments about Iran recently in regards to stock markets:

Gary B. Smith: The stock market's reaction would have been the same no matter what came out of Iran. We are very skeptical of them and are suspect no matter what they say. Right now stocks are focused on other things. Until Iran does something dramatic, which they have not done yet, stocks won't be affected.

Tracy Byrnes: It's been this way forever! Iran's President Mahmoud Ahmadinejad means nothing to us. He's like a little gnat flying around and annoying us. We have to get rid of him, but no one on Wall Street is concerned about him. We knew he was going to blow off the deadline. And until we take him down, he'll have no effect on the market.

There is nothing to be gained from being an analyst regarding Mahmoud Ahmadinejad. All you can do is have a plan in advance and wait for markets to move. Predicting what a nut might do might be fun, but it is pointless for your portfolio.

Setting Up a Fund

I thought this document (PDF) on setting up a fund, which arrived unsolicited in my 'in' box, may be useful for some readers.

How Do You Use This for Strategy?

September 05, 2006

Some recent comments seen in regards to what will now happen with recent commodity index price drops:

Anyway, getting back to today's lesson, stock bulls should be jumping for joy:

As Joey Battapaglia of old school CNBC footage would say, "Ya get ya tek, get ya banks, ya get some retail, and ya just buy 'em up...."

Inertia on Quants

September 03, 2006

James Montier recently wrote about the lack of acceptance of systematic trading:

"The industry has a large dose of inertia contained within it. It is pretty inconceivable for a large fund management house to turn around and say they are scrapping most of the processes they had used for the last 20 years, in order to implement a quant model instead. Another consideration may be the ease of selling. We find it 'easy' to understand the idea of analysts searching for value, and fund managers rooting out hidden opportunities. However, selling a quant model will be much harder. The term 'black box' will be bandied around in a highly pejorative way. Consultants may question why they are employing you at all, if 'all' you do is turn up and run the model and then walk away again. It is for reasons like these that quant investing is likely to remain a fringe activity, no matter how successful it may be."

In a zero sum world, Montier nails yet even more reasons why strategies like systematic trend following will excel into the future.

Perspectives on Risk

Michael J. Mauboussin excerpts (PDF) from a presentation at the Greenwich Roundtable on July 26, 2006.