What Do You Buy or Sell?

Will you trade stocks? Currencies? Futures? Commodities? What markets will you choose? While some people might focus on limited, market-specific portfolios, such as currencies or bonds, others pursue a more widely diversified portfolio of markets. For example, the AHL Diversified Program (the largest trend following fund in the world, now run by Man Financial) trades a diversified portfolio of over 100 core markets on 36 exchanges. They trade stock indices, bonds, currencies, short-term interest rates, and commodities (e.g., energies, metals, and agriculturals; see Table 10.1):

Large events happen more often than you would expect in systems that exhibit power law distributions.

Department of Physics 
UC Santa Barbara

AHL does not have fundamental expertise. No trend following trader keeps fundamental experts on staff. They do not have an in-depth understanding of the companies that comprise whatever stock index. Their expertise is to take these different markets and “make them the same” through price analysis.

I learned not to worry so much about the outcome, but to concentrate on the step I was on and to try to do it as perfectly as I could when I was doing it.

Steve Wozniak

When you look at trend following performance losses are offset by winners. No one ever knows which market will be the big trend that pays for the losses—hence the need for diversification.

AHL is even more precise about diversification:

The cornerstone of the AHL investment philosophy is that financial markets experience persistent anomalies or inefficiencies in the form of price trends. Trends are a manifestation of serial correlation in financial markets—the phenomenon whereby past price movements inform about future price behavior. Serial correlation can be explained by factors as obvious as crowd behavior, as well as more subtle factors, such as varying levels of information among different market participants. Although they vary in their intensity, duration, and frequency, price trends are universally recurrent across all sectors and markets. Trends are an attractive focus for active trading styles applied across a diverse range of global markets.

You can see AHL’s words perform in practice by how another trend following trader described diversification:

Talk is cheap. Show me the code.

Linus Torvalds

Portfolio diversification is often said to lose its importance after you have 7–10 different instruments in your portfolio. We found this simply not to be the case. Pre June 2007, we traded with 18 major markets in the program and we were in 7–8 of them most of the time. In short, our exposure was 7–8 markets at any one time, while signals in 18 were possible. After evaluating the program we discovered that most of our losses [at the time] were coming from one or two sectors that hit their maximum loss at roughly the same time. A breakout in the Ten Year Notes was most likely followed by a breakout in the Five Year Notes. Trading several highly correlated markets had led to exaggerated losses because these markets triggered a larger drawdown as they were stopped out together.

He increased his portfolio to over 40 markets with the goal of being in 15+ markets most of the time. And he still left his core trading system (entry and exits) the same. The turnaround in results was dramatic—all from changing the portfolio diversification.

Paul Mulvaney, for example, made over 40 percent in October 2008 alone. His performance was generated from these markets:

• Currency: 8.91 percent
• Interest Rates: 2.78 percent
• Stocks: 14.59 percent
• Metals: 9.83 percent
• Energy: 3.43 percent
• Crops: 7.84 percent
• Livestock: 4.51 percent

Yes, that is one great outlier month. All months and sectors will not always be positive—clearly. But Mulvaney’s performance during one of the worst months ever is a wakeup call to trend following possibilities. After all, author and film star Ben Stein famously said if you made money in October 2008, you were doing something wrong.

Now, fast-forward eight years. On June 23, 2016 51.9 percent of the United Kingdom voted to exit the European Union. Most prognosticators were surprised, if not shocked. Mulvaney’s performance was +17 percent on June 24. His one-day Brexit performance, his greatest one-day return in the history of his firm, is a fantastic illustration of being on the right side of surprise. Long-time trend following trader Robert Rotella adds, “Qualitative examination of price movements suggests that markets were trending in the direction of the Brexit exit in the prior months. This is supported by systematic analysis over the same period.”

There is a random distribution between wins and losses for any given set of variables that defines an edge. In other words, based on the past performance of your edge, you may know that out of the next 20 trades, 12 will be winners and 8 will be losers. What you don’t know is the sequence of wins and losses or how much money the market is going to make available on the winning trades. This truth makes trading a probability or numbers game. When you really believe that trading is simply a probability game, concepts like “right” and “wrong” or “win” and “lose” no longer have the same significance. As a result, your expectations will be in harmony with the possibilities.

Mark Douglas

There is never one perfect portfolio composition that will capture the next trend. Many trade different portfolios for untold different reasons. Generally speaking, trend followers trade the same markets. However, although larger trend following funds might avoid smaller markets, such as pork bellies or orange juice, other trend following traders might trade currency or bond-only portfolios. Salem Abraham, for example, once made a killing off cattle. Whatever markets chosen to trade, remain open to opportunity when it arrives.

Author Tom Friedman makes the strong argument for sound strategy in a complex world: “If you can’t see the world, and you can’t see the interactions that are shaping the world, you cannot strategize about the world. And if you are going to deal with a system as complex and brutal as globalization, and prosper within it, you need a strategy for how to choose prosperity for your country or company.”¹³ Friedman knows all too well the real power brokers in today’s frighteningly interconnected world are traders—not politicians.

How Much Do You Buy or Sell?

The question many avoid at all costs is the question of money management. Also called risk management, position sizing, or bet sizing, it is a critical component to trend following success, as Gibbons Burke observes:

Money management is like sex: Everyone does it, one way or another, but not many like to talk about it and some do it better than others. When any trader makes a decision to buy or sell short, they must also decide at that time how many shares or contracts to buy or sell—the order form on every brokerage page has a blank spot where the size of the order is specified. The essence of risk management is making a logical decision about how much to buy or sell when you fill in this blank. This decision determines the risk of the trade. Accept too much risk and you increase the odds that you will go bust; take too little risk and you will not be rewarded in sufficient quantity to beat the transaction costs and the overhead of your efforts. Good money management practice is about finding the sweet spot between these undesirable extremes.¹⁴

“I’ve only got a certain amount of money. How much do I trade?” If you have $100,000 and you want to trade Microsoft, well, how much of your $100,000 will you trade on Microsoft on your first trade? Will you trade all $100,000? What if you’re wrong? What if you’re wrong in a big way and you lose your entire $100,000 on one bet?

If you look at the past 30 years, there is only one fundamental investor who has consistently produced huge absolute returns—Warren Buffett. Compare that, however, with countless trend following traders who have outperformed throughout bull and bear market cycles. One of the keys to our success is to have a huge diversification of over 100 financial and commodity markets. A systematic, mechanical approach is the only way to successfully trade so many markets . . . every decision . . . from market entry, position sizing, stop placement . . . must be fully automated.

Christian Baha

Trend following by design makes small bet sizes initially. So, if you start at $100,000 and you’re going to risk 2 percent that equals $2,000. You might say to yourself, “I’ve got $100,000—why am I only risking $2,000? What’s the deal? I’ve got $100,000. $2,000 is nothing.” That’s not the point. You can’t predict where the trend will go—you don’t know up or down.

One trader’s view on the initial risk decision: “There are traders who are unwilling to risk more than 1 percent, but I would find it surprising to hear of any trader who risks more than 5 percent of assets per trade. Bear in mind risking too little doesn’t give the market the opportunity to allow your profitable trade to occur.”¹⁵

It’s not how right or how wrong you are that matters but how much you make when right and how much you do not lose when wrong.

George Soros

Think about money management as getting physically fit. Let’s say you’re a male athlete and you want peak performance. You weigh 185 pounds (84 kg) and you’re six foot one (185 cm). Well, guess what? You can’t lift weights six times a day for 12 hours a day for 30 straight days without hurting yourself during those 30 days. There’s an optimum amount of lifting you can do in a day that gets you ahead without setting you back. You want to be at that optimal point, just as you want to get to an optimal point with money management.

Ed Seykota describes that optimal point with the concept of heat:

Placing a trade with a predetermined stop-loss point can be compared to placing a bet: The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels ­pressure—or heat—from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2 percent on each of five instruments has a total heat of 10 percent, as does a portfolio risking 5 percent on each of two 
instruments.¹⁶

The Pareto principle, the 80/20 rule, the law of the vital few, states that, for many events, roughly 80% of the effects come from 20% of the causes.

Wikipedia

A student of Ed Seykota’s adds: “There has to be some governor so I don’t end up with a whole lot of risk. The size of the bet is small around 2 percent.” Seykota calls his risk-adjusted equity “core equity” and the risk tolerance percentage “heat.” Heat can be turned up or down to suit the trader’s pain tolerance—as the heat gets higher, so do the gains, but only up to a point. Past that point more heat starts to reduce the gain. Traders must be able to select a heat level where they are comfortable.¹⁷

Do you trade the same with $100,000 as you would $200,000? What if your $100,000 goes to $75,000? Tom Basso knows many traders usually begin trading small, say with one contract, and as they get more confident they might increase to 10 contracts. Eventually they attain a comfort level of 100 or 1,000 contracts where they may stay. Basso counsels against this. He stresses the goal is to keep things on constant leverage. His method of calculating the number of contracts to trade keeps him trading the same way even as equity increases
or decreases.¹⁸

In limiting risk, people also limit the opportunity for gain. It is common, today, for investors to own six or eight mutual funds, each of which is likely to be invested in hundreds of stocks. This will, they hope, assure that no little bump, no little meltdown, overly upsets their portfolios. But since when was investing about avoiding the bumps?

Roger Lowenstein

One of the reasons traders don’t trade proportionally as capital increases is fear. Although it might feel comfortable when the math dictates you trade a certain number of shares or contracts at $50,000, when the math dictates trade a certain amount at $500,000, you might become risk-averse. So instead of trading the optimal amount at whatever capital you have, some trade less. This can be avoided by creating an abstract money world. Don’t think about what money can buy; look at numbers like when playing Monopoly® or Risk®.

Dunn Capital speaks to “the money as a way to keep score” perspective: “Part of Dunn’s approach is adjusting trading positions to the amount of equity under management. He says if his portfolio suffers a major drawdown, he adjusts positions to the new equity level. Unfortunately, he says, not enough traders follow this rather simple strategy.”¹⁹

If you start with $100,000 and you lose $25,000 you obviously now have $75,000. You must make your trading decisions off $75,000 not $100,000. You don’t have $100,000 any more. However, Paul Mulvaney felt I was missing a critical aspect in money management: “Trend following is implicitly about dynamic rebalancing, which is why successful traders appear fearless. Many hedge fund methodologies make risk management a separate endeavor. In trend following it is part of the internal logic of the investment process.”

What are the three best market indicators? In order they are:

1. Price

2. Price

3. Price

When Do You Buy or Sell?

When do I buy? When do I sell? These are the questions that keep investors and traders up at night. Yet there is no reason why the buy and sell process should be a melodrama. Obsessing about when to buy or sell keeps your limited time focused on things you can’t control.

For example, Apple has been trading between 100 and 120 for six months. All of a sudden Apple jumps, or breaks out, to a price level of 130. That type of upward movement from a range is an entry trigger for trend following strategy. They think, “I might not know that Apple is going to continue upward, but it’s been going sideways for a while, and all of a sudden, the price has jumped to 130. I’m not in this game to try and find bargains or cheap places to buy. I’m in this game to follow trends, and the trend is up.”

The good thing about science is that it’s true whether or not you believe in it.

Neil deGrasse Tyson

One trend trader outlined the simplicity: “As our systems are designed to send a buy or sell signal only when a clear trend develops. By definition, we never get in at the beginning of a trend or get out at the top.”²⁰ If your goal is to ride a trend that starts at 50 and goes to 100, it does not make a difference whether you got in at 52 or 60 or 70. Even if you got in at 70 and the trend went to 100, you still made a lot. Now, if you got in at 52 (and how you think you might predict the bottom, I will never know) you made more money than if you got in at 70. There are plenty of traders out there who think, “Oh, I couldn’t get in at 52 so I won’t get in at all even if I have the chance to get in at 70.”

Richard Dennis smacks that thinking: “Anytime the market goes up a reasonable amount—say a strong day’s work—after you’ve put on a position, it’s probably worth adding to that position. I wouldn’t want to wait for a retracement. That is everyone’s favorite technique—to buy something strong that retraces. I don’t see any justification in the statistics for that. When beans are at $8.00 and go to $9.00, if the choice is to buy them at $9.00 or buy them if they retrace to $8.80, I’d rather buy them at $9.00. They may never retrace to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement.”²¹

You’ve got to think about big things while you’re doing small things, so that all the small things go in the right direction.

Alvin Toffler

Even if people are somewhat familiar with Dennis’s approach to trend trading, they still love the entry obsession—a misdirection of energy and focus. Seykota dead-panned, “The entry is a big concern before it happens, a small concern thereafter.”²²

He is saying after you are in the trade, entry price isn’t important. You have no idea how high the market is going to go or not. You should be concerned about protecting your downside in case the market goes against you, as opposed to creating drama associated with the perfect entry. After all, trend following trades can last extended time frames: “Positions held for two to four months are not unusual, and some have been held for more than one year, says a spokesman. Historically, only 30–40 percent of trades have been profitable.”²³

The words of the great baseball player Ted Williams immediately come to mind: “Hitting a baseball, I’ve said it a thousand times, is the single most difficult thing to do in sport. If Joe Montana or Dan Marino completed 3 of every 10 passes they attempted, they would be 
ex-professional quarterbacks. If Larry Bird or Magic Johnson made 3 of every 10 shots they took, coaches would take the basketball away
from them.”²⁴

How is it possible to make money with only 40 percent winners? Trend following firm Campbell & Company is clear: “Say, for example, on the 60 percent, you lose 1 percent of your capital, but on the 40 percent winning trades you make 2 percent. Over longer periods of time, say a year or more, this would net 20 percent on a broadly diversified program.”²⁵

Trend following rules to enter and exit are driven by what is commonly called technical indicators. The technical indicator for trend following strategy is price action (i.e., breakout, moving average, etc.). However, many remain preoccupied with the hundreds upon hundreds of other indicators that promise prediction. They debate nonstop which is better, always assuming there must be something better. And they always yell at me that I didn’t provide them the secret.

Có chí làm quan, có gan làm giàu.

People, they love blood. They love action. Not this talky, depressing, philosophical bullshit.

Michael Keaton 
Birdman

Technical indicators, however, are small components of the overall trading system. They are some of the tools needed in the trading toolkit, but not the kit itself. A technical indicator accounts for maybe 10 percent of the overall trading success. When some trader opines, “I tried indicator X and found it was worthless” or “I tried indicator Y and found it useful,” that makes no sense. These statements imply an indicator is the actual trading system. By itself a technical indicator is meaningless. That means the suits that come on CNBC every week to talk technicals are meaningless? Yes.

When Do You Get Out of a Loser?

The time to think most clearly about why and when to exit is before getting in. In any trading system, the most important thing is to preserve your capital. A preset sell strategy gives you opportunity to not only preserve capital, but to also redeploy into more opportune markets. When do trend traders get out of a losing position? Fast! This is fundamental to trend following.

The logic of cutting losses and then cutting them even more has been around far longer than trend following, as Bernard Baruch notes: “If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.”

You are buying and selling risk. As a technical trader, that’s the only way to look at it.

Mark van Stolk²⁶

For example, you enter GOOG with a 2 percent stop loss. This means if you lose 2 percent, you exit. Period. Get out. Don’t debate it. Look back at the British pound trade in my Chapter 2 Dunn profile. That chart (see Figure 2.3) shows the constant starts and stops. Dunn keeps receiving entry signals and then exit signals. The trend is up and then it is down. He enters and then exits. Dunn knows he can’t predict the direction of the British pound. He only knows he has received an entry signal, so he gets on board. Then he receives an exit right after that, so he gets out. Then another entry signal, then another exit comes. Dunn did say he “rides the bucking bronco.”

It became evident that the most direct way to make money and the one most compatible with my strengths was to be a position trader using computer models to develop the entry and exit points.

Michael J. Clarke

Traders call these back-and-forth swings whipsaws. Whipsaws are quick ups and downs that go nowhere. Your trade is jerked, or whipsawed, back and forth, causing small losses due to lack of sustained trends. Seykota says the only way to avoid whipsaws is to stop trading (see his “Whipsaw” song on YouTube). Whipsaws are part of the game. Don’t want to live with them—don’t trade.

An old pro trader sent in a great story about his days at trend following incubator Commodities Corporation that makes the point:

Back in the early '90s, 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 gentlemen. 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 percent 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.

Guaranteed that young trader moved onto another profession.

When Do You Get Out of a Winner?

You have seen the headline hype: “Use Japanese candlesticks to spot reversals” or “Determine support and resistance” or “Learn proper profit-taking.” Stop. You can’t spot reversals until they happen. There is no way to define the concept of support and resistance as 100 people could have 100 different definitions. These directions all try to do the impossible—predict. Tom Basso slams profit objectives: “A new trader approaches an old trend follower and asks, ‘What’s your objective on this trade?’ The old trend follower replies that his objective is for the position to go to the moon.”

Reason’s biological function is to preserve and promote life and to postpone its extinction as long as possible. Thinking and acting are not contrary to nature; they are, rather, the foremost features of man’s nature. The most appropriate description of man as differentiated from nonhuman beings is: a being purposively struggling against the forces adverse to his life.

Ludwig von Mises²⁷

Exiting a winning position can be a challenge because you have to be comfortable with letting a trend run as far as it can, crest, and then begin to decline before considering an exit with profits. Say you are up 100 percent in paper profits. If you cash in, those paper profits become real. But you have made a big mistake because you limited yourself in how much you could make. If you are long several positions, and there are huge open profits on the table, and the trend is still up—that is not the time to get out of a winner.

I have no ego in the stock market. If I make a mistake I admit it immediately and get out fast. If you could play roulette with the assurance that whenever you bet $100 you could get out for $98 if you lost your bet, wouldn’t you call that good odds? I never bought a stock at the low or sold one at the high in my life. I am satisfied to be along for most of the ride.

Nicolas Darvas 
Time Magazine 
May 25, 1959

Profit targets cap profits. For example, you enter at 100 and before you ever enter, you establish you will exit if the price reaches a 
25 percent gain or 125. The idea of a profit target sounds wise at first blush. However, if you are riding a trend you have to let it go as far as it can go. You need to fully exploit the move. You don’t want to exit at 125 and watch the trend go to 225.

Although profit targets keep you from getting to 225, they also play a damaging role in the overall trend following portfolio. Trend following needs those home runs to pay for its whipsaw losses. If you are artificially creating a profit target for no other reason than comfort, you are limiting potential for big trends. This, in turn, limits the ability to cover the small losses you’ve incurred. If you had used profit targets, there is no way you would have been around to win the huge profits from the events described in Chapter 4.

Trend following profits come from the meat, or middle, of a trend (see Figure 10.1):

Novice traders trade 5 to 10 times too big. They are taking 5 to 10% risks on a trade they should be taking 1 to 2 percent risks.

Bruce Kovner

FAQ 1: Starting Capital

Ed Seykota was once asked how much money someone should have before starting to trade. He responded, “Good money management is equity invariant. I’d ask a trader who thinks he needs a certain amount before he can trade exactly what amount he would need to stop trading.” There is no dollar amount too little or too big that allows you to sit back and assume your starting capital alone is the secret.

Information: the negative reciprocal value of probability.

Claude Shannon

Numerous factors related to starting capital exist, not least of which is the personal discipline and ability to stick with it. Anyone who promises a certain amount of starting capital needed to win is full of it. However, what if you have unlimited resources? Rich can be a benefit or strike against you. Jaromir Jagr, the famous hockey player, and trend trader William Eckhardt have polar views on starting capital.

Jagr is the riverboat gambler. He doesn’t play the stock market but romps through it; last year, published reports estimated he took a hit [loss] of anywhere from $8 million to $20 million in the Dot-com market. He doesn’t just have a girlfriend who is pretty and bright; he has a girlfriend who is a former Miss Slovakia and a second-year law student.²⁹ Jagr might be a great hockey player, but his approach is straight to the poorhouse. Backed by the millions he made playing hockey Jagr is the trader Eckhardt avoided:

I know of a few multimillionaires who started trading with inherited wealth. In each case, they lost it all because they didn’t feel the pain when they were losing. In those formative first years of trading, they felt they could afford to lose. You’re much better off going into the market on a shoestring, feeling that you can’t afford to lose. I’d rather bet on somebody starting out with a few thousand dollars than on somebody who came in with millions.³⁰

I am hard-pressed to recall when any sort of bubble was accurately identified in real time on the cover of a major media publication. If anything, the opposite is true.

Barry Ritholtz

Consider net worth examples of trend following traders that started as one-man shops:

• Bruce Kovner is worth over $5.3 billion.³¹
• John W. Henry is worth $2.1 billion.³² He used his trend following gains to buy the Boston Red Sox for $700 million.
• Bill Dunn made $80 million in 2008 when the rest of the world was blowing up.³³
• Michael Marcus turned an initial $30,000 into $80 million. He also taught Bruce Kovner. Marcus was a student of Ed Seykota’s.³⁴
• David Harding is worth over $1.387 billion.³⁵
• Kenneth Tropin made $120 million in 2008 as buy and hold collapsed. Earlier in his career he led John W. Henry’s firm.³⁶

That is inspirational. A small fraction of those huge fortunes is motivating—if you still have a pulse.

FAQ 2: Trend Following for Stocks

One of the great myths about trend following is it does not work on stocks. That is 100 percent false. Trends in stocks are no different than trends in currencies, commodities, or futures. Jerry Parker’s trend following firm, for example, has adapted its system to stock trading and he is not alone (e.g., David Harding). He notes his system works well with stocks, particularly stocks in outlier moves that are in single industries.³⁷

Bruce Terry, a disciple of Richard Donchian, dismisses out of hand the not-for-stocks meme: “Originally in the 1950s, technical models came out of studying stocks. Commodity Trading Advisors (CTA) applied these to futures. In the late 1970s and early 1980s, stocks were quiet and futures markets took off. That is how the CTA market started. It has come full circle. People are beginning to apply these models to stocks once again.”³⁸

From my leave-no-stone-unturned research, I am reminded of the opening line I found in a Managed Account Reports article from 1979: “Trading stocks and commodity futures by means of trend following techniques is an art with a long history.”³⁹

People that work hard and legitimately do everything that they can, they tend to be luckier.

Julian Edelman Patriots Football Team

Whales only get harpooned when they come to the surface, and turtles can only move forward when they stick their neck out, but investors face risk no matter what they do.

Charles A. Jaffe

FAQ 3: Computers and Curve Fitting

Larry Hite knows a computer can’t get up on the wrong side of the bed in the morning, which is why computers handle his decision making and implementation of his trading rules: “If your boyfriend or girlfriend breaks up with you, you’ll feel one way; if you get engaged, you’ll feel another way.”⁴⁰

Hite would much rather have one smart guy working on a lone Macintosh than a team of well-paid timekeepers with an army of supercomputers. At the same time, however, Hite is adamant the real key to using computers successfully is the thinking that goes into the computer code. When someone asked him why go the computer route when people power is so important, he replied, “Because it works—it’s countable and replicable. I’m a great fan of the scientific method. And the other things are not scientific. If I give you the algorithms, you should be able to get the same results I did. That to me means a great deal.”⁴¹

It is useful to think of yourself as an intellectual nomad. In the world of the nomad, there is no carefully defined turf.

Thomas Friedman⁴²

However, technology can over-optimize or curve-fit a trading system to produce something that looks great on paper alone. Barbara Dixon, a Donchian student, notes: “When designing a system, I believe it’s important to construct a set of rules that fit more like a mitten than like a glove. On the one hand, markets move in trends, but on the other hand, past results are not necessarily indicative of future performance. If you design a set of rules that fit the curve of your test data too perfectly, you run an enormous risk that it will fizzle under different future conditions.”⁴³

If you think about it, it doesn’t matter what you do because landings are most likely to be average. If a pilot had an exceptional landing, his next landing was likely to be average. If he had a poor landing, his next landing was likely to be average, also. By slicing the data and only looking at what follows good landings and praise, you only see part of the picture. You must consider how data was selected before you can draw conclusions.

James Simons

A robust trading system, one that is not curve-fit, must ideally trade all markets at all times in all conditions. Trend following parameters or rules must work across a range of values. System parameters that work over a range of values are considered robust. If the parameters of a system are slightly changed and the performance adjusts drastically, beware. For example, if a system works great at 20, but does not work at 19 or 21, that system is not robust. On the other hand, if a system parameter is 50 and it also works at 40 or 60, the system is much more robust and reliable.

Trend trader David Druz has long championed robustness in trading systems. He dismisses trades of short-term traders who fight for quick hitting, arbitrage-style profits as pure noise. Traders who focus on short-term trading often miss the longer-term trends—those trends where long-term trend following often bags its biggest opportunities. To wait like that, you need complete faith in your trading system. However, you are in serious trouble if all you think you need to succeed at trading is the latest hardware and software. As Barbara Dixon warns: “Contemporary databases, software, and hardware allow system developers to test thousands of ideas almost instantaneously. I caution these people about the perils of curve fitting. I urge them to remember one of their primary goals is to achieve discipline, which will enable them to earn profits. With so many great tools, it’s easy to change or modify a system and to develop indicators rather than rules, but is it always wise?”⁴⁴

It is easy to get caught up in the computer program hype. Advertisements run nonstop everywhere promising instant riches. Fancy charting software will make you feel like Master of the Universe, but that is false security. When describing his early trading successes, John W. Henry made clear it was philosophy, not technology:

In those days, there were no personal computers beyond the Apple. There were few, if any, flexible software packages available. These machines, far from being the ubiquitous tool seen everywhere in the world of finance and the world at large today, were the province of computer nerds . . . I set out to design a system for trading commodities. But things changed quickly and radically as soon as I started trading. My trading program, however, did not change at all. As I said, it hasn’t changed even to this day.⁴⁵

First, solve the problem. Then, write the code.

John Johnson

One of Henry’s long-time associates elaborated: “Originally all of our testing was done mechanically with pencil and graph that turned into Lotus spreadsheets, which was still used extensively in a lot of our day to day work. With the advent of some of these new modeling systems like system writer, day trader and some of the other things, we’ve been able to model some of our systems on these products. Mostly just to back test what we already knew, that trend following works.”⁴⁶

Tom Basso clarifies: “You’ll find that the more you’re computerized, the more markets you’ll be able to handle. Computers leverage your time if you know how to use them.”⁴⁷ And Richard Donchian makes clear the time needed to execute successfully as a trend following trader:

If you trade on a definite trend following, loss-limiting method, you can trade without taking a great deal of time from your regular business day. Because action is taken only when certain evidence is registered, you can spend a minute or two per market in the evening checking up on whether action-taking evidence is apparent, and then in one telephone call in the morning, place or change any orders in accord with what is indicated. Furthermore a definite method, which at all times includes precise criteria for closing out one’s losing trades promptly, avoids . . . emotionally unnerving indecision.

The obvious is always least understood.

Prince Klemens von Metternich

The minute or two Donchian refers to takes preparation time. After you test your system and are satisfied with results enough to begin trading, the work is still not done. System results must be periodically compared to actual results to ensure that testing closely reflects real time. It is also helpful to keep a journal to record how well you stick to executing your system.

One trend trader trained at Commodities Corporation told me:

Early in my trading career I found myself hung up on the “need” to be right rather than the “desire” to make money. I learned early that being “right,” of having a high percentage of winners, had very little to do with my overall trading success. Those who have a need to be right with a high percentage of winners will find themselves passing on their best trading opportunities, assuming they use some degree of discretion in their trade selections. One of my trading buddies enjoys a trading success rate annually of around 15 percent winners with 50 percent losers and 35 percent breakeven trades. In 2005, he made over 300 percent on his initial beginning of year trading capital [of] a seven-figure account. This is a risk-reward numbers game and most who think it is something else usually face a “forced awareness” at some point in their trading careers. To further emphasize my point, everyone has seen ads on the Internet for systems being promoted at 90 percent accuracy. I bet 3/4 of these systems are based on a set of past criteria that have very little to do with their future performance. Let’s say you do 100 trades in a calendar year. The average winning trade makes a net $100 so you make a net $9,000 in the “winners.” Now the bad news is the 10 losing trades are for $1,000 so you lose a total of $1,000 for the year in a system that had 90 percent winners. Now, I realize this is a stretch from reality, but mathematically this is what happens once a trader commits capital to the so-called “sure thing” trading systems!

Trend following legend Ken Tropin was even more specific:

In order for a system to be successful, it has to be what I call robust. Robust means I can test that system in a market I designed it around. Say I’m using it in the treasury bonds, and then if I switch that market and I try that system in the Euro, it still works. And if I change its parameters, it still works. And if I switch it over to corn—something totally different than treasury bonds—it still works. And if I look at some data that was out of sample from what I designed it around, it still works. Then I have something that might be interesting and have a chance of living in the future. Because the nature of data is it changes a little all the time. And so the key to success in systems trading is to have what I call a loose fitting suit. I can’t have a suit that’s so tight and perfectly proportioned to me that if I gain two pounds, it won’t fit the data anymore.

Andrew Lo of MIT brings it back to simplicity:

The first [rule of thumb] being that no matter how complex and subtle a strategy is and no matter how sophisticated it might be, it has to be possible to describe that strategy in relatively simple and intuitive terms to a sophisticated investor. In other words, regardless of how subtle and impressive and sophisticated the strategy is, I’ve never come across anything that couldn’t be described in relatively straightforward terms as to what the value added of that strategy was.

Nearly every time I strayed from the herd, I’ve made a lot of money. Wandering away from the action is the way to find the new action.

Jim Rogers

FAQ 4: Day Trading Limits

When you trade with higher frequency, the profit you earn per trade decreases while transaction costs stay the same. This is not a winning strategy. However, many traders believe that short-term trading is less risky. Short-term trading by definition is not less risky, as evidenced by the catastrophic blowouts of Victor Niederhoffer and Long-Term Capital Management (LTCM). Do some short-term traders excel? Yes. However, think about the likes of whom you might be competing with when you are trading short-term, such as Jim Simons and Toby Crabel. Professional short-term traders, the HFT guys, have hundreds of staffers working as a team 24/7. They are playing for keeps, and looking to eat your lunch in the zero-sum world. You don’t stand a chance Mr. Day Trading Dreamer.

But day trading flaws are invisible to many. Sumner Redstone, billionaire CEO of Viacom, talked of constantly watching Viacom’s stock price, hour after hour, day after day. Although Redstone is a brilliant entrepreneur and has built one of the great media companies, his obsession with share price is pointless. Redstone might see his company as undervalued, but staring at the screen will not boost it.

FAQ 5: Wrong Way to View a Trade

Leo Melamed is chairman emeritus to the CME (episode #265 on my podcast). He is recognized as the founding father of financial futures. He was named to the top 10 most important Chicagoans in business of the twentieth century. Yet, with this tremendous resume and success, he is clearly not a trend following trader:

The idea behind digital computers may be explained by saying that these machines are intended to carry out any operations which could be done by a human computer.

Alan Turing

The Hunt silver debacle also provided the setting for my worst trade. My company partner George Fawcett and I had become bullish on silver beginning in June 1978, when it was trading around $5.00 an ounce level. We were right in the market, and silver prices moved higher. In September 1979, silver reached the high price of $15.00 an ounce, and the profit we were each carrying was substantial. George and I had never before made that kind of money, it was truly a killing. How much higher would silver go? Wasn’t it time to take the profit? Large profits, as I learned, were even more difficult to handle than large losses. 
I had a very good friend . . . with special expertise in the precious metals markets. . . . Since he knew I was long silver, I ventured to ask him his opinion. “Well, Leo,” he responded, “you have done very well with your silver position and I really can’t predict how much higher silver will go. But I’ll tell you this, at $15.00, it is very expensive. On the basis of historical values, silver just doesn’t warrant much higher prices.” I never doubted that he gave me his honest and best opinion. I transmitted this information to George and we decided that if nothing happened by the end of the week, we would liquidate our positions and take our profits. That’s exactly what we did. This was in late October 1979. So why was this my worst trade when in fact it was the biggest profit I had ever made up to that time? Because, within 30 days after we got out of our position, the Hunt silver corner took hold. It did not stop going higher until it hit $50.00 an ounce in January 1980. George and I had been long silver for nearly two years, and had we stayed with our position for just another 30 days, we would have been forced to take a huge profit. We both vowed never to calculate how many millions we left on the table.⁴⁸

Lynx Asset Management, which uses mathematical models to decide when and which securities to buy and sell, posted a 5.1 percent gain on [Brexit] Friday in one of its funds. Capital Fund Management, a $7 billion firm in Paris, gained 4.2 percent that day in its Discus fund, while Systematica Investments, the $10.2 billion fund run by Leda Braga, gained 1.35 percent in its main BlueTrend fund.

Bloomberg

The computer model tells us when to get in and when to get out. The computer understands what the price is telling us about the trend of the market. All of the systems are designed to risk modest amounts of capital and to stay with winners as long as possible.

Ken Tropin

I can see why his 1979 silver trade was his worst trade. He described no predefined entry criteria. He never gives a reason why he and his partner were bullish on silver in 1978, nor does he explain why he entered the silver market other than it was at such a low price ($5.00). When the price of silver started to increase, he attempted to find out how high it would go, which is impossible. However, because he had no clearly defined exit rationale, he was uncertain when to get out. Without an exit strategy Melamed fell back on conventional trading wisdom that buying higher highs is wrong. He attempted to use fundamentals to justify that silver would not continue to increase and then set a profit target to get out. By having a profit target instead of an exit plan, Melamed lost out on millions of dollars of profit. Now, he has had a fantastic career, but his trade example contrasts sharply with trend following.

Rob Romaine brings it back to preparation: “The value of a disciplined trading systems approach is that it allows you to design your strategy during non-stressful times. Then, when the markets are tough, you need only to execute your plan rather than being forced to face difficult decisions under pressure when you are most likely to make mistakes.”

Let me state emphatically the big picture point: If you are sitting in front of 20 monitors pretending to be Master of the Universe, like Bobby Axelrod in Billions, and imagining you can watch all those screens simultaneously and react cat-quick to thousands of pieces of real time data, give me a break. You can’t, even though this guy would argue vociferously for his supernatural monitor scanning skills.