Treat your life like a game.
—Ray Dalio
Trends come and go. Trend followers do too. Some stay longer than others.
—Ed Seykota1
Larry Hite described a conversation with a friend who couldn’t understand his absolute adherence to a mechanical trading system. His friend asked, “Larry, how can you trade the way you do? Isn’t it boring?” Larry replied, “I don’t trade for excitement; I trade to win.”
In Absolute Returns, author Alexander Ineichen stresses that trading is nothing more than a game. There are three types of players in this game:
If, within a half of an hour of playing whatever game, and you don’t know who the patsy is, you’re the patsy or the game.
Throughout, I have introduced traders who didn’t know they were in the game and became the game in the big events of Long-Term Capital Management, the Barings Bank collapse, the October 2008 market crash, and Brexit. I have introduced traders and investors who did not know they were in the game and who pursued Holy Grails that never panned out. And I introduced trend following traders who knew they were in a game and brought an edge to the table every time they played. If you know it’s a game and you must know that by now, the choices are stark.
If you’re concerned this work will create a new generation of trend following traders, and that impact in the markets will negatively affect the frequency, direction, and intensity of trends (as well as an ability for everyone to make money), take note of timeless wisdom from trend follower Keith Campbell: “We are trend followers, not trend generators. At the beginning or end of a major trend, we may provide a little bump or a minor goose, but it will be an extremely superficial, temporary effect.”3
Many Turtles claim the biggest reason they no longer tolerate immense drawdowns or strive for colossal returns is because customers want a more conservative approach.4
Periods of above-average performance are alternated with periods of below-average performance. As soon as the inevitable, less attractive market environment commences, investors with wrong expectations are likely to become disgruntled. They will start complaining and with good reason: They will not understand why they lose money.
Transtrend
He is 100 percent spot on. Recall Larry Harris in Chapter 3: Traders play the zero-sum game for numerous reasons. Not all play to win. However, trend following is about playing the zero-sum game to win. And let’s face it, that attitude will cause feelings of intimidation, defensiveness, and jealousy. At the end of the day, for trend following trading to lose its effectiveness, dramatic changes must unfold:
Embrace money management: Most don’t know how much to buy or how much to sell. They only worry about when to buy rarely thinking about when to sell. Recklessly bet 50% on one opportunity alone that could have the odds of a coin flip? People do it all the time. Need even more proof? Las Vegas and Macau (China). Go see both firsthand.
The only way to make sense out of change is to plunge into it, move with it, and join the dance.
Alan Watts
The broad application of these principles globally in markets all around the world, Chinese porcelain, gold, silver, markets that exist, that don’t exist today, markets that others are making lots of money in that we’re not trading. We will eventually start broadening out and realizing that trend following is a great way to trade. What other way can you trade and get a handle on risk?
Jerry Parker5
Let’s be candid: Most are more comfortable with the status quo—even if that means losing their life savings when the next black swan swims in—and at least then if the neighbors lose it all too, they can be happy in misery together. Accepting that all of their market knowledge is faulty would predictably trigger in investors a mega release of the stress hormone cortisol. Millions would rather zone out on Netflix, bicker on Facebook, post on Instagram, send troll tweets, farm digital crops, or pretend the next president will solve it all, than learn how to trade correctly for the chance at the life changing gain.
Markets may initially trend for fundamental reasons, but prices overshoot by ludicrous amounts. At some point, prices go up today simply because they went up yesterday.
Michael Platt
It’s not surprising that trend following is sometimes accused of throwing markets into disarray. Whenever a stock tanks, a bubble bursts, or scandal hits, winning traders catch the blame 9 times out of 10. The blame is never affixed to the little old lady in Omaha who lost her life savings gambling on biotech penny stocks. The blame is never placed on the masses that were gambling the Dow would go up forever, only to see it crater 50 percent. Few take responsibility for losses, and who better to target when the mob is feeling panicky than rich winners? Here are my favorite misconceptions that make trend following devil incarnate evil:
Future shock is the shattering stress and disorientation that we induce in individuals by subjecting them to too much change in too short a time.
Alvin Toffler
Giving trend followers flak for making money on the downside ignores the skill involved: “Traders have always been an easy target for the press whenever the public is looking for someone to blame for volatile markets, and the press have singled out ‘the short sellers.’ Making money in down markets is portrayed as obscene and to blame for additional turbulence. The industry is not about ‘bad boys’ manipulating the market and gambling; it is about specific trading skills practiced by highly experienced traders who are rewarded on performance alone.”6
Most battles are won before they are ever fought.
General George S. Patton
The notion that producing money in down markets is obscene is in itself obscene. Markets have rules. You can go long or you can go short. Serious players trying to make f-you money deal with the rules and don’t make excuses. And if you don’t know the rules, that’s on you.
Jerry Parker, however, believes trend following must do better at explaining the inherent skill set: “Another mistake we made was defining ourselves as managed futures [industry term for trend following], where we immediately limit our universe. Is our expertise in that, or is our expertise in systematic trend following or model development? So maybe we trend follow with Chinese porcelain. Maybe we trend follow with gold and silver, or stock futures, or whatever the client needs. But a day will come when people will see that systematic trend following is one of the best ways to limit risk and create a portfolio that has some reasonable expectation of making money.”7
The Sharpe ratio appears at first blush to reward returns (read: good) and penalize risks (read: bad). Upon closer inspection, things are not so simple. The standard deviation takes into account the distance of each return from the mean, positive or negative. By this token, large positive returns increase the perception of risk as though they could as easily be negative, which for a dynamic investment strategy may not be the case. Large positive returns are penalized and therefore the removal of the highest returns from the distribution can increase the Sharpe ratio: a case of “reductio ad absurdum” for Sharpe ratio as a universal measure of quality.
David Harding
In an unpredictable world, trend following is the best tool to manage risk and uncertainty while possibly producing out-sized returns. The performance sets of David Harding, Martin Lueck, Ken Tropin, Leda Braga, Ewan Kirk, Bill Dunn, Jean-Philippe Bouchaud, Jerry Parker, Keith Campbell, George Crapple, and Larry Hite, to name a few over the past 40 years, are incontrovertible facts.
Richard Dennis’s Turtle students (see my book TurtleTrader) were originally instructed to make as much money as possible. They had no restrictions except to shoot for home runs. They were absolute return traders while under Dennis’ guidance. However, when they went out solo to trade for clients, there was style drift. Many accepted clients who demanded less leverage and ultimately less return.
Everyone wants to invest when you’re at new highs and making 50 percent a year. Everyone says they want to get in at a 10 percent drawdown or a 20 percent, or whatever, and no one ever does it. I just want to point out that right now, here is another chance to do just that—buy us at historical lows—and very few people are thinking in those terms. They want to buy the lows, but never seem to.
Richard Dennis8
Dunn Capital knows to aim for and win big profits, trader and client must be synchronized. Dunn is adamant about alignment: “Now there is, of course, the possibility of turning down the leverage and trading more capital, but with less leverage. That works fine if the client will go along with you and you’re charging management fees because you’re charging management fees on the capital and then incentive fees on the profit. [We do] not charge any management fees to any of its clients . . . we care about the numbers that are generated.”9
Some might feel safer with watered-down trend following at a lower-vol, lower-reward, but the true way to the change your life money is through higher-vol, higher-reward. The key, regardless of leverage choice, is to be in concert, as trend trader Jason Russell prescribes: “Managers often say they are managing to long-term objectives but act to meet short-term objectives of clients who have not spent the time understanding what trend following means to them. As much as the managers, industry, and regulators try to educate and illustrate, the ultimate responsibility lies in the hands of the client.”
Today is in the middle of June and there is a lot of talk about the weather, the grain situation, and whether it rains or snows or is dry. I have no idea. It’s not the kind of thing I deal with. I don’t have any way to use information like that. I don’t think anyone else really does either. If I think it is going to rain, perhaps it’s an indication of how I should dress for the day, but little else.10
Bottom line, trend following strategies stylistically vary due to volatility targets (leverage choices), speed (short or long-term trend targeting) and sector exposure (narrow or widely diversified). Trader Josh Hawes summed up the choices from another vantage: “There is fund level risk, account level risk, trading system-level risk and position level risk.” Let that sink in before you leap.
It’s more than the model, though. An associate drove home the point: “Trend trading and even trading in general isn’t for everyone. As too few people check out what the day-to-day life of a trader is like, and trend trading specifically, I strongly recommend they find out before making a life-changing commitment.”
Optimism means expecting the best, but confidence means knowing how to handle the worst.
Max Gunther11
Life-changing commitment means not needing to be right. Most must be right no matter what. They live to have others know they’re right. They don’t even want success. They don’t want to win. They don’t want money. They want to be absolutely right. The winners, on the other hand, they just want to win.
That’s not all. You commit to patience in a trading process not structured on quarterly performance measures. You work hard to gain experience and great experience leads to discipline. You commit to the long-term. A real strategy might have one year when you are down 10 percent. The following year you might be down 15 percent. The next year you might be up 115 percent. If you quit at the end of the year two you never get to year three. That’s the reality of sound strategy—for life or trading
Although this may seem a paradox, all exact science is dominated by the idea of approximation.
Bertrand Russell12
Larry Hite paints the picture of that risk choice:
Life is nothing more than a series of bets and bets are really nothing more than questions and their answers. There is no real difference between, “Should I take another hit on this Blackjack hand?” and “Should I get out of the way of that speeding and wildly careening bus?” Each shares two universal truths: a set of probabilities of potential outcomes and the singular outcome that takes place. Every day, we place hundreds, if not thousands, of bets—large and small, some seemingly well considered, and others made without a second thought. The vast majority of the latter, life’s little gambles made without any thought, might certainly be trivial. “Should I tie my shoes?” Seems to offer no big risk, nor any big reward. While others, such as the aforementioned speeding and wildly careening bus, would seem to have greater impact on our lives. However, if deciding not to tie your shoes that morning causes you to trip and fall down in the middle of the road when you finally decide to fold your hand and give that careening bus plenty of leeway, well then, in hindsight the trivial has suddenly become paramount.
To receive my free interactive trend following presentation send a picture of your receipt to [email protected].
With trend following, you commit to a bigtime decision that’s not trivial: Trade by yourself seizing opportunity, or let a trend following pro do it for you. There are pros and cons to both choices, but you won’t know the best direction until you get in the game and stop with the passive-buy-and-hope-long-only-everything-will-be-all-right-I-trust-the-Fed-implicitly-black-swans-are-extinct insanity.
For unlike the foundation of the efficient market theory, trend following’s enduring principles are not grounded in intricate algorithms or kept inside theorems with obvious holes. Trend following principles are solid proof that typical strategy seen across Wall Street and Main Street is at best built on a clumsy error or at worst a slick lie.
Our system of elite education manufactures young people who are smart and talented and driven, yes, but also anxious, timid, and lost, with little intellectual curiosity and a stunted sense of purpose: trapped in a bubble of privilege, heading meekly in the same direction, great at what they’re doing but with no idea why they’re doing it.
William Deresiewicz13