- The Market
- Winning and Losing
- Investor v. Trader: How Do You See the World?
- Fundamental v. Technical: What Kind of Trader Are You?
- Discretionary v. Mechanical: How Do You Decide?
- Timeless
- Has Trend Following Changed?
- Trend Following Modus Operandi: Follow Price
- Follow the Trend
- Handling Losses
- Conclusion
- Key Points
This chapter is from the book
This chapter is from the book
This chapter is from the book
Timeless
Trend Following is not new. The strategy is simply discovered by new generations of traders at different times:
"[Salem Abraham, a trend follower,] began researching the markets by asking a simple question: Who is making money? The answer was trend followers and his journey began."19
Defining a trend is like defining love. We know it when we see it, but we are rarely sure exactly what it is. Fung and Hsieh's paper goes a long way to doing for trends what poets have been trying to do for love since time immemorial. They give us a working model that quantitatively defines their value for us. Traders will not be surprised to learn that Trend Following advisors performed best during extreme market moves, especially during bad months for equities.20
Few people have made the journey with Salem Abraham. During the dot-com era of the late 1990s, so many investors and traders with so little strategy were making so much money that trend followers disappeared from the radar screen even though they kept right on making money.
Since Trend Following has nothing to do with short-term trading, cutting edge technologies, or Wall Street Holy Grails, its appeal was negligible during the stock market bubble. If investors could jump on the bandwagon of practically any "long only" hedge fund manager or turn a profit trading themselves by simply buying internet stocks and holding on to them, what need was there to adopt a strategy such as Trend Following?
However, when we look at how much money trend followers have made since the bubble has popped, Trend Following becomes far more relevant. The following chart (Chart 1.1) shows a hypothetical index of three longtime Trend Following firms compared against the S&P stock index. The chart combines Dunn Capital Management, Campbell and Co., and John W. Henry and Co. into an equally-weighted index:
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Chart 1.1.Trend Following Index Compared to S&P and Nasdaq
Yet even when Trend Following success is brought to their attention, investors are still often skeptical. They say the markets have changed and that Trend Following no longer works. Their concern usually stems from a random press story of a trend follower who "blew up" and lost all of his and his clients' money. But the truth is that Trend Following hasn't changed, even though a single trend follower may have. That is a big difference.
Let's put change and Trend Following in perspective. Markets behave the same as they did 300 years ago. In other words, markets are the same today because they always change. This is a philosophical underpinning of Trend Following. A few years ago, for example, German mark trading had significant trading volume. Now the Euro has replaced the German mark. This was a huge, yet typical, change. If you are flexible, market changes, like changes in life, don't have to impact you negatively.
Change is not merely necessary to life—it is life.
Alvin Toffler
Accepting the inevitability of change is the first step to understanding Trend Following philosophy. John W. Henry describes the benefits of understanding change:
"But what won't change? Change. When a period of difficult performance continues, however, most investors' natural conclusion is that something must be done to fix the problem. Having been through these drawdowns before, we know that they are unpleasant, but they do not signal that something is necessarily wrong with the future. During these periods almost everyone asks the same question in these exact words: 'Have the markets changed?' I always tell them the truth: 'Yes.' Not only have they changed, but they will continue to change as they have throughout history and certainly throughout our 19 years. Trend Following presupposes change. It is based on change."21
Markets go up, down, and sideways. They trend. They flow. They surprise. No one can forecast a trend's beginning or end until it becomes a matter of record, just like the weather. However, if your trading strategy is designed to adapt to change, you can take advantage of the changes to make money:
"If you have a valid basic philosophy, the fact that things change turns out to be a benefit. At least you can survive. At the very least, you will survive over the long term. But if you don't have a valid basic philosophy, you won't be successful because change will eventually kill you. I knew I could not predict anything, and that is why we decided to follow trends, and that is why we've been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends."—John W. Henry22
The people who excel in any field are people who realize that the moment is there to be seized—that there are opportunities at every turn. They are more alive to the moment.
Charles Faulkner23
What does Henry mean by "a valid basic philosophy"? He is talking about a trading strategy that can be defined, quantified, written down, and measured in terms of numbers. Do you have one of those? Does your broker have one? Does your mutual fund manager have one? Does your high-flying hedge fund have one? Trend followers do not guess if they must buy or sell. They know what to do, because they have their "valid basic philosophy" set in a plan.