- 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
Follow the Trend
Don't try to guess how far a trend will go. You can't. Peter Borish, former second-in-command for Paul Tudor Jones, lays bare the only concern a trader must have:
"Price makes news, not the other way around. A market is going to go where a market is going to go."28
The concept of price as the trading cue is just too darn simple for people to accept. This is demonstrated by the mainstream press, who always emphasize all the wrong numbers:
"At some point investing is an act of faith. If you can't believe the numbers, annual reports, etc., what numbers can you believe?"—Bill Griffith, Anchor, CNBC
Bill Griffith misses the point when he asks what numbers you can believe if you can't believe a company's annual report. It doesn't matter whether you can or cannot believe the earnings statement. All of these numbers can be doctored. The traded price can't be fixed. It's the only number to believe. However, this simple fact does not diminish the confusion. Alan Sloan, by all accounts a fine finance reporter, searches for numbers to trust:
"If some of the smartest people on Wall Street can't trust the numbers you wonder who can trust the numbers."
What numbers is Sloan talking about? Balance sheets? Price-earnings ratios? You can't ever trust those numbers. Someone can always alter them. Beyond that, even if you knew accurate balance sheet numbers, they can never help you determine when or how much to buy or sell. John W. Henry drives home the critical lesson:
". . . [P]olitical uncertainty is one reason why John W. Henry & Company, Inc. (JWH) investment decisions are not driven by discretionary judgements. How, for example, do you measure the impact of statements from Messrs. Greenspan, Rubin, Summers, Miyazawa, or Sakakibara? Even if JWH knew all the linkages between fundamentals and prices, unclear policy comments would limit our ability to generate returns...trying to interpret the tea leaves in Humphreys-Hawkins testimony or the minds of Japanese policy authorities does not lend itself to disciplined systematic investing. Instead of trying to play a losers game of handicapping policy statements our models let market prices do the talking. Prices may be volatile but they do not cloud the truth in market reactions. Our job is to systematically sift price data to find trends and act on them and not let the latest news flash sway our market opinions."29
You can't read tea leaves. John W. Henry can't. Ed Seykota can't. Nobody can. William Eckhardt, a longtime trend follower and former partner of trend follower Richard Dennis, builds off Henry's wisdom by describing how price is what "traders live and die by." The moment you add any other variables to the decision-making process, you've diluted price:
"An important feature of our approach is that we work almost exclusively with price, past and current . . . Price is definitely the variable traders live and die by, so it is the obvious candidate for investigation . . . Pure price systems are close enough to the North Pole that any departure tends to bring you farther south."30
Ed Seykota is a genius and a great trader who has been phenomenally successful. When I first met Ed he had recently graduated from MIT and had developed some of the first computer programs for testing and trading technical systems. . . .Ed provided an excellent role model. For example, one time, he was short silver and the market just kept eking down, a half penny a day. Everyone else seemed to be bullish, talking about why silver had to go up because it was so cheap, but Ed just stayed short. Ed said, "The trend is down, and I'm going to stay short until the trend changes." I learned patience from him in the way he followed the trend."
Michael Marcus31
How does a trend follower perceive the trading process? A well-known trend follower relates this story about trading sugar. He had been buying sugar—thousands of sugar contracts. Every day, the market was closing limit up. Every day, the market was going higher and higher. This trend follower just kept buying more and more sugar each day limit up. A broker was watching all this. One day the broker called after the market was closed because he had extra contracts of sugar that were not balanced out, and he said to this trend follower, "I bet you want to buy these other 5,000 contracts of sugar." The trend follower replied, "Sold."
Think about that: After the market has closed limit up for days in a row, this trader says, "Sure, I'll buy more sugar contracts at the absolute top of the market." Why is this an important lesson? Everybody instinctively wants to buy sugar on the dip. Let it come down low. Let me get a bargain. Trend Following works by doing the opposite, by buying higher prices.
Let's say you saw a stock go from 5 to 100. When it was at 5, you didn't know it was going to go to 100. And trend followers didn't know it was going to go to 100 either. But they were buying all along, knowing that it could go to 100 even though it might not. So did it make sense to miss out on this trade that went to 100 because you did not enter at 5? Would you have avoided the trade if you had had the chance to get in at 20 instead of 5? If you got in at 20 and it went to 100, you made a great trade. You can't time the trade. No one can pick a top or bottom.
Trend followers are in the moment. They know that attempting to pinpoint the beginning of a trending market is futile. When trends begin, they often arise from a flat market that doesn't appear to be trending in any direction. The idea is to take small bets early on in a market to see if the trend does, indeed, mature and get big enough to make big money. How do Trend Following strategies succeed? Michael Rulle, President of Graham Capital Management and a trend follower, states:
"The ability of Trend Following strategies to succeed depends on two obvious but important assumptions about markets. First, it assumes that price trends occur regularly in markets. Secondly, it assumes that trading systems can be created to profit from these trends. The basic trading strategy that all trend followers try to systematize is to 'cut losses' and 'let profits run.'"33
We asked Charles Faulkner, a modeler of top traders and an expert in Neuro-Linguistic Programming, to expand upon this, at first glance, simple idea:
"Many traders have told me the first rule of trading is to, 'Cut your losses, and let your profits run.' And then, that it's the hardest thing to do. Seldom do any of them wonder why, and yet this is exactly where the efficient market hypothesis breaks down, and the psychological nature of the markets shows through. When we lose or misplace something we expect to find it later. The cat comes back. We find our car keys. But we know a dollar on the street will not be there with the next person who passes by. So experience teaches us that losses are unlikely and gains are hard. 'A bird in the hand is worth two in the bush.' This is when I tell them that they earn their trading profits by doing the hard thing—by going against human nature. This is where the discipline comes in, the psychological preparation, the months of system testing that give the trader the confidence to actually trade against his natural tendencies."
You will also find additional research from Duke University on our Web site, http://www.trendfollowing.com, that takes Rulle's point to an academic proof.
If cutting losses and letting profits run is the trend follower's mantra, it is because harsh reality dictates that you can't play the game if you run out of money. Nor can you predict the trend direction, as Christopher Cruden, Managing Director of the trend follower Tamiso and Co., points out:
"I would prefer to finish with a certain currency forecast, based upon my own fundamental reading of the market and one which underpins my personal investment philosophy . . . The only problem is I can't tell you when this will happen or which event will be first. On that basis alone, it seems best to stay with our systematic approach."35
In Patton my favorite scene is when U.S. General George S. Patton has just spent weeks studying the writing of his German adversary Field Marshall Erwin Rommel and is crushing him in an epic tank battle in Tunisia. Patton, sensing victory as he peers onto the battle field from his command post, growls, "Rommel, you magnificent bastard. I read your book!"
Paul Tudor Jones as quoted in the Foreword to The Alchemy of Finance
Cruden knows a potential forecast will give uncertain investors a feeling of confidence, but he also knows forecasting is impossible. Why pretend?
A good example of not letting profits run can be seen in trading strategies that take profits off the table before a trend is over. For example, a broker revealed to us that one of his strategies was to ride a stock up for a 30 percent gain and then exit. That was his strategy. Let it go up 30 percent and get out. Sounds reasonable. However, a strategy that uses profit targets is problematic. The biggest problem is that it goes against the math of getting rich, which is to let your profits run. Trend followers ride trends as far as they can instead of taking their profits as soon as they make them. If you can't predict the end or top of a trend, why get out early and risk leaving profits on the table?
For example, you start with $50,000. The market takes off and your account swells to $80,000. You could, at that point, quickly pull your $30,000 profit off the table. Your misconception is that if you don't take those profits immediately, they will be gone. Refusing to risk those accumulated profits is a big mistake.
Are you a bull market baby? Can you survive in any situation?
Trend followers realize that a $50,000 account may go to $80,000, back to $55,000, back up to $90,000, and from there, perhaps, all the way up to $200,000. The person who took profits at $80,000 is not around to take the ride up to $200,000. Letting your profits run is tough psychologically. But understand that in trying to protect every penny of your profit, you actually prevent yourself from making big profits.