Trend Following: An Interview With Michael Covel
The following is an interview of Michael Covel by Trade2Win Content Editor John Forman. Michael is the author of the highly regarded book Trend Following, which makes a very strong case for the value of trend trading methods.
At the very beginning of your book you differentiate between traders and investors. Why is trading better than investing?
Investors buy and hold. Hoping that the market will continually move up, they buy long with no exit plan. They do not manage risk so they give up control. Traders, on the other hand, do not care whether the market goes up or down. They buy long or sell short and they always have an exit plan. They have predefined exit points meaning they know when to exit for profit and when to exit to minimize loss. Traders practice risk management. They define risk. They know with mathematical certainty exactly how much they are willing to lose. They take control.
Because the global playing field is being leveled you are going to need a border-less mindset in order to succeed. In order to profit from today’s uncertain markets, it is crucial to understand how to utilize risk, leverage, probability, hedging and opportunity costs. You must be comfortable with alternative investments. Whether you trade for yourself or have someone trade for you, I believe you must think and act like a trader.
Look, how many people, just at the end of the nineties were finally feeling good about themselves because they had achieved a level of financial security off of their investments. Then the dot-com bubble came along and by the time it was over they had lost a significant amount of money. They are still angry with the analysts, experts, and brokers, whose advice they took. Now they doubt they will ever achieve their investment goals. They are stressed because they don’t know what else to do but hold on to their remaining investments and hope for the best. They still believe that pipe dream of buying at the bottom as the way to go. That’s the mentality of a so-called investor.
Then you look at a trend following trader who has an objective and rational approach. They have enough confidence in their own decision-making that they don’t act on investment recommendations from others. They wait patiently until the right opportunity (trade) comes along. They are never too proud to buy a stock that is making new highs. Conversely, when they see that they are wrong, they exit immediately. They view a loss as an opportunity to learn and move on. They do not personalize their trading decisions.
Your book is about trend trading, which you note is a form of technical analysis. First, how do you define trend following?
In my book I define trend following as a strategy that seeks to capture the majority of a trend, up or down for profit. It trades for profit in the major asset classes – stocks, bonds, currencies, and commodities. Van Tharp describes it great:
“Let’s break down the term ‘Trend Following’ into its components. The first part is “trend”. Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices…’Following’ is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then ‘follow’ it.”
What trend following is not is prediction or forecasting about how the markets will go. Trend following is based on reacting to price, price and again, price. It is not based on trying to predict price directions.
Second, how is it different than other types of technical analysis?
There are essentially two types of technical analysis. One form is based on the ability to “read” charts and use "indicators” to divine market direction. These technical traders use methods designed to attempt to predict market direction. I have found no evidence that this works. There is another type of technical analysis is not predictive. It’s reactive. Trend followers are traders who use a reactive technical approach based on price. Instead of trying to predict a market direction, their strategy is to react to market’s movements whenever they occur. Trend followers’ technical approach to trading is based on what is happening in the present rather than anticipating what will happen. Trend following strategies are based on statistically validated trading rules.
With this type of technical analysis you can’t enter at the exact bottom or exit at the exact top of a trend. You also don’t trade every day – you trade when there is opportunity. Moreover there are no price targets with this approach to technical analysis.
Why do you consider trend following superior to any other style of trading?
Trend Following goes against all the customs, rituals, trappings, and myths we have grown accustomed to associating with Wall Street trading success. Trend following traders respond to what is happening in the market rather than anticipating what will happen. And they base their trading decisions on one piece of core information: The market price. That makes them different from the vast majority of traders and investors who rely on fundamental data to make their trading decisions. They think the only way to beat the market is to gather all of the information you can find. They want news, they want CNBC, they want The Wall Street Journal, they want crop reports, they want OPEC rumors, they want Greenspan’s shoe size – they believe all of this extraneous information will help them to make profitable trading decisions. And when they make a decision, 99 times out of a 100 it is to buy and hold, hoping that the market will go one way if they just hang in there. Hope is not a good trading strategy!
Trend followers, on the other hand, who are technical traders by nature, say enough! The market price is the best source of information about the market direction because the market price is the aggregate vote of everyone. It doesn’t matter if the market goes up or down because all you care about is the price. All markets, from stocks and bonds to metals, currencies and commodities can be traded the same because all you need to know is the market price. Trend Followers see the world in trends. Trend followers know that trends will arrive in unpredictable ways going either up or down. Trend followers simply want to be on board to ride those unpredictable trends for profit. Think about it – what else can you really believe in beside the market price? Or, to quote John W. Henry, “The greatest action, the wisest, the best action that you can take in almost any situation is to stay with what is, instead of jumping to conclusions or trying to come up with conclusions. Just pay attention to what is.”