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?
Thinking like a trader is the only way to profit in today?s markets.
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.?
Is trend trading essentially restricted to longer-term position trading, or can day and/or swing traders trade in this manner as well?
I’m not sure exactly what people mean when they say day trading or swing trading. I assume that means shorter term trading. Trend following techniques are not short-term in nature.
For a good short term trading story, consider the question trend follower Ed Seykota was recently asked in his chat forum:
"I am new to trend following and wish to ask you what your favorite chart is for determining a given market’s trend? Daily, Weekly, Yearly, Hourly?"
"Hmmm…your list seems to lack scaling options for minute, second, and millisecond. If you want to go for the really high frequency stuff, you might try trading visible light, in the range of one cycle per 10-15 seconds. Trading gamma rays, at around one cycle per 10-20 seconds, requires a lot of expensive instrumentation, whereas you can trade visible light "by eye." I don’t know of even one short-term trader, however, who claims to show a profit at these frequencies. In general, higher frequency trading succumbs to declining profit potential against non-declining transaction costs. You might consider trading a chart with a long enough time scale that transaction costs are a minor factor – something like a daily price chart, going back a year or two."
I agree with Ed’s pithy wisdom, but he is not saying short term is impossible.
There do exist shorter term systematic traders who have done quite well (Toby Crabel, Jim Simons). They would agree with Ed that their style is hard. The shorter you go the more you need great execution, fantastic data and multiple systems. To be a great shorter term mechanical trader is a different animal than trend following, but it is a style that a select few have mastered.
So how does one go about identifying a tradable trend?
Trend following involves far more than simply attempting to "ID a trend".
In my book I outlined the proper way to think about trend trading including how to find a trend. First and foremost you must answer these 5 questions before you ever start trading:
- How do you determine what market to buy or sell at any time?
- How much of a market do you buy or sell at any time?
- How do you determine when you buy or sell a market?
- How do you determine when you get out of a losing position?
- How do you determine when you get out of a winning position?
Yes, IDing a trend is important, but it is a piece of the puzzle. For those familiar with technical analysis, you are most likely familiar with price breakouts. Those are typical means used to enter the market when trading as a trend follower. But now that you see the 5 questions you need to answer, doesn’t the question of "how do identify a trend" seem like the wrong question to be overly fixated on? And for whatever reason, people are overly fixated on this.
Think about this way. Locating targets of opportunity in their crosshairs is the goal of all Trend Followers. Bill Dunn, a great Trend Follower for over 25+ years, nicknamed one of his funds T.O.P.S. to reference targets of opportunity systems. Trend Following is a classic targeting of an opportunity. Take what is given and ride the crest of a trend up or down. No prediction. Here is a great chat post:
"Trend Followers accept the limitations in one’s ability to understand all of the structural linkages between supply and demand. The world is complex and hard to understand, and there are different levels and types of uncertainty. There is certainty that markets will move but the direction may not be predictable nor is the level of change discernable. Trend Followers use directional signals because price adjustments may indicate movement to a new equilibrium. In an uncertain world, a market trend may be a rational strategy."
Unlike many traders, who typically employ a passive buy and hold strategy, and only depend on rising markets for profit, Trend Followers use dynamic strategies designed to take long positions (in a rising market) or short positions (in a declining market), to profit from both.
Trend Follower View of World:
- Unstable world.
- World is uncertain and dynamic.
- Market players form rational beliefs but make mistakes.
- Learning takes time; slower adjustment to information happens.
- Fundamental changes are often unanticipated.
Non-Trend Follower View of World
- Stable world.
- World is knowable and static.
- Market players generally form rational expectations.
- Markets adjust quickly to new information.
- Fundamentals do not change dramatically in the short run.
You profile several notable people in the book. What did you learn from these luminaries?
The best way to understand trend following is to meet the men and women who use it. While interviewing for the book I learned critical trading lessons such as how to think in the long term, how to cut losses, never change your core strategy, the importance of compounding, and how to win either way by going short.
After the book came out I spent the next six months going around the world doing extensive informational interviews with some of the greatest traders of today. The lessons I learned from these interviews are invaluable and I hope to share them one day with others in a second book. (See my blog: www.michaelcovel.com).
Here are just two of the hundreds of insights I have gathered:
- I met with the president of a trend following firm who manages over $3 billion dollars for clients. A very down to earth guy, his most direct advice was for people to focus on their plan and not stay preoccupied with others’ plans. He drove home the point that if you dare to be great, in whatever your chosen profession, standing outside the crowd is where the great rewards will be found. If you only want to work for the man, you can’t be the man.
- From another long time successful trader I gained a number of insights such as that there are many more Long Term Capital Managements ready to implode today. He pointed out that for the last 4 years the arbitrage ("stat arbitrage and convertible arbitrage") guys are using more and more leverage to generate less and less return ("too much gearing"). He added, "They think they have found the Key to Rebecca and they have not found anything." He also said: "When people’s emotions drive their decision making, systems traders have the luxury of being able to stick with it."
In your book, you spend a considerable amount of time addressing the mental side of trading. What have you found to be the key determinants of success for the trend follower?
These recent months of in-person interviews with great traders have only reinforced what I believe to be the essential ingredient of success: entrepreneurial zeal. Whether soft-spoken and retiring or crazy-men, these guys are self-made, often several times over. And it’s not the genius of a trend following system that makes them wealthy. It’s their self-discipline, willingness to be responsible for what they do, and their hard work. Trend Following rules are the easy part. It’s playing by them that is so difficult for many. Frankly it all comes down to defining what you really want. Most people don’t want to become rich, they just want to be rich. That’s no definition. That’s a dream. To become anything you need entrepreneurial zeal, you need passion.
But I believe there are a number of key determinants:
- Lack of discipline ? Traders are often lazy when it comes to the education needed to trade successfully.
- Impatience ? Traders often have an insatiable need for action.
- No objectivity ? Traders tend not to cut our losses fast enough. We marry our positions.
- Greed ? Traders often want quick profits.
- Refusal to accept the truth ? Traders often do not want to believe that the only truth is price.
- Impulsive behavior ? Traders often jump into the markets based on a story in the morning paper or on MSNBC.
- Inability to stay in the present ? Traders often spend time thinking about how they are going to spend their profits or regretting mistakes they made in the past
- Avoiding false parallels ? Traders often look for patterns from the past that will enable them to predict what will happen in the future.
The quote by Carl Sagan, ?It is far better to grasp the universe as it really is than to persist in the delusion, however satisfying and reassuring?, is a great reminder of what it takes for trend following success.