Hiding in Plain Sight

Excerpted with permission of the publisher, Wiley, from Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets by Michael Covel. Copyright (c) 2017. All rights reserved. This book is available at all booksellers.

Trend following, and assorted derivatives of price-based trading, is not a new concept. It goes back across names like David Ricardo, Jesse Livermore, Richard Wyckoff, Arthur Cutten, Charles Dow, Henry Clews, William Dunnigan, Richard Donchian, Nicolas Darvas, Amos Hostetter, and Richard Russell. Believe it or not, it literally goes back centuries, with data to prove it.

AQR’s Cliff Asness clarifies: “Historically, it’s been a strategy pursued primarily by futures traders and in the last 10–20 years by hedge funds. The trading strategy employed by most managed futures funds boils down to some type of trend following strategy, which is also known as momentum investing.”

Even traders not typically associated with trend following eventually find their way. In Hedge Fund Market Wizards, Jack Schwager asked Ed Thorpe, an American mathematics professor, author, hedge fund manager, and blackjack player best known as the “father of the wearable computer,” if he believed “there are trends inherent in the markets?” Thorpe replied: “Yes. Ten years ago, I wouldn’t have believed it. But a few years ago, I spent a fair amount of time looking at the strategy. My conclusion was that it works, but that it was risky enough so that it was hard to stay with it.”

Thorpe noted he used trend following, too. And so it goes; price-based trend strategies discovered by new and old generations at different times. Salem Abraham, now an established trend following veteran, began researching the markets in his early twenties by asking a simple question: “Who is making money?” His answer was “trend followers” and his journey began.

Still, not many have made the journey. During the Dot-com era of the late 1990s, throughout the Fed-induced S&P run-up after March 2009, and even today into 2017, many with zero strategy have made money in other ways, so trend following becomes a blip on the radar screen—seemingly not so important.

And since trend following has nothing to do with high-frequency trading, short-term trading, cutting-edge technologies or Wall Street hocus pocus nonsense, its appeal is universally lost during extraordinary delusions unleashed inside the madness of crowds—that is, until bubbles pop. Trend following is not sexy until after the masses get poached and bleed out.

Nonetheless, if you look at how much money trend following has made before, during, and after assorted market bubbles, it becomes far more relevant to the bottom line of astute market players.

Yet, even when over the top trend following success is thrown onto the table, skeptical investors can be tough sells. They might say markets have changed and trend following no longer works. But philosophically trend following hasn’t changed and won’t change, even though markets might not always cooperate.

Let’s put change in perspective. Markets behave the same as they did hundreds of years ago. In other words, markets are the same today because they always change—humans are involved, after all. This behavioral view is the philosophical underpinning of trend following. A few years ago, for example, the German mark had significant trading volume. Then the euro replaced the mark. This was a huge change, yet a typical one. If you are flexible and have a plan of attack—a solid strategy—market changes, like changes in life, won’t kill you. Trend followers traded the mark; now they trade the euro. That’s how to think.

Accepting that inevitability of change is an initial step to understanding. One trend follower elaborates:

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 draw downs 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. Trend following presupposes change. It is based on change.

Markets of course are built by design to go up, down, and sideways. They trend or chop. They flow or don’t. They are consistent, then they surprise. No one accurately can forecast a trend’s beginning or end until it becomes a matter of record. However, if your trading strategy is designed to adapt, you can take advantage of changes:

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.

A valid basic philosophy means a trading strategy that can be defined, quantified, written down, and measured in terms of numbers. Trend following does not guess at buys and sells. It knows what to do because valid basic philosophy is codified into a specific plan for all contingencies.

The Man Group, one of the largest trend following traders, describes the source behind their profits:

. . . trends as a persistent price phenomenon that stems from changes in risk premiums—the amount of return investors demand to compensate the risks they are taking. Risk premiums vary massively over time in response to new market information, changes in economic environment, or even intangible factors such as shifts in investor sentiment. When risk premiums decrease or increase, underlying assets have to be priced again. Because investors typically have different expectations, large shifts in markets result over several months or even years as expectations are gradually adjusted. As long as there is uncertainty about the future, there will be trends for trend followers to capture.

About the Author:

Michael W. Covel searches. He digs. He goes behind the curtain to reveal a state of mind the system doesn’t want you in.

Michael teaches beginners to seasoned pros how to generate profits with straightforward and repeatable rules. He is best known for popularizing the counterintuitive and controversial trading strategy, trend following. His perspectives have garnered international acclaim and have earned him invitations with a host of organizations: China Asset Management, GIC Private Limited (Singapore), BM&F Bovespa, the Managed Funds Association, Bank of China Investment Management, the Market Technicians Association, and multiple hedge funds and mutual funds. He also has the distinction of having interviewed five Nobel Prize winners, including Daniel Kahneman and Harry Markowitz, on his Trend Following podcast—which now exceeds 500 episodes and 5 million listens.

Check out Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets.

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