Michael Covel on Trend Following

by Michael Covel

Accepting the inevitability of change is the first step to understanding trend following philosophy. One trend follower described it:

“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 and certainly throughout our 19 years. Trend following presupposes change. It is based on change.”

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.

Don’t try to guess how far a trend will go. You can’t. Peter Borish, former second-in-command with 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.”

However, the concept of price as the trading cue is just too darn simple for people to accept. This is seen in the mainstream press that always emphasizes the wrong numbers. Bill Griffith, an anchor at CNBC, once pondered:

“At some point, investing is an act of faith. If you can’t believe the numbers, annual reports, etc., what numbers can you believe?”

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, fixed, or cooked. The traded market price can’t be fixed. It’s the only number to believe. You can see it every day in the paper or online. However, this simple fact does not diminish the confusion. Alan Sloan, by all accounts a fine finance reporter, searches for numbers to trust without ever understanding how futile his search will be:

“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, how can they can help you determine when or how much to buy or sell? A critical lesson from a great trend trader:

“…Political uncertainty is one reason why investment decisions are not driven by discretionary judgments. How, for example, do you measure the impact of statements from [government leaders]? Even if [we] 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 loser’s 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 flashes sway our market opinions.”

You can’t read tea leaves. Nobody can. William Eckhardt, a longtime trend follower and former partner of trend follower Richard Dennis (the father of the ‘Turtles’), builds off that wisdom by describing how price is what traders live and die by:

“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.”

How does a trend follower implement that philosophy? Trend trader Ed Seykota told me a story about trading sugar. He had been buying sugar—thousands of sugar contracts [futures]. Every day, the market was closing limit up. Every day, the market was going higher and higher. He just kept buying more and more sugar each day limit up. A broker was watching all this. One day, the broker called Seykota after the market was closed, because he had extra contracts of sugar that were not balanced out, and he said to Seykota, “I bet you want to buy these other 5,000 contracts of sugar.” Seykota replied, “Sold.”

Think about that: After the market has closed limit up for days in a row, Seykota 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. Get a bargain. Trend following works by doing the opposite: by buying higher prices.

October 2008 is a great illustration of that trend trading view. Stock markets crashed. Millions of people lost trillions of dollars when their long-held buy and hold strategies imploded. The Dow, S&P, and Nasdaq fell like stones with the carnage carrying over into November 2008. Most everyone has felt the ramifications: jobs lost, firms going under, and fear all around. No one made money during this time. Everyone lost. Hold on, is that really true? It is not true. There were winners during October 2008, and they made fortunes ranging from +5 percent to +40 percent in that single month.

Who were the winners? Trend followers. How did they do it? First, let me state how they did not do it:

1. Trend followers did not know stock markets would crash in October 2008.
2. Trend followers did not make all of their money from shorting stocks in October 2008.

What did they do? Trend followers made money from many different markets from oil to bonds to currencies to stocks to commodities:

• One fund run by John W. Henry & Co., founded by Boston Red Sox baseball-team owner John W. Henry, was up 72.4 percent through October 2008.
• TransTrend, a Dutch-based trend following trader managing more than $1 billion in assets, saw one of its funds go up +71.75 percent from January 2008 through November 2008.
• Clarke Capital Management Inc., led by Michael Clarke, saw its $72.2 million fund gain 82.2 percent through October 2008. Clarke, as but one example of his winning bets, shorted crude oil when it was around $140, and then stayed with the trade down to $80 before exiting, thereby collecting the bulk of the trend.
• Trend follower Bernard Drury started selling short S&P 500 index futures in November 2007. The index is down about 36 percent since and the largest Drury fund was up 56.9 percent through October 2008.10
• Paul Mulvaney, another trend following trader who has used a much longer timeframe in his trading (weekly bars), saw his fund post a 45.49 percent return for the month of October 2008—yes, in one month.

Answer the following five questions and you have the core components of a trend following trading system to potentially make that kind of money:

1. How does the system determine what market to buy or sell at any time?
2. How does the system determine how much of a market to buy or sell at any time?
3. How does the system determine when you buy or sell a market?
4. How does the system determine when you get out of a losing position?
5. How does the system determine when you get out of a winning position?

It comes down to putting your rules into an automated system that answers all 5 of those questions at all time. This style is all about a reactive form of technical analysis – coupled with a certain discipline and psychological grounding.

Let me conclude with a story about luck and skill. The firm Altegris has placed over $1 billion of client assets with assorted trend trading managers. The president of Altegris, Jon Sundt, postulated:

“Can a great trader have great skill and no opportunity to make money? Can a bad trader have no skill and tons of opportunity to make money? The answer is yes to both questions. Luck is at play in the short-term for most traders. There will always be ‘some guy’ with a great one-year return, but the sustained edge appears only over time.”

What’s Sundt’s big picture point? He wants you to think about what happens when the bad trader with no skills finally finds himself with no opportunity. If you don’t want to embrace his wisdom, you will eventually feel massive pain in your trading account.

There will always be critics, and there will always be cheerleaders. I, however, find solace in performance numbers and trend following’s massive performance numbers are the real story, the truth if you will.

Bottom line, no matter how many people agree or disagree with the content of this book, and I know there are big fans and big critics, positive performance numbers from trend followers, especially from historic months like October 2008, paint a picture you either accept or reject—it’s your choice.

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