DAVE: Hi Michael, Welcome to Real World Trading.

MICHAEL: Nice to be here.

DAVE: Lets get started by defining the term ‘Trend Following.’ What exactly do you mean??

MICHAEL You know, there is a good definition in the book by Van Tharp. I will simplify the definition even more. If a market is trending up, you want to be long that market, trading that market as it goes up, as far as it might go up, so you’re following that trend. On the flip side, if the market reverses and goes South, you want to be following it that way. It’s the idea to follow the trend of the market, up or down.

DAVE: That sounds simple enough, but how does it differ from a buy-and-hold philosophy? Markets have a long-term up-trending bias. Why not just call Trend Following “buy and hold”?

MICHAEL: Jerry Parker, one of the great trend followers profiled in my book, calls “buy and hold”, “buy and hope”. Buy and Hold is totally different from Trend Following.

DAVE: OK, explain the difference to me.

MICHAEL: When you say “buy and hold,” you are really saying “OK, I’m going to make a bet on the market, I’m going to get in.” However, you don’t have an exit strategy if you are wrong. Warren Buffet is one of the kings of buy and hold He is tremendously successful, but he is not a Trend Follower. Think of the little old lady from Omaha that bought Drugstore.com in the spring of 2000 on a buy-and-hold approach and then it cratered. So I think it’s the not having an exit strategy that what really causes problems for traders.

DAVE: It’s having an exit strategy that differentiates your concept of Trend Following from the basic Warren Buffet type “buy-and-hold” idea. Is this correct?

MICHAEL: That’s one. I think another thing is that Warren Buffet talks a lot about value, and trying to ascertain the value of an asset that you might be investing or trading in, where trend followers say, gosh, I really don’t care the name of this market--what it is, I don’t care about the fundamentals--just let me ride that trend.

DAVE: Your book reads like a who’s who of famous traders. Are all the traders profiled in the book trend followers?

MICHAEL: Most are, one example of a gentlemen who I quote from is Jim Rogers. He is not a trend follower per se, but I would argue that the money he has made has been made by riding some mammoth trends.

DAVE: Right, he is sort of a trend follower by default. Is this what you mean?

MICHAEL Correct, but he is obviously a fantastic trader in his own right.

DAVE: One of the primary concepts in the book is that price tells one everything they need to know about how to trade. Can you elaborate?

MICHAEL Well, a lot of decision-making theory and behavioral finance theory emanating from the universities is now starting to back up what trend followers have always known. Which is, you can’t fit a world filled with so many variables. I mean, let’s say you want to trade Microsoft. What do you focus on to trade it? Do you focus on the news reports on CNBC? Do you focus on Bill Gate’s statements, PE ratios, some type of metric that you’ve determined, so how in the world, where you got all these variables, can you condense it to one variable where you can make all of your decisions off one variable, a variable that encompasses everything you need to know about that particular market in real time? In real time the only thing that any of us can know on any given day is the price of that market. It reflects all the fears, hopes, directional biases, whatever is reflected in that one number. For trend followers, they want to say I want to follow the trend of that market. I’m going to look at that market price to tell me the trend, I’m not going to try to predict that trend, can’t predict it, how can I predict it, none of us can predict anything, but trend followers say I’m going to look at that market price each day and if that market price each day starts at ten and it goes to twelve and it goes to fifteen and it goes to twenty, well that price is telling you something.

DAVE: OK, do trend followers use any other indicators other than price to determine trend? Something like a moving average?

MICHAEL Well, the trend followers I discuss in the book are obviously technical traders by nature.

DAVE: Right.

MICHAEL When analyzing price, they will use various indicators to get themselves into a trade. It could be a moving average, it could be a break out. Most of them probably prefer a breakout, you know, something that’s not delayed, or not a lag, so looking at that price movement right then and there. The trick is with trend followers, they don’t look at an indicator and say ”I’m going to use x, y and z indicator which will predict further movement.” Trend followers say, “OK, when our indicator moves in a certain direction we will react to either the up or down price movement in real time to take a position, but we’re not looking at a moving average and saying to ourselves that it’s going to predict how far that move is going to go because no one knows how far the move is going to go. Me, you, the guy behind the tree, no one knows.”

DAVE: Regarding Trend, you quote Paul Tudor Jones’ ex chief technical guy –Peter Borish. Peter is extremely intelligent. What are his views on price?

MICHAEL: Peter believes that price makes news, not the other way around.

DAVE: All right, so this goes back to your idea that price is all you need to know. Can you give us an example of price making news?

MICHAEL: Well sure, look at last year. Last year we had all the cattle, cattle went up by the time cattle got the highs people were blaming it on mad cow, or the Atkins diet and so forth. You know the price had gone up and then they invented the news stories to fill in why the price had gone up.

DAVE: I tend to agree with that. It’s an interesting perspective. I think that you were probably the first person that’s ever really tried to quantify trend following and I found that really fascinating. You took a list of performance data and applied it to these famous trend following traders. Can you elaborate on this?

MICHAEL: I think you hit something, you hit you hit the nail on the head there and I think when you have that light bulb go off and you can look at several different examples. Look at Long Term Capital Management. They started to have real trouble in the summer of 1998 and it’s all over the news, the major publication, the feds involved, all the major New York banks are involved, but nobody was really writing the story at the time of guess who’s making billions.

DAVE: Right.

MICHAEL: The performance data reflects that the trend followers were reaping the rewards of the LTCM debacle.

DAVE: OK, moving on here, is volatility a friend or enemy of the trend-following trader?

MICHAEL: Volatility is really a friend of almost any trader. If you don’t have volatile markets, there is no movement. Volatility could also be the precursor to movement, but you know, trend followers need volatility, they need movement.

DAVE: You also put forth the concept that trend following reflects and profits from the fact that markets are a zero-sum game. What do you mean by this?

MICHAEL: Well I think, in its truest sense, the idea of a zero-sum game is two players playing the game and there’s going to be a winner and a loser and the wins will come from the losers. A really great example of this in the last ten years, a really stark example would be John Henry and Barings Bank.

DAVE: Do you mean the Nick Leeson, the “rogue trader”example? Where he almost busted the Queen’s bank?

MICHAEL: Yes, that is what I am referring to. John Henry was the leader in this win. He basically was on the other side of Leeson’s trades. By following his trend system, Henry was able to capture much of Leeson’s losses. People don’t like talking about the markets being a zero-sum game since many feel that it is wrong .

DAVE: Wrong? You mean like unethical?

MICHAEL: Correct. I know you mentioned your friend Jonathan Hoenig before we started the interview. I am sure he has a few comments on this issue.

DAVE: For sure. Any objectivist, Libertarian would have an issue with the concept of zero sum being unethical.

MICHAEL: The markets are just a creation where we can all and play. The market has rules and I mean sometimes people will say, oh the shorts sellers, those short sellers messed everything up. You can go long in the market, you can go short in the market. Those are the rules. And doing my research, my homework, you just got to look at this and say objectively, why would you criticize somebody because they went into the market and they just happened to be a little better than you at it, they worked a little bit harder, they studied a little bit more, and they just knew they could play the game a little better than you, so when they happened to beat you, all you can do is turn around and criticize them for winning.

DAVE: Yes, I think that criticism of winners is unfortunately part of the culture today.

MICHAEL: Responsibility is not a positive word anymore, blame seems to have become the word of the day and it’s unfortunate but you know from a market standpoint, from a trend-following standpoint, its just not our issue.

DAVE: I would take the zero-sum game idea one step further, saying the markets are actually a negative sum game. This is due to the vig, or commissions on every transaction.

MICHAEL: Good point.

DAVE: When you lose, you lose what you decided to bet, plus the commission. When you win , you win minus the commission or vig.

MICHAEL: Absolutely correct.

DAVE: And you actually win less than you win.

MICHAEL So it means you have to account for the extra part.

DAVE: Right.

DAVE: So you’re actually behind the 8 ball from the beginning.

MICHAEL: I think you bring up a good point in the sense that most people probably don’t like to think of the fact that when they make a decision in the marketplace that their correct decision could invariably be taking money from the person that made the incorrect decision.

DAVE: Unfortunately, that is the nature of the market. If someone feels this way, they should not be trading.

MICHAEL: Sure.

DAVE: I know you mention Victor Niederhoffer and his questioning of trend following. Victor’s fund has been performing extremely well lately, and most of the trend followers you profile are having tremendous draw downs currently.

MICHAEL: I was not aware of Niederhoffer’s recent performance, but yes, you are correct, several of the big-name trend followers are having a draw down this year.

DAVE: Why is this? If these guys follow the trend, they are obviously on the wrong side of it now. Can you explain this seeming contradiction?

MICHAEL: Drawdowns are not uncommon for trend followers. It’s the nature of the beast. For example: one of the greatest trend followers--Bill Dunn of Stewart, Florida--is notorious for having drawdowns. He is having one right now. However, when you look at Bill’s performance data, you say okay, do I want to be with a man you know that can, from an equity peak drawdown 30 or 40 percent, but then when he recovers, he goes up another 100 percent? See, that’s the thing with trend following—it’s about absolute returns.

DAVE: What do you mean by absolute returns?

MICHAEL: Absolute returns would simply just mean we are in this to make the most money possible.

DAVE: Okay, over a certain period of time?

MICHAEL: Correct.

DAVE: Okay.

MICHAEL: Trend followers like John W. Henry or Keith Campbell at Campbell and Company, or Jerry Parker at Chesapeake Capital, or Bill Dunn at Dunn Capital. Okay, however these men have all been trading for over twenty years. So it’s not uncommon to have a draw down. It’s the nature of the beast. When markets don’t trend, which there has been a lot of choppiness this year, trend followers can’t make money, but when you go ahead and you start to compare some of these numbers, the absolute return numbers of-- let’s say at like Dunn capital versus the S&P--those numbers start to make quite a big difference over the long haul.

DAVE: I find your concept of trading systems in Chapter Ten of the book very fascinating, particularly the part about getting out of a losing position. Can you elaborate on that a little bit on your rules, or your concept of getting out of a losing position and then getting out of a winning position?

MICHAEL: Well for example, let’s just take a step back. Let’s assume you’ve gotten into the market. If the market doesn’t go your direction, you know you have to have a system for getting out. So if you get in and let’s say you place a two percent bet.

DAVE: OK, go on.

MICHAEL: Well, you know if it goes against you and you lose two percent, you’ve got a choice. Do you follow your rules and you get out, come back to play another day, or do you lose the two percent and sit there and say if I just hang on, it’s going to come back, or maybe it goes down another two percent, say well if I hang on, it might come back? That’s the nature of trend following, when you enter the market, this gets back to the lack of prediction. When you enter the market, as a trend follower, you can’t predict the direction. So you’re going to have to make these small little bets and see if the market goes your way. If it doesn’t go your way, which is essentially what’s happened for this year, you’re going to end up with a lot of small losses that can add up to equal your draw down.

DAVE: That seems to make sense. Now, how does a trend follower handle a winning trade?

MICHAEL: Getting out with a win, trend followers will say, okay, I’m going to come to this market, I’m going to place my bet, let’s say, I only want to risk two percent, the market starts to go up, let’s say for a long trade, the market’s starting to go up, it goes in your direction, and it just keeps going your direction. And let’s say you got in a stock and you got in at a level of 10 and it goes up to 50.

DAVE: OK, then what?

MICHAEL: You’re sitting there and you’re saying ‘Gosh what do I do now?’ I mean it’s gone up, it has gone from 10 to 50. Man, I’ve done well. Should I take my money off the table, should I have a profit target? The trend followers would say, no, just sit there because you don’t have any idea how high that market is going to go.

DAVE: Right.

MICHAEL: So sit there and let that market go and reach its peak. And then when it reaches its peak you’re going to have a rule that says okay, I will get out after the market has reached a peak and starts to retrace. Trend followers never get in the exact bottom of a market, because you can’t predict the bottom.

DAVE: Right.

MICHAEL: Look the other way going short. You know you’re shooting for the middle of a trend and there’s a little chart in my book, kind of a crude little chart that just shows they’re shooting for the middle of a trend.

DAVE: Now is this where a concept of trailing stops comes into play?

DAVE: Well, I think you probably have some argument amongst trend followers, perhaps some used trailing stops, perhaps they don’t, a lot of great trend followers would say, once again, let’s pretend that we’re talking about a long trade, and you get into that market and the market starts to move up, and then you say to yourself, okay, where do I want my stop to be? If you get in at 10, the market goes to 20, are you going to move your stop up to below the 20, or are you going to leave it down at the 10? A lot of great trend followers will say, you know, we’re going to get in and we’re not going to have a tight stop, because markets are often very volatile, in terms of the up side, trend followers typically have a lot of upside volatility, meaning. Often you would have been better off just letting the market naturally ebb and flow within your diversified portfolio.

DAVE: Let me go over what you’ve taught us so far. Trend following is different from buy and hold because you have an exit in mind, you just don’t hold through anything. Secondly, be prepared to take a lot of small losses before you catch a big trend.

MICHAEL: Correct.

DAVE: Do these trend followers have a number on these small losses? Do they try five times and then you say it’s not a trend?

MICHAEL: Well, you can have different trend followers with different strategies, but ultimately when the market moves, most of them are going to be getting on board. So for example, let’s say they’re following a particular bond or interest rate, and they’ve been stopped out six times in a row. I mean what you can’t do, you can’t really say to yourself if you’ve done your homework, you’ve done your research, you’ve traded this way for a long time, you know it works, and you have the confidence, you can’t say to yourself, midstream, okay, uh I had six small losses in a row, I have now lost 15 percent of my money, I give up, I’m going to go back to buy and hold. I mean, you have to believe in what you’re doing and be well researched.

DAVE: Right.

MICHAEL: You know, the last thing I want someone to do is to read this interview and say I’m going to just fly off and start trend following tomorrow. I mean, that would be a big mistake. They really should do their homework first. You want to find out how a particular trading method, trading system, a trend following trading system would have performed over the long term, you want to you’re your confidence in it. So, when the situation you describe happens, you don’t panic.

DAVE: Right.

MICHAEL: Likewise, it gets back to a diversified portfolio also, because you and I and your readers, we all know really quickly, if you’re only trading one market and you get a string of small losses in a row, you can have the mother of all drawdowns really fast.

DAVE: Right. Speaking of a diversified portfolio, how much money is needed to really diversify to catch the trends, It seems to me it would require a larger sum of money than the average day trader. Is that accurate?

MICHAEL: What do you mean?

DAVE: To have a properly diversified portfolio to take advantage of these trend-following ideas takes lots of capital.

MICHAEL: It’s going to really depend on the markets you follow. For example, there’s a new exchange coming online called Hedge Street. Hedge Street has been working for five years to get permissions and they’re going to have their CFTC permission, NFA permissions and all. It’s a group put together out in the Stanford area and the point is they’re going to be shooting for markets of much smaller sizes, so I think it really depends in terms ultimately what you assemble in your portfolio. I think if you look back in history some, and some of these account sizes go back a few years, but John Henry, if you could go back through his public disclosure document, and you could look at his original program you know it was funded with $16,000 in that account and that was what he got started with.

DAVE: Wow, that’s really a success story.

MICHAEL: Sure. And Ed Seykota’s famous client that started with $5,000. So I think if you can create reasons why something can’t work as opposed to looking at the overall strategy. For example, you brought up day trading.

DAVE: Right.

MICHAEL: Start to make the comparison in your mind as to what trend following is, you know and then make it the comparison in your mind as to what day trading is and then if you really start to make those comparisons, I think people are hard pressed not to say well, gosh, you know, when I do all my homework in day trading, to me it feels like the really successful day trader has to be someone like Jim Simmons at Renaissance or Citadel, these folks that have got hundreds of people on staff.

DAVE: Right, you’ve mentioned this Ken Griffith.

MICHAEL: Right. Millions of dollars of computer equipment and they’re arbing off little incremental moves that the average person can’t even see, let alone compete with.

DAVE: Right, but it takes a certain type of person.

MICHAEL: It takes a certain type of person. You bring up the idea of what Long Term Capital Management was all about. I mean one of their principles said you know the idea of our strategy unlike trend followers, you know trend followers are trying to hit the big home run. You know, they’re saying, I’d rather have a bunch of strike outs and a big home run, because I’ve done my homework and I know that works better over the long run.

DAVE: Right, exactly.

MICHAEL: You know that strategy at some point and time. If that strategy is predicated on having a only a 100 year flood, which their strategy was predicated on, but in the real world you often have the 100 year flood, every three to four years, those kinds of strategies that look like they’re low risk, really aren’t low risk.

DAVE: Right, right. I believe Naseem Taleb gets into that idea.

MICHAEL: He does, very bright guy.

DAVE: Very bright guy. What is your opinion on his randomness theory? Perhaps these successful trend followers are simply aberrations , the black swans of success.

MICHAEL: Umm. But I think there some commonality in the thought process and he’s got the idea of a black swan or an outlier. You know the situation where you can have where you’re saying, gosh, umm you know you know how could anyone have predicted that in the summer of 1998 LTCM would have blown up.

DAVE: Right, no, there’s no way.

Mike How can you predicted these unexpected events like LTCM? I think that’s what he’s really going for also as he’s getting people to realize that you know the world unlike, unlike the Nobel prize winners at LTCM that they wanted a nice, nice tidy market place. Everything was neat, clean and there were never any ripples in the current.

DAVE: Right.

MICHAEL: You know, he’s saying quite clearly there are ripples and when they when they happen, boy they can shake everybody out. You have got to be prepared for it.

DAVE: Absolutely. Is there anything you would like to leave our readers with?

MICHAEL: A lot of people have probably heard the term trend following, but what I try to do with this book is through the of interviews and research is to give people kind of a holistic view on it. I think there are a lot of people out there that say, I don’t see my magic indicator in the book. Or I don’t see any magic formula. I think, Ed Seykota is really pointing to the numbers and the math is very important. Right you’ve got to have the system, you’ve got to have the approach, then once you have that down, it really becomes 90% mental. I really want your readers to understand that you know trend following is as much a trading strategy that you can computerize and put into trading recipes or wealth lab. It is also a philosophical psychological approach to the market. And that is often as tough as anything. It is really important to question yourself. Here is an example, Have I got my emotions in check? Have I really thought through the psychology of this? How is my decision making? Can I stomach a draw down? You know and not only can I stomach a draw down, can I believe in the rebound. Can I believe in my strategy? Versus the person who is jumping from strategy to strategy, picking up losses all along the way, and probably never really adding all of those losses up. You know, just bouncing, just looking for the next Holy Grail, looking for the quick fix, when in my research, I just couldn’t find the quick fix I couldn’t find the holy grail or the market secret. It, it doesn’t seem to be there.

DAVE: It doesn’t, I agree. Well thank you very much for joining us today Michael. It’s been it’s been a pleasure.

MICHAEL: I appreciate the time.