Trading Foundations: Brick by Brick

Have you thought about the bricks that go into the foundation of trading success?

Anyone who has had a little success investing and chalked it up to luck needs to be wary of falling into the trap of hoping Dame Fortune will look kindly on them a second time. They must consider increasing their odds of winning again by relying on a system instead of luck. Successful investing is neither easy nor obvious. But if you can find a system that gives you the critical edge in the trading process, why not take advantage of it?

What are some crucial components or building blocks of a great money-producing trading system?

• A system of comprehensive risk management including market exposure weightings, stop-loss provisions and capital commitment guidelines that preserve capital during trend-less or volatile periods.
• A way to limited risk of each position to a predetermined % of equity.
• A strategy for monitoring market volatility and adjusting trading size when risk and volatility exceed predetermined limits.

Keep in mind these key words from Richard Dennis:

Anytime the market goes up a reasonable amount – say a strong day's work – after you've put on a position, it's probably worth adding to that position. I wouldn't want to wait for a retracement. That is everyone's favorite technique - to buy something strong that retraces. I don't see any justification in the statistics for that. When beans are at $8.00 and go to $9.00, if the choice is to buy them at $9.00 or buy them if they retrace to $8.80, I'd rather buy them at $9.00. They may never retrace to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement.

While the trading basics don't change, providing context is always helpful. That said, consider some key lessons and insights that may help you to become a better trader:

ROBTv.com Interview

I did a quick 6 minute live interview today at 2:50EST for Report on Business Television, the Canadian version of CNBC. I did not get the feeling the interviewer was familiar with trend following trading completely, but I appreciated the opportunity to defend the strategy. I will try to put the video online here, but you can listen to the MP3 of the interview here. On a side note, the remote location's lights, where this was filmed in Washington, DC, are not good on the eyes!

Degree in Math?

A reader wants confirmation on pursuing a math degree for trading success:

"Michael, I have a feeling you're going to throw a dozen eggs at me for this question. I'm considering applying to Columbia's Master of Arts Degree in Mathematics with Specialization in The Mathematics of Finance. Will this give me more success in trading or can I do without it? Do many of the top traders have degrees in Mathematics? Regards, V."

I have no idea if a degree in math will help you or not. Trading is trading, math is math. There are plenty of great traders without math degrees and plenty of great traders with math degrees. I will not throw any eggs at you, but I did have a pretty strong throwing arm. That said, much more fun to throw a baseball than an egg!

Critic Misses Point

The following comments came in about Trend Following:

"One of the weirdest sections of the book is the author's critique of Warren Buffett, widely considered to be one of the greatest investors of the modern era. Covel calls Buffett a buy-and-hold investor and then proceeds to criticize buy-and-hold. Why denigrate buy-and-hold by making the claim that one of the greatest investors of all time is an example of the buy-and-hold approach? This undermines the author's argument that trend-following is better than the more passive buy-and-hold method, not to mention the fact that Buffett is actually a value investor."

This point doesn't make sense. Pages 202-204 of Trend Following indeed offer criticism of Buffett -- for specific reasons. More comments:

"Covel presents the results of numerous trend-following commodities traders. These include John Henry and Bill Dunn, among others. The author cites the performance results for several of these through June 2003, but does not include results since that time. This is interesting considering the fact that the new expanded edition was released in November 2005."

Incorrect. Performance in the book appendices is well into 2005. More comments:

"Covel compares commodity trading results to the S&P 500, but he's comparing apples to oranges. He should be comparing the results of commodities traders to commodity indices. Had he done so, it would be clear that many trend-followers' results have not been stellar in the last few years. Most commodity indices are up at least 20% per annum in the last 3 years. Jim Rogers' commodity index fund returned 19.6% in 2005, compared to an average return of -4.4% for twelve of Covel's trend-following "hall-of-famers."

Why the focus on the word "commodity"? Trend following is a strategy. It is not predicated on simply trading commodities alone. Trend followers trade financial instruments across the globe ranging from stocks to currencies to energies to wheat to gold to bonds. To refer to trend followers as "commodities traders" is naive and intentionally misleading in my opinion. A good comment from trend follower Jerry Parker. Lastly, picking the last 3 years of an "index" to compare to 30 years of a "specific strategy" doesn't make sense logically to me. More comments:

"I am a commodities trader and to some extent a trend-follower."

Once again, the point of saying "commodities trader" misses the point. Are bonds commodities? Are stocks commodities? Are currencies commodities? You say you are to some extent a trend follower, but your other writings state unequivocally that you are a trend follower. Which is it? More comments:

"I believe trend-following is a viable strategy, but it's not as easy as the author claims...I don't mean to be overly negative. The book has its merits. It is well-written and provides a useful introduction to the subject. However, Trend Following does not provide a balanced look at the subject it covers and the results cited are out-of-date. The author should have done a better job highlighting the challenges involved this methodology and that this type of approach is not appropriate for many investors."

Challenges? Trend Following spells out in detail the risks. It spells out drawdowns. It also spells out the potential large rewards. Who is trend following trading not for? Who should not have some portion of trend following in their portfolio? Of course, some out there will say, "why take the time to respond to rants?" I take the time to respond to comments, good and bad, as they can all be educational.

Bird Brains

A reader, Ken Keeling, writes:

"Most investors would be better off if they had a bird's brain. Consider a flock of Canadian geese flying in formation overhead. Flying in V formation allows them to fly faster than they could if they were all trying to fly home independent of one another. Aerodynamics explains it, but how many birds made it through a university? Then how the heck do they do it? After all a bird's brain is pretty small. Turns out complexity theorists have show that the V pattern can be explained by three simple rules:

Apparently birds' brains can handle these rules. Now it seems to me that trend trading's simple rules are like the bird's simple rules. However, humans get into trouble because they have the belief that simple rules must be wrong, or that we can 'do better' if we develop more complex rules. Too bad, because that is where many traders go wrong."

I like the example. The advantage of simple rules can never be stated enough!

Speculation Speech

Feedback about speculation:

"I read your site all the time, and anxiously await updates. While browsing the internet, I stumbled upon a speech that my grandfather gave in 1955. Growing up, I knew that my grandfather was a successful trader and member of the Chicago Board of Trade, but I always thought he was just a 'pit' trader. I was shocked to read this (PDF). I learned more information about his trading than I ever did from his children (my mom, aunt and uncle). He talks about an ever changing world, limiting losses & following trends. His statement "I believe that in our desire for security and in making our adjustments to changes, we all end up being speculators", really floored me and gave insight into my own trading. As you say, trend following is nothing new."
Tim Skarecky

You can read the PDF Tim refers to here (PDF).

Conclusion

I always welcome feedback. If you think I hit the mark, drop a line. If you think my logic is faulty or flawed, I want to hear from you. It is all about education and we can all learn from each other.

Michael W. Covel is the founder and President of Trend Following. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition (Prentice Hall, November 2005) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at TurtleTrader.com, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.