Famed Stanford University psychologist Leon Festinger once said, "A man with a conviction is a hard man to change. Tell him you disagree and he turns away. Show him facts or figures and he questions your sources. Appeal to logic and he fails to see your point."
Although trend following has been one of the most successful trading strategies for decades, some critics downplay the massive profits accumulated by trend followers, arguing there are just a few chance winners -- "lucky monkeys," they claim.
BEAT THE AVERAGES
Not true. Large numbers of trend followers have found a way to outpace market averages. They have done so with hard work and the ability to stick with a trading plan -- usually for a very long time. Some argue, "There's no romance in trend following." The romance is found in returns. Money is the ultimate aphrodisiac.
Think of it this way: Performance data examples from the great trend followers could be the foundation of every college finance class. When you show up on the first day, instead of your teacher handing you a syllabus and telling you to buy certain books, you are handed one piece of paper that simply shows the performance histories of professional trend following traders for the last 50 years.
The entire semester could be built around that study alone. But first, to judge systematic trend following performance, you need a baseline. The S&P 500 is the barometer for making money in the markets. Comparing to it is wholly appropriate (even though some might carp). Who are some of the top-performing trend following traders over the last 30 years? How much have they made? Consider:
o Bruce Kovner is worth more than $4.1 billion
o John W. Henry is worth $840 million
o Bill Dunn made $80 million in 2008
o Michael Marcus turned an initial $30,000 into $80 million
o David Harding is now worth more than $690 million
o Ed Seykota turned $5,000 into $15 million over 12 years
o Kenneth Tropin made $120 million in 2008
o Larry Hite has made millions upon millions over 30 years
o Louis Bacon is worth $1.7 billion
o Paul Tudor Jones is worth $3 billion
o Transtrend, a trend-trading fund, has produced hundreds of millions, if not billions, in profit
Where do you start? The trend. What is a trend? The question has hit me for over a decade. You don't spot trends. You don't find trends. You react to market movements, and hopefully at the end of a big move, a big trend, you will have made great money from that big trend.
Consider an example to better make my point. A new trader asked: "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?" One old pro trend trader responded: "Your list lacks 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. 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."
All trends are historical. None are in the present. There is no way to determine a current trend, or even define what current trend might mean. You can only determine historical trends. And the only way to measure a now trend, one entirely in the moment of now, would be to take two points, both in the now and compute their difference. However, with that limitation in mind, you can proceed to define, compute, and use trends. That's no philosophical word smithing. It is critical that you let the distinctions sink in.
BUILD YOUR SYSTEM
Now, let's get practical. Answer the following five questions and you have a trend following trading system:
1. What market do you buy or sell at any time?
2. How much of a market do you buy or sell at any time?
3. When do you buy or sell a market?
4. When do you get out of a losing position?
5. When do you get out of a winning position?
Said another way:
1. What is the state of the market?
2. What is the volatility of the market?
3. What is the equity being traded?
4. What is the system or the trading orientation?
5. What is the risk aversion of the trader or client?
IT'S BLACK OR WHITE, NO GRAY
You want to be black or white with this. You do not want gray. If you can accept that mentality, you have got it. Some might say, "Oh, I have a system." What he typically means is that he has a system, and it advises him what to do. If he likes the advice, he'll take it, and if he doesn't like the advice, he won't take it. If you're going to trade using a system, you must slavishly use the system and avoid discretionary overrides. You do what the system says no matter how smart or dumb you feel at that moment.
RIDE THE TREND
Trend following at its root is simply an idea. It's a trading philosophy with rules for making buy and sell decisions in any market. A trader takes an idea, turns it into a mathematical formula and tests it to see if it would have made money. A good trend following trading system doesn't buy low and sell high; it rides trends. Trend followers don't get entry or exit signals and apply some extra layer of 'human judgment.' They don't try to be smarter than the system.
Bottom line, trend following is about putting the odds on your side and winning in the long run. That's a goal we should all strive for.
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