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This chapter is from the book

Follow the Trend

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.”28

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 John W. Henry:

  • “...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 Messrs. Greenspan, Rubin, Summers, Miyazawa, or Sakakibara? 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.”29

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 Henry’s 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.”30

How does a trend follower implement Dennis’ 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.

Trend followers know that attempting to pinpoint the beginning of a trending market is futile. When trends begin, they often arise from a flat market that doesn’t appear to be trending in any direction. The idea is to take small bets early on in a market to see if the trend does, indeed, mature and get big enough to make big money. How do trend following strategies succeed? Michael Rulle of Graham Capital Management offers:

  • “The ability of trend following strategies to succeed depends on two obvious but important assumptions about markets. First, it assumes that price trends occur regularly in markets. Secondly, it assumes that trading systems can be created to profit from these trends. The basic trading strategy that all trend followers try to systematize is to ‘cut losses’ and ‘let profits run.’”33

I asked Charles Faulkner, a modeler of top traders, to expand upon what at first glance appears to be a simple idea:

  • “...the first rule of trading is to, ‘Cut your losses, and let your profits run.’ And then, that it’s the hardest thing to do. Seldom do any of them wonder why, and yet this is exactly where the efficient market hypothesis breaks down, and the psychological nature of the markets shows through. When we lose or misplace something, we expect to find it later. The cat comes back. We find our car keys. But we know a dollar on the street will not be there with the next person who passes by. So experience teaches us that losses are unlikely and gains are hard. ‘A bird in the hand is worth two in the bush.’ This is when I tell them that they earn their trading profits by doing the hard thing—by going against human nature. This is where the discipline comes in, the psychological preparation, the months of system testing that give the trader the confidence to actually trade against his natural tendencies.”

If cutting losses and letting profits run is the trend follower’s mantra, it is because harsh reality dictates that you can’t play the game if you run out of money. Nor can you predict the trend direction, as trend trader Christopher Cruden points out:

  • “I would prefer to finish with a certain currency forecast, based upon my own fundamental reading of the market and one that underpins my personal investment philosophy...The only problem is I can’t tell you when this will happen or which event will be first. On that basis alone, it seems best to stay with our systematic approach.”35

A good example of not letting profits run can be seen in trading strategies that take profits off the table before a trend is over. For example, one broker told me that one of his strategies was to ride a stock up for a 30 percent gain and then exit. That was his strategy. Let it go up 30 percent and get out. Sounds reasonable. However, a strategy that uses profit targets is problematic. The biggest problem is that it goes against the math of getting rich, which is to let your profits run. If you can’t predict the end or top of a trend, why get out early and risk leaving profits on the table?

For example, you start with $50,000. The market takes off and your account swells to $80,000. You could, at that point, quickly pull your $30,000 profit off the table. Your misconception is that if you don’t take those profits immediately, they will be gone.

Trend followers know that a $50,000 account may go to $80,000, back to $55,000, back up to $90,000, and from there, perhaps, all the way up to $200,000. The person who took profits at $80,000 is not around to take the ride up to $200,000. Letting your profits run is tough psychologically. But understand that in trying to protect every penny of your profit, you actually prevent yourself from making the big profits.

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