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Author Note
What makes a great trader? Turtle Trader author explains trend following
Michael Covel - May 15, 2008
Originally profiled in the book ‘Market Wizards’ Larry Hite is a noted hedge fund manager with a long career. One of Hite’s strengths is his ability to break down the complicated for the layperson. He sees trading and speculation in these stark, but simple terms: “Every bet that we make involves a trade-off based on a decision to pay or risk something of value (time, money, emotional involvement, a bunch of bananas) for the uncertain prospect of gain. Placing winning bets in investing, as in life, therefore requires the development of a strategic ability to make better bets (i.e. critical tradeoffs) between and among financial and non-financial outcomes. Where most of us tend to trip up, often unwittingly, is when we fail to grasp the complete extent and true nature of the tradeoffs implicit in what always come down to choices.”
While Hite nails head on where our energies should go (risk management), the unfortunate reality is that everyone seems to focus on “other” issues. And of all of these other trading issues, we seem to spend the most time debating fundamental analysis v. technical analysis. It is an argument that may be the single biggest dividing line between the average investor and the professional long time winning hedge fund manager.
Before adding fuel to this already overheated fire, it is useful to pin down the jargon with a couple of definitions. In my book Trend Following, I define fundamental analysis as the study of external factors that affect the supply and demand of a particular market. Fundamental analysis focuses on factors like weather, government policies, domestic and foreign political and economic events, price-earnings ratios, and balance sheets to make decisions. By monitoring supply and demand factors, or “fundamentals” for a particular market, it is supposedly possible to predict a change in market conditions before that change has been reflected in the price of the market. The vast majority of Wall Street is clearly a proponent of fundamental analysis.
Technical analysis operates in stark contrast to fundamental analysis. It is based on the belief that, at any given point in time, market prices reflect all known factors affecting supply and demand for that particular market. Instead of evaluating fundamental factors outside the market, technical analysis looks at the market prices themselves to make decisions. Technical traders believe that a careful analysis of daily price action is an effective means of capitalizing on price trends. However, the understanding of technical analysis gets tricky. There are essentially two forms of technical analysis. One form is based on an ability to “read” charts and use “indicators” to divine the market direction. These so-called technical traders use methods designed to attempt to predict a market direction.
Prediction, whether fundamental or technical is not what great traders do.
On the contrary, great traders technically ‘react’. Instead of trying to predict a market direction based with some form of technical analysis, their strategy is to react to the market’s movements whenever they occur. These traders make decisions based on what has happened rather than anticipating what will happen. They keep their strategies based on statistically validated trading rules. This enables them to focus on the market’s movement and not get emotionally involved with the unknowns of predictive technically analysis or for that matter fundamental analysis.
However clear these definitions may appear on the page, the sad truth is that for most people, Jim Cramer and his nightly fundamental “calls” is still the advice that “sounds” most credible. For them reality is a smart man with an overwhelming amount of information about every company under the sun. He appears to be able to look into the future and make seemingly sound predictions. Why not buy into Cramer’s Mad Money advice every night? There are problems. Consider feedback from one of my blog readers Chuck Cain:
"What do fundamental analysts analyze? It doesn’t make sense to base an analysis on data containing errors. Example? Banks can set earnings in quite a wide range by changing this period's addition to 'reserves for loan losses'. You wouldn't believe what gets done to this poor number when the trial balance bottom line doesn't look good. The IRS won't let banks use this number; the IRS requires actual loan losses, instead. It doesn't make sense to base analysis on numbers which are made up. Example? Worldcom, Enron, enough said. Why base analysis on numbers that have a high margin of error? How useful would it be for a friend to give you a phone number for a dream date without telling you that he’s only so confident that the area code is correct? How do fundamental analysts know which numbers are wrong, are estimates, have large error margins, or are completely bogus? What is fundamental analysis worth if these numbers aren't screened out? If they are screened out, what's left?" Michael Gibbons, a technical trader who reacts to price movement, expanded on the old saying, “garbage in garbage out”: “I stopped looking at news as something important in 1978. A good friend of mine was employed as a ‘reporter’ by the largest commodity news service at the time. One day his major story was about sugar and what it was going to do. After I read his piece, I asked: ‘Gary, how do you know all of this?’ I will never forget his answer...he said, ‘I made it up.’”
Haven’t you ever felt that way when hearing some fantastic Wall Street prediction? Deep down you heard the prediction and knew it was BS, but were just afraid to say so!
At the end of the day instead of trying to assemble all of the fundamental analysis that purports to tell you why and what price is doing, why not just follow price from the beginning and make decisions off that? No matter how intense the fundamental versus technical analysis debate becomes there are still, as Larry Hite would remind us, only three critical issues to making money:
1. What can I win?
2. What can I lose?
3. What are the probabilities of each outcome?
And the traders who think like that are best known as ‘trend following’ traders. I have written two books that feature the term ‘trend following’ heavily (‘Trend Following: How Great Traders Make Millions in Up or Down Markets’ and ‘The Complete TurtleTrader’), but for many the term is a problem. For example, here are assorted trading style descriptions I pulled from the websites of trend following traders.
Winton Capital, a $10 billion dollar fund run by David Harding, states their style:
“Winton Capital employs a quantitative trading system based on mathematical algorithms derived from advanced statistically based research into historical price movements.” A smaller fund run by Cole Wilcox frames their trading this way:
“Our firm Blackstar Funds, LLC manages a multi-advisor commodity pool that invests primarily in systematic, long-volatility programs. We focus mainly on trend following programs from the commodities, financial futures and currency trading arenas, as they tend to be the most systematic in terms of trading and portfolio management.” Christian Baha’s billion plus dollar fund emphasizes international diversification:
“Superfund Capital Management makes each…trading decision using fully automated, computerized proprietary trading systems, which trade in more than 100 futures markets, which automatically send buy and sell signals, and constantly monitor relevant risk factors on the traded futures markets in the U.S., Canada, Europe and Asia. By using an automated system, human emotions are completely eliminated from the capital management process.” EMC Capital’s Liz Cheval (One of two female Turtles trained under Richard Dennis) is brief, but specific:
“EMC employs a systematic technical model for investment.” Campbell and Co., a firm with thirty years of producing above average returns, is clear about their strategy:
“We invest in a multitude of markets and instruments including global interest rates, equities, stock indices, currencies, energy and assorted commodities. We use futures, forward and option contracts as well as long and short positions to capture trends or exploit inefficiencies in the markets. All of the markets in which we trade have a high degree of liquidity and transparency.” And finally, in my quick tour of websites, Salem Abraham is not shy about how he does it at his shop:
“Abraham Trading Company’s trading methodology is a systematic, multi-system approach implementing filtering techniques that avoid trades with adverse risk/reward characteristics. While the goal is to capture profits, the system only enters the market during periods when the risk/reward of a trade is heavily in the trade’s favor. If unacceptable risk characteristics exist, the system will even avoid trades that have a positive profit expectation.” Even though I have achieved some level of niche recognition for making the phrase ‘trend following’ more widespread, the term just does not paint the whole picture and in many instances confuses people. For example, trend following traders are trying to answer these five trading system questions at all times:
1. What is it 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?
Here are ways to answer these questions:
1. What is it the state of the market? The state of the market simply means. “What is the price that the market is trading at?” If Microsoft is trading at 40 a share today, then that is the state of that market.
2. What is the volatility of the market? All traders need to know on a daily basis how much any market goes up and down. Two markets priced roughly the same are very different is one goes up and down 10% of a given day versus 5%. You need to know that.
3. What is the equity being traded? Trend followers must know how much money they have at all times, because every decision must be made on how much you have now, not what you used to have.
4. What is the system or the trading orientation? Trend followers use precise rules to tell them when to buy or sell any market at any time based on the movement or trend of the market price.
5. What is the risk aversion of the trader? For example, if you have $10,000 in your account, should you bet all $10,000 on Google stock? No. Betting 2% of your account on a trade is more sensible.
The next time you hear some talking head make a prediction or forecast, pause and consider those five questions. I can guarantee you that those traders who make the big money answer them everyday at all times.
Bio: Michael Covel is the author of the bestselling Trend Following. His latest book The Complete TurtleTrader is the first complete look at Richard Dennis’ famous turtle trading experiment – a revealing look at nature versus nurture. Covel has presented on the topic of trend trading and hedge funds from China to Japan to Europe to the United States. He is currently producing his first film documentary an edgy examination of investor behavior set for a 2008 theatrical release.
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