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Statistical Thinking: Trend Following Principle

Larry Hite said it straight:

“I have noticed that everyone who ever told me that the markets are efficient is poor.”

To comprehend trend following’s true impact, you have to look at trend followers’ performance data, the returns they generate. Their performance data makes clear that they were the winners in the biggest trading events, bubbles, and crashes of the last 30 years.

Wall Street is famous for corporate collapses or mutual and hedge fund blow-ups that transfer capital from winners to losers and back again. However, interestingly, the winners always seem to be missing from the after-the-fact analysis of the mainstream media. The press is fascinated with losers. Taking their lead from the press, the public also gets caught up in the drama and narrative of the losers, oblivious to the real story: Who are the winners and why?

Occasionally, the right question is asked: “Each time there’s a derivatives disaster, I get the same question: “If Barings was the loser, who was the winner? If Orange County was the loser, who was the winner? If Procter & Gamble was the loser, who was the winner” (source: Herb Greeenberg, Answering the QuestionWho Wins From Derivatives Losers. The San Francisco Chronicle, March 20, 1995, D1)?

Prominent academics in finance searching for winners also come up short, as Christopher Culp of the University of Chicago laments: “Its a zero-sum game. For every loser there’s a winner, but you cant always be specific about who the winner is.” When the big trading events happen, many people know the losses are going somewhere, but after time passes, they stop thinking about it. Reflecting on the unknown is not pleasant, as author Alexander Ineichen notes: “Fear is still in the bones of some pension fund trustees after Mr. Leeson brought down Barings Bank. The failure of Barings Bank is probably the most often cited derivatives disaster. While the futures market had been the instrument used by Nick Leeson to play the zero-sum game [and] someone made a lot of money being short the Nikkei futures Mr. Leeson was buying.”

Someone did indeed make a lot of money trading short to Leesons long. Perhaps Wall Street looks at the issue through the wrong lens. Michael Mauboussin and Kristen Bartholdson know that standard finance theory comes short when explaining the winners during high impact times: “One of the major challenges in investing is how to capture (or avoid) low-probability, high-impact events. Unfortunately, standard finance theory has little to say about the subject.” The unexpected events that everyone refers to are the source of big profits for trend followers. Big, unexpected events made David Harding, Christian Baha, Transtrend, Sunrise Capital, Michael Clarke, Bernard Drury, Paul Mulvaney, Bill Dunn, Salem Abraham, Bill Eckhardt, John W. Henry, and Jerry Parker (to name a few) rich.

Trend trader Michael Rulle explains trend followings success during uncertain times:

“For markets to move in tandem, there has to be a common perception or consensus about economic conditions that drives it. When a major event occurs in the middle of such a consensus, such as the Russian debt default of August 1998, the terrorist attacks of September 11, 2001, or the corporate accounting scandals of 2002 [and the 2008 equity market crash], it will often accelerate existing trends already in place…events do not happen in a vacuum… This is the reason trend following rarely gets caught on the wrong side of an event. Additionally, the stop loss trading style will limit exposure when it does. When this consensus is further confronted by an event, such as a major country default, the event will reinforce the crisis mentality already in place and drive those trends toward their final conclusion. Because trend following generally can be characterized as having a long option profile, it typically benefits greatly when these occurrences happen.”

However, big events also generate plenty of inane analysis by focusing on unanswerable questions such as those posed by Thomas Ho and Sang Lee, authors of “The Oxford Guide to Financial Modeling”:

  1. What do these events tell us about our society?
  2. Are these financial losses the dark sides of all the benefits of financial derivatives?
  3. Should we change the way we do things?
  4. Should the society accept these financial losses as part of the survival of the fittest in the world of business?
  5. Should legislation be used to avoid these events?

It is not unusual to see people frame market wins and losses as a morality tale. These types of questions are designed to absolve the guilt of the market losers for their bad strategies (i.e. Amaranth, Bear Stearns, Bernard Madoff, etc.). The market is no place for political excuses or social engineering. No law changes human nature. If you don’t like losing, examine the strategy of the winners. The performance histories of trend followers during the 2008 market crash, 2002 stock market bubble, the 1998 Long- Term Capital Management (LTCM) crisis, the Asian contagion, the Barings Bank bust in 1995, and the German firm Metallgesellschaft’s collapse in 1993, answer that all important question: Who won?

Inefficient Markets

The hedge fund Long Term Capital Management (LTCM) went bust in 1998, and that event is more relevant today than ever. It laid the foundation for government induced bubble/bailout schemes still employed daily. LTCM promised to use complex mathematical models to make investors wealthy beyond their wildest dreams. It attracted elite Wall Street investors and initially reaped fantastic profits with secret money-making strategies. Ultimately, its theories collided with reality.

To understand the LTCM debacle, it starts with two academic legends: Merton Miller and Eugene F. Fama who developed the Efficient-Markets Hypothesis. The premise of their hypothesis was that stock prices were always right so you could not divine the markets future direction. It assumed that everyone was rational (source: Roger Lowenstein, When Genius Failed. New York: Random House, 2000, p. 34).

Miller and Fama believed that perfectly rational people would never pay more or less for a financial instrument than it was actually worth. A colleague, and fervent supporter of the Efficient-Markets Hypothesis, Myron Scholes was also certain that markets could not make mistakes. He and his associate, Robert Merton, saw the finance universe as tidy and predictable. They assumed that the price of IBM would never go directly from 80 to 60 but would always stop at 79 3/4, 79 1/2, and 79 1/4 along the way (source: Lowenstein, When Genius Failed, p. 69). LTCMs founders believed the market was a perfect normal distribution with no outliers, no fat tails, and no unexpected events.

Once Wall Street was convinced by LTCM that the markets were a nice, pleasant, orderly, and continuous normal distribution, with no risk, LTCM began using mammoth leverage for supposedly risk-free big returns. That is where problems started. They ignored the unexpected in their strategy. If a random bolt of lightning hits you when you are standing in the middle of a field, it might feel like a random event. But if your business is to stand in random fields during lightning storms, then you are clearly ignoring obvious and real risks (source: Broadcast Transcript, Trillion Dollar Bet. Nova, No. 2075, February 8, 2000).

Trend followers made a killing as LTCM went through the cheese grater. Returns for trend following traders in August and September of 1998 were almost like one continuous credit card swipe direct from LTCM. LTCM lost billions and top trend followers made billions (source: Covel, Trend Following, p. 157). Yet its worse than just one hedge fund blowing up and trend followers winning again. Eugene Fama’s efficient market misstep has also given mutual funds the cover they needed to raise massive assets (and milk insane fees out of the average Joe).

For the last 30 years, there has been a sophisticated marketing campaign, boosted by an even more sophisticated political lobbying campaign, all designed to convince everyone attached to the matrix that they could do no better than guessing or throwing darts, so in turn just invest all of your money in mutual funds and hold on for the long term (long term is never usefully defined of course; it could be your death).

For a man who has the numbers against him, Fama remains defiant in the face of his intellectual defeat. Recently he was asked this question about technical trading (read: trend following):

Interviewer: Some researchers argue that a market- timing strategy based on buy/sell signals generated by a 50 or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?
Fama: An ancient tale with no empirical support.

Clearly, Fama has no answer for the reality of trend following performance. He would rather commit Seppukua form of Japanese ritual suicide, than admit an error. He would rather die with honor than fall into the hands of superior market wisdom (source: Having lived through the financial crisis of 2007-08, the man in the street knows markets are not efficient. But the Efficient-Market Hypothesis, like a Hollywood monster, has proved very hard to kill off (source:

Fortunately for you, there is a way out. There is inspiration. The great trend followers are not academics, magicians, charlatans, or pedigreed investment bankers. They are self-starter entrepreneurs who, through concentration, drive, and fierce independent streaks, have cultivated that rare knowledge to mint money. Trend following proves daily that the Efficient-Markets Hypothesis has more in common with Scientology, versus any useful trading enlightenment. Understand the comparisons made herein. It’s all part of you interpreting the puzzle.

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