Seasoned traders know the importance of risk management. If you risk little, you win little. If you risk too much, you eventually run to ruin. The optimum, of course, is somewhere in the middle.
Placing a trade with a predetermined stop-loss point can be compared to placing a bet: The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure — or heat — from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2% on each of five instrument & has a total heat of 10%, as does a portfolio risking 5% on each of two instruments.
Our studies of heat show several factors, which are:
1. Trading systems have an inherent optimal heat.
2. Setting the heat level is far and away more important than fiddling with trade timing parameters.
3. Many traders are unaware of both these factors.
Michael Covel starts the discussion off with Mark Zuckerberg and the virtual reality realm we are entering. There is now an infamous picture of Mark Zuckerberg walking down an aisle with a huge audience behind him hooked up to helmets. All audience members are in a virtual reality. Michael bridges the gap between speculative follies of the past, with the virtual reality bubble we are about to embark on.
David Harding and James Holmes wrote a book titled, “The Pit and the Pendulum: A Menagerie of Speculative Follies.” Michael reads an excerpt from the book, giving a historical narrative about how people have behaved over the centuries. People always get excited about something new, and that “something new” historically always seems to crater and crash. The chapter Michael reads from is titled “Basking in an Indian Summer: The Bombay Share Mania of 1865.” The excerpt relates to cotton exports during the American Civil War. Bombay saw massive profits in cotton and silver due to cotton exports being halted in America during the war. Due to the boom in the economy Bombay saw huge expansion in their commercial sectors. Investors were only focused on the short term rather than long term.
When the American Civil War ended the Indian economy hit depression. Banks went bankrupt and the housing market crashed. The Bombay commercial world went totally bust. This is only one of many speculative examples that are in “The Pit and The Pendulum.” History always repeats itself. All speculative follies go down the same path. The only difference is the name or market caught up in the mania. Whether it be technology, cotton, or tulips, it’s all the same. How do you protect yourself from the next big mania? Educate yourself and have a strategy in place.
In this episode of Trend Following Radio:
Bombay cotton market 1865
Bubbles and mania
Profiting from the speculation
Having a plan in place
“All speculative follies go down the same path. The players involved look the same. They act the same. They talk to same. The only thing that is different are the names. It’s always a new technology. It’s always an innovation.” – Michael Covel
Today on Trend Following Radio Michael Covel interviews Jim Rogers. Jim is a famed American investor based in Singapore. He was co-founder of the Quantum Fund, and has authored numerous books. Today’s conversation is geared toward the central banking system and the direction Michael and Jim think the world’s economy is headed.
Michael starts the podcast off talking about negative interest rates and if that is a possibility in the U.S. Jim brings up a study published in 2007 that said, “We have the Federal Reserve, we have 1,000 of the most brilliant economists in the world how can we be wrong? How can people say that we are wrong?” Jim says that for the last 30 years the Fed has done just that. They have gotten just about everything wrong. Janet Yellen has been getting everything wrong since before she was even head of the Fed. She blames her blunders on the market being wrong or the public being wrong. According to Jim, every head of the Fed has been an academic and political hack.
Michael posits, “Everyone should be able to imagine another stock crash, we have had enough of them.” Jim says that the debt is staggering right now so when we have a crash it is going to be utter chaos. When we have extreme economic problems a war usually follows as well as someone coming in on a white horse to save the day. That white horse person will also cause more debt and make things even worse. This is the first time in history that government is actually out to destroy the people who have saved and set away for retirement. The middle and saving class has been destroyed before, but that was because of war or inflation. Jim says that it is mind boggling that the government’s solution to clearing up debt is to create more debt.
Next, Michael asks, “How do you see China right now?” Jim says that when they had their big market crash they chose to invest in the future with money they had saved. In America, we did the opposite. We chose to bail out the bureaucrats and make sure the rich didn’t go poor. The European and Japanese central banks have come out saying that they will practice unlimited QE funding. They will print unlimited amounts of money to solve their economic problems. Most do not question this because most people have no idea who or want the central bank is.
Lastly, Michael asks Jim what the best way is to prepare for potential problems that may unfold in the future. Jim says the first thing is to not listen to the news or what you may read on the internet. Stay with what you know and if you don’t think you know something, do nothing..
In this episode of Trend Following Radio:
Negative interest rates
Central banking systems
The impact of unintended consequences
Preparing for the future
“For the last 30 years look at who we have had down there [as the head of the Federal Reserve]. They have all been academic and political hacks.” – Jim Rogers
There are so many questions to ask yourself before entering a trade. The most critical question to ask is “How much risk are you willing to take”:
The question investors typically avoid at all costs is the question of money management. Money management is also called risk management, position sizing, or bet sizing, and it is the critical component to trend following success as Gibbons Burke observes:
“Money management is like sex: Everyone does it, one way or another, but not many like to talk about it and some do it better than others. When any trader makes a decision to buy or sell (short), they must also decide at that time how many shares or contracts to buy or sell—the order form on every brokerage page has a blank spot where the size of the order is specified. The essence of risk management is making a logical decision about how much to buy or sell when you fill in this blank. This decision determines the risk of the trade. Accept too much risk and you increase the odds that you will go bust; take too little risk and you will not be rewarded in sufficient quantity to beat the transaction costs and the overhead of your efforts. Good money management practice is about finding the sweet spot between these undesirable extremes.”
When you look at a trading strategy, you must ask, “I’ve only got a certain amount of money. How much do I trade?” If you have $100,000 and you want to trade Microsoft, well, how much of your $100,000 must you trade on Microsoft on your first trade? Must you trade all $100,000? What if you’re wrong? What if you’re wrong in a big way, and you lose your entire $100,000 on one bet?
How do you determine how much to bet or trade each time? Trend followers make small bet sizes initially. So, if you start at $100,000, and you’re going to risk 2 percent, that will be $2,000. You might say to yourself, “Oh my gosh, I’ve got $100,000, why am I only risking $2,000? I’ve got $100,000. $2,000 is nothing.” That’s not the point. You can’t predict where the trend is going to go. One trend follower presented a view on the initial risk decision:
“There are traders who are unwilling to risk more than 1 percent, but I would find it surprising to hear of any trader who risks more than 5 percent of assets per trade. Bear in mind that risking too little doesn’t give the market the opportunity to allow your profitable trade to occur.”
Think about money management as you would about getting into physical shape. Let’s say you’re a male athlete and you want to get into great shape. You weigh 185 pounds, and you’re six foot one. Well guess what? You can’t lift weights six times a day for 12 hours a day for 30 straight days without hurting yourself sometime during those 30 days. There’s an optimum amount of lifting that you can do in a day that gets you ahead without setting you back. You want to be at that optimal point just as you want to get to an optimal point with money management. There indeed is just such a number. Ed Seykota describes that optimal point with the concept of “heat”:
“Placing a trade with a predetermined stop-loss point can be compared to placing a bet: The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure—or heat—from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2 percent on each of five instruments has a total heat of 10 percent, as does a portfolio risking 5 percent on each of two instruments.”
Chauncy DiLaura, a student of Seykota’s, adds to the explanation, “There has to be some governor so I don’t end up with a whole lot of risk. The size of the bet is small around 2 percent.” Seykota calls his risk-adjusted equity “core equity” and the risk tolerance percentage “heat.” Heat can be turned up or down to suit the trader’s pain tolerance—as the heat gets higher, so do the gains, but only up to a point. Past that point, more heat starts to reduce the gain. The trader must be able to select a heat level where he is comfortable.
Also critical is how you handle your capital as it grows or shrinks. Do you trade the same with $100,000 as you would $200,000? What if your $100,000 goes to $75,000?
Trend follower Tom Basso knows traders usually begin trading small, say with one contract and as they get more confident they might increase to 10 contracts. Eventually they attain a comfort level of 100 or 1,000 contracts, where they may stay. Basso counsels against this. He stresses that the goal is to keep things on constant leverage. His method of calculating the number of contracts to trade keeps him trading the same way even as equity increases.
One of the reasons traders sometimes can’t keep trading proportional as capital increases is fear. Although it might feel comfortable when the math dictates that you trade a certain number of shares or contracts at $50,000, when the math dictates to trade a certain amount at $500,000, people might become risk averse. So instead of trading the optimal amount at whatever capital you have, people trade less. How can this be avoided? Create an abstract money world. Don’t think about what the money can buy, just look at the numbers like you would when playing a board game, such as Monopoly or Risk.
However, because capital is always changing, it’s critically important to keep trading consistent. A description of Dunn Capital’s trading echoes Basso’s view: “Part of [Dunn’s] approach is adjusting trading positions to the amount of equity under management. He says if his portfolio suffers a major drawdown, he adjusts positions to the new equity level. Unfortunately, he says not enough traders follow this rather simple strategy.”19
If you start with $100,000 and you lose $25,000, you now have $75,000. You must make your trading decisions off $75,000, not $100,000. You don’t have $100,000 any more. However, Paul Mulvaney felt I was missing a critical final aspect of money management:
“Trend following is implicitly about dynamic rebalancing, which is why I think successful traders appear to be fearless. Many hedge fund methodologies make risk management a separate endeavor. In trend following it is part of the internal logic of the investment process.”
Recent feedback in from a listener:
Nice to virtually meet you. My name is Natalie and I’m driving cross country and enjoying your podcasts! Episode 100 is my ultimate favorite, I listen to that one at least 3/4 times a month!
As of recently (last year or so) I’ve been getting more into trend following. Lately I’ve been on [nam] screening for stocks that have just crossed over the 200dma on the daily chart and seeing how they act.
I was hoping you could answer something that’s been on my mind. I was recently scanning [name] and came across 3 stocks I don’t know too much about at all, BUT, technically they look very good. (All have just cleared the 200dma on the daily chart which sparks my interest).
My question is… after you find something that looks technically good for trend following, what’s the next step you take for due diligence and good measure to confirm the trend and any thoughts one might have before starting a position? Do you check the fundamentals?
I’m sure your quite busy, but any response or guidance, or episode you can point me into would be greatly appreciated.
1. There is no short answer.
2. You don’t use fundamentals.
3. You need a tracking portfolio from the start.
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 (Bill Eckhardt inspired):
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?
You want to be black or white with this. You do not want gray. If you can accept that mentality, you have got it.
Life is a series of bets. Decisions on top of decisions. Choosing a trading strategy is one of those decisions to bet on. Consider an excerpt from Trend Commandments:
You want to see life as a continuum running on a loop back and forth from risk to reward. If you want a big reward, take a big risk. If you want an average reward and an average life, take an average risk. Easier said than done, however, if you want the big reward. Our system is notorious for playing Whac-A-Mole with achievers. From an early age, people are conditioned by families, schools, and virtually every other shaping force in society to avoid risk. To take risks is inadvisable; to play it safe is the message. Risk can only be bad. However, winners understand risk is highly productive, and not something to avoid. Taking calculated risks is different from acting rashly. Playing it safe is the true danger. Far more often than you might realize, the real risk in life turns out to be the refusal to take a risk. If life is a game of risk, then to one degree or another, being comfortable with assessing odds is the only option for a fulfilling life. Consider trading from a “startup” business perspective. Every business is ultimately involved in assessing risk. Putting capital to work to make it grow is the goal. In that sense, all business is the same. The right decisions lead to success, and wrong ones lead to insolvency.
Blunt, but true.
Now, feedback from a listener that made the right bet:
Trend following has indeed changed my life. After a 20-year career on Wall Street I am now a successful, profitable, independent trader. Have I made money with trend following? Yes, indeed. Living a nice life in Chicago with three kids going to private school, enjoying the finer things. My strategy is not difficult to execute at all. Very basic and straight forward. I keep it as simple as possible. I will absolutely continue to execute this strategy. Mind you–always looking at new information and ideas.
This time on Trend Following Radio, Michael Covel talks with Paul Slovic. Paul is president of Decision Research and a professor of psychology at the University of Oregon, and today he talks with Michael about the science behind risk perception.
To demonstrate how people tend to conflate actual risk with their perceptions of risk, Michael and Paul discuss a topic that’s always been a hot button issue in the public consciousness, nuclear power. In the early days of this industry, people were rightfully concerned with the possible mismanagement of such a potentially dangerous technology – concerns seemingly crystallized by the partial meltdown at Three Mile Island in 1979. Similar concerns continue to be raised today, particularly in light of the Fukushima disaster of 2011. But as Paul explains, neither of these tragedies can completely outweigh the obvious benefits of nuclear power. It’s a case of risk perception to overcome the actual risk posed.
The conversation also focuses on the role of the media in influencing people’s decision-making processes. Why is it, you might ask, that the media spends so much more time pushing negative stories than positive ones? The answer, according to Paul, goes back to biology. It’s a survival mechanism in human beings that we’re affected far more by negative stimuli than positive stimuli. This makes sense when you consider the external dangers we’ve faced in our evolution. So today, we tend to harp on the bad things that happen while ignoring the good.
In this episode of Trend Following Radio:
The psychometric paradigm of risk perception
Balancing risk vs. reward
The concept of affect heuristics
How the media sways the public’s risk assessment
Fast vs. slow thinking
Risk in the context of decision making
“Bad is stronger than good. If something goes wrong in a system it decreases our trust in the management of that system more than when something goes right. Something goes right, it doesn’t really boost our trust and confidence. It’s the negative that outweighs the positive, and the negative is being conveyed to us much more frequently and forcefully through the media than the positive is.” – Paul Slovic
On today’s show, Michael Covel talks about decision-making, and how too often people allow the “rules” of others to dictate the actions they take. This, as Michael explains, is indicative of the politically correct culture that’s taken root in all of society.
What are we to think when wildly successful comedians such as Jerry Seinfeld, Louis C.K, and Chris Rock flat-out refuse to play college campuses because of the closed-minded, irrationally sensitive nature of today’s student bodies? How have we arrived at a place where anything less than absolute conformity to preselected attitudes and beliefs means running the risk of being labeled “something”? Racist? Homophobic? Sexist? The list goes on.
What’s worse, as Michael points out, is that this culture of victim-hood has many feeling they’re entitled to certain things simply because they “exist”. These are the people who blindly accept societal rules, rather than analyze and develop proper strategy. Good decision-making, whether in trading or everyday life, means developing a plan and a set of rules and then sticking to them. Because in the end, everyone gets what they want (to paraphrase trader Ed Seykota).
In this episode of Trend Following Radio:
Good decision-making through clarity
Examining identity politics
Operating under your own rules
Political correctness: it’s about agendas
Good trading means using your system and your mind
The importance of staying focused
“We’ve been crippled by social security, Medicare, Medicaid, by welfare, by entitlements. And that is the root of the problem. Entitlements. Let me be clear…You are entitled to nothing.” – Frank Underwood