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Larry Hite: His Afterword for Trend Following

When I started trading in the commodity futures markets over 35 years ago, the industry didn’t even have a name. Today, the business has grown to the point where there are a myriad of ways to describe the funds that operate and their many styles of investing. The particular discipline of trading that I practiced, even before the nomenclature existed, is now plainly and aptly termed trend following. In fact, while I have seen many strategies come and go, most of the other managers that I have known to survive and thrive over the past few decades in global futures markets are also trend followers.

For having made my living as a trend follower, I’ve yet to come across a more compelling study, so clearly distilled, than has been offered by Michael Covel in Trend Following. I first met Michael Covel when he was working on this book. I was a little hesitant at first about sharing some of the rather simple secrets of my trade. And, I didn’t make it easy on Covel. I started interviewing him on his investments and how he managed his risk. He quickly made me realize that he not only understood trend following, but that he embraced it much like me.

We delved into the roots of trend following and my investment strategies to explore why they work rather than just accepting the results. In reading Trend Following, I now see how well he was able to translate his knowledge, and the perspectives of many of my colleagues, to paper.

Back in the 1970s, most of the guys I knew traded individual markets. The ones who traded wheat did not talk to the guys who traded sugar. And, the guys who invested stocks did not care to talk to either one, because commodities were for “speculators” and not “investors.” Further, the bond crowd thought the stock guys were cowboys. Each group had developed it’s own superiority complexes and fundamentally believed that only industry experts like them could understand the subtle dynamics of their markets. I guess that’s part of the reason that no one cared much for trend followers like me — I viewed every market the same way and each represented nothing more than a trade to me.

Today, for all the different facets, I believe everyone has come to speak the same language. It’s the language of risk. In my early days, there was only one guy I knew who seemed to have a winning track record year after year. This fellows name was Jack Boyd. Jack was also the only guy I knew who traded lots of different markets. If you followed any one of Jack’s trades, you never really knew how you were going to do. But, if you were like me and actually counted all of his trades, you would have made about 20 percent a year. So, that got me more than a little curious about the idea of trading futures markets across the board. Although each individual market seemed risky, when you put them together, they tended to balance each other out and you were left with a nice return with less volatility.

I could always see, after I got to Wall Street, how, for all the confusion, markets were driven by people and their emotions. That was what all of these markets had in common — people — and people just don’t change. So, I set out to understand similarities in the way that markets moved. When I added up Jack’s trades, only a few big trades made him all the money. For each of these big winners, I was there when “experts” told Jack that these markets couldn’t go any higher, but they did. Then, when I looked at Jack’s losses, they tended to be relatively small.

Although it took me many years to put it all together — remember, there were no books like this back then — these seemingly small observations became the foundation for me of two important, intertwined investment themes: trend following and risk management. Jack was not so much a trend follower, but he did practice the first rule of trend following: Cut your losers and let your winners run.

Most of the guys that I knew who lost a lot of money actually tended to be more right than wrong. They just lost a lot on a few big losers. I believe that people put too much of a premium on being right. In some ways, it’s one of the drawbacks for people who went to the best schools and always got straight As — they are too used to always being right. It gets back to people and emotions. Everyone is happy to take lots of little winners — it makes them feel good. When their trades go against them, on the other hand, they hold on because they don’t want to accept being wrong. Many times, these trades come back and they are able to capture their small profit. To me, that kind of trading is a little bit like picking up nickels in front of a steamroller.

Thankfully, the markets don’t care about me or you or where we went to school. They don’t care if you’re short or tall. I was never very good in school and I wasn’t a good athlete either. With my background, the way I saw it, I never had any problem with the idea that I could be wrong. So, I have always built in an assumption of wrongness to anything that I do. We now kindly refer to this practice as risk management, but I just wanted to answer the question: “What’s the worst thing that could happen to me?” I never wanted to do anything that could kill me. Knowing that I was not likely to be right that often, I had to trade in a way that would make me a lot of money when I was right and not lose me a lot of money when I was wrong. If that wasn’t enough, it also had to be simple enough for me to understand.

After many years of searching and learning things the hard way, I evolved my own version of trend following. The idea made sense and I had some good examples to follow. Still, I wanted to prove to myself that it worked without betting real money. I had to test what would have happened had I traded that way in the past. These were the early days of computers and we even had to “borrow” time on university computers to test and prove our theories. It was a painstaking task, but it gave me the comfort that I needed. Now, in reading Trend Following, the do-it-yourselfers might argue that having a book that illustrates these same basic principles takes some of the fun out of it.

Actually, Covel, like any good trend follower, has not focused solely on the endpoint. He gives you a deep understanding of the most important part: the path. Unlike so many other books that have been written about investing, Trend Following goes beyond the results to explore the journey of this outstanding group of traders.

For my staff at Hite Capital, Covel’s Trend Following is required reading. For my daughters at home, it has finally settled the question I seemed never to have been able to clearly answer myself, “Daddy, what do you do for a living?” This book captures and conveys what so many traders have taken careers and large losses to learn. And lucky for all of us, you don’t have to be Phi Beta Kappa to understand it.

We no longer live in that world of wheat guys, sugar guys, and stock guys. Trend following trading is an important force in every market and should be a part of any diverse investment portfolio. For me, the discipline of trend following goes beyond trading and money management. Trend following is a way of thinking that can be employed in many parts of life as we all tend to continue to do the things that work for us and stop doing those activities that don’t.

The way I see it, you have two choices — you can do what I did and work for 30-plus years, cobbling together scraps of information, seeking to create a money-making strategy, or you can spend a few days reading Covel’s book and skip that three-decade learning curve.

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