Trend Following Theory by Michael Covel

“A back of an envelope algorithm is often good enough to compete with an optimal formula, and certainly good enough to outdo expert judgment.”
Jerry Parker, the most successful TurtleTrader

Michael Covel
Michael Covel

Most investors attempt to study economic realities–supply and demand factors–that they believe underlie market values. They rely on government policy, economic projections, price-earnings ratios, and balance sheet analysis (and so on) to make buy and sell decisions. The religion of fundamental analysis is about telling stories–stories you will instantly recognize:

  • Crude oil traded near an eight-week low because of concern fuel demand will be curbed amid signs of slowing economic growth in the U.S. and the U.K.
  • History suggests the time is right to buy Dow stocks.
  • It’s not too late to profit from rally as market’s cycle shifts in favor of blue-chip stocks.
  • They’re cheap by recent historical standards.
  • The index’s trailing price to earnings ratio, a measure that shows investors how much they are paying for a dollar in earnings, is well below what it has averaged.
  • The price to earnings ratio for the S&P 500.
  • Commodities look to be more expensive in the coming sessions and coming weeks to months.
  • Has the metals correction run its course?
  • My gut tells me the indices are overdue for a setback but the jury is still out.
  • Secular decline over the last four cycles.
  • We feel an interim top is in.
  • Decline in nominal GDP.
  • Based on supply and demand constraints, corn and soybeans need to trade higher to ration demand and to find more acreage.
  • Initial unemployment claims.
  • Is this just a correction or could it turn into something more serious?
  • Political and social unrest in the Middle East.
  • Big miss in headline payrolls.
  • Key driver of seasonal demand patterns in gold.
  • A bullish USDA report aided in corn appreciation.
  • Rising energy and materials shares, spurred by surging oil and gold prices, have kept stocks in positive territory.
  • The FOMC is meeting today and tomorrow so stay alert as even inaction can be a market mover.
  • EBITDA.

The fundamentals (read: bullshit) never stop.

Why?

Investors crave “cause and effect” explanations and feel security in the illusion that there is a deeper understanding. It does not matter if the moneymaking strategy works or not. All that matters is the story. Sheep go to slaughter much easier when they’re comforted and showered with sweet nothings. How can the religion of fundamental analysis, taught on every college campus and practiced at every mutual fund, generate repeatable alpha?

It cannot.

Trend following trading is different. It does not predict market direction. Trend trading demands self-discipline to follow precise rules (no guessing or wild emotions). It involves a certain risk management that uses the current market price, equity level in your account, and current market volatility.

Trend traders use an initial risk rule to determine their trading size at entry. That means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements will lead to an exit. A trend trader’s average profit per trade is significantly higher than the average loss per trade.

Trend following aims to capture the middle, or the meat, of a market trend, up or down, for profit. You will never get in at the absolute bottom or get out at the absolute top. Stocks, ETFs, LEAPS options, bonds, currencies, futures, and commodities are all ripe to trade.

This is the only trading strategy that can be traded on a desert island. As long as price data is available, all else is inconsequential. Media, fundamentals, broker opinions, talking heads, and so on are simply not necessary to profit.

Unfortunately, not everyone comprehends or wants to comprehend that.

Consider Erin Burnett of CNBC. She was interviewing David Harding–a successful trend trader–and asked: “A lot of people obviously want to know what your secret is. What was the magic bullet?”

Harding replied: “The secret strangely enough is not having an idea of what we are going to be doing in advance. We react to the unfolding markets trends rather than make forecasts of what’s going to happen.”

Burnett missed his point entirely in her response: “When you look out right now do you think, big picture, I know you are quantitative, but do you believe that we are in a fundamental cycle or are we in a bubble?”

Harding tried to let her see the light: “It’s not false modesty for me to say I don’t know. I really don’t know. I really do not have the gift of second sight.”

Everything Flows

Markets go up, down, and sideways. They trend. They flow. They surprise.

Look at insurance, gambling, and other related businesses. It is clear that even a small positive edge, along with a solid view of probabilities, can lead to fortunes. However, that does not mean the path to prosperity will necessarily be comfortable.

Think about the emotional ups and downs when facing the unknown. Leaving Las Vegas recently, I drove down toward Hoover Dam. Knowing I would soon be from the vantage point of the new Hoover Dam bridge spanning the Colorado River, the feeling of anxiety was encompassing. During the decline, you do not know how far you will be able to see down, but when you finally get to the bridge, you can’t actually see the dam over the ledge! The wall is too high.

Keeping in check how you react to the unexpected or unknowable–the life of a trend trader.

Consider a story about a trading seminar where a notable trend follower was the guest speaker. The audience peppered him with questions: “Do you like gold?” “Where do you think the Canadian dollar is headed?” “How do you know when there is a top?” To each of these, he replied: “I like gold, its shiny, pretty, makes nice jewelry” or “I have no idea where the Canadian dollar is headed.” Many were not impressed. They felt they had wasted their money. However, his message could not have clearer. The answers were found in the very questions each person asked. Do not ask, “How do you know the trend is moving up?” Instead, ask, “What is going to tell me the trend is up?” Not, “What do you think of gold?” Instead, ask, “Am I correctly trading gold?”

His answers placed everyone in front of a mirror and worse yet, some did not know it.

The idea that you can know enough about Crude Oil, Apple, Google, Bitcoin, GE, or whatever market to trade them all the same may seem preposterous, but think about what they all have in common: Price.

Market price is objective data. You can look at individual price histories, without knowing which market is which, and still trade all successfully. That is not what they teach at Harvard, Wharton, Stern or Darden.

Trading coach Charles Faulkner paints the picture of the trend following mindset you won’t find at those schools:

  • No one can predict the future.
  • If you can take the would-be, could-be, should-be out of life and look at what actually is, you have a big advantage over most human beings.
  • What matters can be measured, so keep refining your measurements.
  • You don’t need to know when something will happen to know that it will.
  • Prices can only move up, down, or sideways.
  • Losses are a part of life.
  • There is only now.

Let’s get practical. Answer the following five questions and you have a trend following trading system:

  • What market do you buy or sell at any time?
  • How much of a market do you buy or sell at any time?
  • When do you buy or sell a market?
  • When do you get out of a losing position?
  • When do you get out of a winning position?

You want to be black or white with this. You do not want gray. If you can accept that mentality, you have got it. Author Van Tharp clarifies:

“Let’s break down the term ‘trend following’ into its components. The first part is ‘trend.’ Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices … ‘following’ is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then ‘follow’ it.”

Another way of saying trend following from a pro trend trader:

“Systematic managers trade by following non-emotional sets of trading rules often based on mathematical models of market behavior. Systematic managers use their judgment and intuition in designing their market models and trading systems. Discretionary managers, on the other hand, apply judgment and intuition in making every trading decision.”

Yet another view:

“A trend follower attempts to identify developing price patterns with this property and trade in the direction of the trend if and when they occur. They use only the current and historical price of the asset to make trading decisions and the approach can be summarized by the expression follow the herd.”

Some ask: “What is a trend?” One of the best explanations comes from top trend follower and one of my mentors, Ed Seykota:

“A trend is a general drift or tendency in a set of data. All measurements of trend involve taking a current reading and a historical reading and comparing them. If the current reading is higher than the historical reading, we have an up-trend. If lower, we have a down-trend. In the improbable event of an exact match, we have a sideways trend. The direction of the trend depends upon the method we use to perform the comparison. Real instruments fluctuate minute-to-minute, day-to-day and year-to-year. We have, therefore an enormous supply of historical points to use to determine trend. As such, we can determine as many instances of trend as we please, in any direction that we please. There is no such thing as the trend; there are countless trends, depending on the method we use to determine a trend. People typically pick a method for determining trend that fits with their current positions and/or view of the market. All methods of defining trends compare various combinations of historical price points. All trends are historical, none are in the present. There is no way to determine the current trend, or even define what current trend might mean; we can only determine historical trends. The only way to measure a now-trend (one entirely in the moment of now) would be to take two points, both in the now and compute their difference. Motion, velocity and trend do not exist in the now. They do not appear in snapshots. Trend does not exist in the now and the phrase, “the trend” has no inherent meaning. When we speak of trends, we are speaking, necessarily, from some or another view of history. There is no such thing as a current trend. When we speak of trends we are necessarily projecting our own definitions. With that in mind, we can proceed to examine ways to define, compute and use trends.”

There are many ways to describe trend following, but they all come back to the same thing: Trend following trading is reactive by nature. It does not forecast or predict markets or price levels. Prediction is impossible. Trend trading demands self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in your account and current market volatility. Trend traders use an initial risk rule that determines position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit from your entire trade. Historically, a trend trader’s average profit per trade is significantly higher than the average loss per trade.

Trend trading is not a passing fad or hyped-up secret black box either. Beyond mere rules, the human element is core. It takes discipline and emotional control to stick with trend trading through inevitable market ups and downs. Trend following seeks to capture the majority of a market trend, up or down, for profit. It aims for huge profits in all markets.

You want safe?

No you don’t.

There is no such thing.

Author Seth Godin said it well:

“Golf is not safe. My grandfather died playing golf. Speaking up is not safe. People might be offended. Innovation is not safe. You’ll fail. Perhaps badly. Now that we’ve got that out of the way, what are you going to do about it? Hide? Crouch in a corner and work as hard as you can to fit in? That’s not safe, either. Might as well do something that matters instead.”

Key points that further illuminate trend following:

  • Profit in up and down markets: Trend following doesn’t swear an allegiance to a bull or bear market. It follows trends to the end. No matter how ridiculous trends might appear early and no matter how insanely extended they might appear at the end, follow trends. Why? They always go farther than anyone expects. Ignore momentum at your peril.
  • No more buy and hold, analysts, or news: Trend following decision-making doesn’t involve discretion, guesses, gut feelings, or hunches. It’s not day trading or buy and hope. It doesn’t involve passive indexing, in and out trading, or fundamental analysis. No more 24-hour news cycles, daily turbulence, or sensational hype. No black boxes or magic formulas either. Let go of the Holy Grails.
  • No prediction: Trends exist everywhere, always coming and always going. Markets are no different: They trend up and down. That said, no one can predict a market trend, you can only react to one. Trend following never anticipates the beginning or end of a trend. It only acts when the trend changes. There is no need to figure out why a market is trending, just follow it. You don’t need to understand electricity to use it.
  • The big money of letting profits run: Trend following at its best aims to compound absolute returns. It doesn’t shoot for average. The goal is to make the knock your socks off returns, not passbook savings interest. Trend following also has the unique ability to lie and wait for targets of opportunity. That means killing it on unpredictable surprises.
  • Risk management is top priority: Trend following always has defined exit protocols to control injury to your account. Stop losses and proper leverage usage are standard practice. Trend following also has low to negative correlations with most other investment opportunities.
  • Takes advantage of mass psychology: Trend following takes advantage of panicky sheep behavior. Strict discipline minimizes behavioral biases. It solves the eagerness to realize gains and reluctance to crystallize losses. Too many people believe what pleases them. Most behaviors are simply driven by the impulsive moment of now. Trend following wins because of that.
  • Scientific approach to trading: Trend following doesn’t require a belief, but rather it relies on unwavering scientific principles. It has a defined edge just like the MIT card-counting team that beat Vegas casinos. Be the casino, not the hapless player. Trend following uses rigid rules rooted in numbers. Think process not outcome. Remember, frequency of correctness is not the issue, the magnitude of correctness matters. Winning percentage means zilch.
  • Strong historical performance in crisis periods: Trend following is adaptable to differing climates and environments performing best during periods of rising volatility and uncertainty. The unknown will happen again. Are you ready? You have to be able to ride the bucking bronco. Ride the storm out and stay alive.
  • No traditional diversification: Trend following is not restricted to any single market or instrument. A focus on price action allows trend following to be applied to an exceptionally large variety of markets. Price is the one thing that all markets have in common. A trend trading system for treasury bonds should also work on the Euro and stocks. Trend following is robust.
  • No government reliance: Forget Social Security, bailouts, stimulus plans, and roads to nowhere. Those won’t help you to make money; they only help you lose. When the Fed puts on or takes off the training wheels (read: rate manipulation), will you be ready to mint cash or will you sit there and just take it again? If your portfolio is grounded in sound principles you can win no matter what happens.

Your next steps are right here:

Listen to interviews with trend following legends.

Read about the origins of trend following.

Read more about trend following systems & training.

The Author