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Praise for Trend Following“Michael Covel’s Trend Following: essential.”—Ed Seykota, trend follower and original market wizard“Trend Following by Michael Covel? I’m ‘long’ this book.”—Bob Spear, developer of Trading Recipes Software“Michael Covel’s Trend Following is a breakthrough book that captures theessence of what really makes markets tick. Diligently researched andcomprehensive in scope, it will replace The Market Wizards as the must-readbible for a new generation of traders.”—Jonathan Hoenig, portfolio manager, Capitalistpig Hedge Fund LLCand Fox News contributor“Investment books that have a lasting appeal offer insight that resonates with alarge number of investors. We believe Michael Covel’s Trend Following will besuch a book.”—Richard E. Cripps, Legg Mason chief market strategist“Please read [Trend Following] whether you think you have an interest in trendfollowing or are not sure Covel has hit a home run with it.”—Gail Osten, editor-in-chief, Stocks, Futures, & Options magazine“Michael Covel has written the definitive book on trend following. With carefulresearch and clear insight, he has captured the essence of the most successful ofall trading strategies. Michael knows his subject matter and he writes about itwith passion, conviction, and enthusiasm. This enjoyable and well writtenbook is destined to become a classic.”—Charles LeBeau, author of Technical Traders Guide to ComputerAnalysis of the Futures Markets“Trend Following is an engrossing and educational journey through theprinciples, pitfalls, players, and psychology of aggressive technical trading ofthe investment markets. [It is] rich in its wisdom and historical study.”—Gerald Appel, president of Signalert Corporation and publisherof Systems and Forecasts newsletter
“Conventional wisdom says buy low and sell high, but what do you do nowthat your favorite market—be it a stock, bond, or commodity—is at an all-timehigh or low? For a completely different perspective, from people who actuallymake money at this business, take a look inside. Michael Covel has written atimely and entertaining account of trend following—how it works, how to do it,and who can do it. While it’s not for everybody, it might be for you.”—Charles Faulkner, NLP modeler and trading coach, featured innumerous books including The New Market Wizards“I think the book did a superb job of covering the philosophy and thinkingbehind trend following (basically, why it works). You might call it the MarketWizards of Trend Following.”—Van K. Tharp, Ph.D., president, International Institute of TradingMastery, Inc. Van was originally profiled in The Market Wizardsby Jack Schwager.“I think that this book documents a great deal of what has made trendfollowing managers a successful part of the money management landscape(how they manage risk and investment psychology). It serves as a strongeducational justification on why investors should consider using trendfollowing managers as a part of an overall portfolio strategy.”—Tom Basso, retired CEO, Trendstat Capital Management, Inc.Tom was originally profiled in The New Market Wizardsby Jack Schwager.“Michael Covel mixes a unique blend of trend following matters with thethoughts and quotes of successful traders, investors and society’s leaders.This is a valuable contribution and some of the best writing on trend followingI’ve seen.”—Robert (Bucky) Isaacson, managed money and trend followingpioneer for more than 30 years“Trend Following: Definitely required reading for the aspiring trader.”—David S. Druz, tactical investment management and trend followerfor 25 years“Michael Covel reveals the real secret about trading—that there is no secret. Hispoints are peppered with wisdom from experts across the industry.”—John Ehlers, president, MESA Software
Trend Following(Updated Edition)
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Trend Following(Updated Edition)Learn to Make Millionsin Up or Down MarketsMichael W. Covel
Vice President, Publisher: Tim MooreAssociate Publisher and Director of Marketing: Amy NeidlingerExecutive Editor: Jim BoydEditorial Assistants: Myesha Graham and Pamela BolandOperations Manager: Gina KanouseDigital Marketing Manager: Julie PhiferPublicity Manager: Laura CzajaAssistant Marketing Manager: Megan ColvinCover Designer: Chuti PrasertsithManaging Editor: Kristy HartProject Editor: Betsy HarrisCopy Editor: Deadline Driven PublishingProofreader: Kathy RuizSenior Indexer: Cheryl LenserCompositor: Nonie RatcliffManufacturing Buyer: Dan Uhrig 2009 by Pearson Education, Inc.Publishing as FT PressUpper Saddle River, New Jersey 07458This book is sold with the understanding that neither the author nor the publisheris engaged in rendering legal, accounting or other professional services or advice bypublishing this book. Each individual situation is unique. Thus, if legal or financialadvice or other expert assistance is required in a specific situation, the services ofa competent professional should be sought to ensure that the situation has beenevaluated carefully and appropriately. The author and the publisher disclaim anyliability, loss, or risk resulting directly or indirectly, from the use or application ofany of the contents of this book.FT Press offers excellent discounts on this book when ordered in quantity for bulkpurchases or special sales. For more information, please contact U.S. Corporateand Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com. Forsales outside the U.S., please contact International Sales at international@pearson.com.Company and product names mentioned herein are the trademarks or registeredtrademarks of their respective owners.All rights reserved. No part of this book may be reproduced, in any form or by anymeans, without permission in writing from the publisher.Printed in the United States of AmericaEighth Printing: March 2011ISBN-10: 0-13-702018-XISBN-13: 978-0-13-702018-8Pearson Education sonEducation Australia PTY, Limited.Education Singapore, Pte. Ltd.Education North Asia, Ltd.Education Canada, Ltd.Educación de Mexico, S.A. de C.V.Education—JapanEducation Malaysia, Pte. Ltd.The Library of Congress Cataloging-in-Publication data is on file.
For Uyen.
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ContentsForeword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiiiPreface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xviiAcknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxiPart I.11 Trend Following . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3The Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Winning Versus Losing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4Investor Versus Trader . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Fundamental Versus Technical . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7Discretionary Versus Mechanical . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11In Plain Sight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Modus Operandi: Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Follow the Trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 Great Trend Followers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27David Harding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Bill Dunn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32John W. Henry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Ed Seykota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58Keith Campbell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67Jerry Parker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71ix
xTrend Following (Updated Edition): Learn to Make Millions in Up or Down MarketsSalem Abraham . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Richard Dennis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Richard Donchian . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Jesse Livermore and Dickson Watts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Part II74788590. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 953 Performance Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Absolute Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98Fear of Volatility and Confusion with Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Drawdowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111Zero Sum Nature of the Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114George Soros and Zero Sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1164 Big Events, Crashes, and Panics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123Event #1: 2008 Stock Market Bubble and Crash . . . . . . . . . . . . . . . . . . . . . . 126Day-by-Day Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136Event #2: 2000–2002 Stock Market Bubble . . . . . . . . . . . . . . . . . . . . . . . . . . 138Event #3: Long-Term Capital Management Collapse . . . . . . . . . . . . . . . . . . . 151Event #4: Asian Contagion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164Event #5: Barings Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168Event #6: Metallgesellschaft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172Final Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175The Always “New” Coming Storm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1785 Baseball: Thinking Outside the Batter’s Box . . . . . . . . . . . . . . . . . . . . 181The Home Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182Moneyball and Billy Beane . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185John W. Henry Enters the Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186Red Sox 2003–2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188Part III. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1916 Human Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Prospect Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Emotional Intelligence: Daniel Goleman . . . . . . . . . . . . . . . . . . . . . . . . . . . .Charles Faulkner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Ed Seykota’s Trading Tribe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Curiosity Is the Answer, Not Degrees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Commitment to Habitual Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Occam’s Razor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Fast and Frugal Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .The Innovator’s Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Process Versus Outcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .193194200201202204206211212213216218
xiContents8 Science of Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Critical Thinking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chaos Theory: Linear Versus Nonlinear . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Holy Grails . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Buy and Hold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Warren Buffett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Losers Average Losers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
—Ed Seykota, trend follower and original market wizard “Trend Followingby Michael Covel? I’m ‘long’ this book.” —Bob Spear, developer of Trading Recipes Software “Michael Covel’s Trend Followingis a breakthrough book that captures the essence of what really
