Trend Following. Ritholtz Barry

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that any departure tends to bring you farther south.”55

      Understanding how a trend follower implements that philosophy is illustrated in Ed Seykota’s sugar story. He had been buying sugar – thousands of sugar futures contracts. And every day, the market was closing limit up. Every day, the market was going nonstop higher and higher. Seykota kept buying more and more sugar each day limit up. An outside broker was watching all of Seykota’s action. And one day the broker called him after the market close, and since he had extra contracts of sugar that were not balanced out, he said to Seykota, “I bet you want to buy these other 5,000 contracts of sugar.” Seykota replied, “Sold.”

      After the market closes limit up for days in a row, Seykota says, “Sure, I’ll buy more sugar contracts at the absolute top of the market.” Everybody instinctively wants to buy sugar on the dip or on the retracement. Let it come down lower they pine. “I want a bargain” is their thinking – even if the bargain never appears. Trend following works by doing the opposite: It buys higher highs and sells short lower lows.

      Good Traders Confuse Price

      The trading histories of Julian Robertson and Louis Bacon, two famed hedge fund titans, underscore the importance of price for decision making.

      After the Dot-com crisis Julian Robertson shut his long-running hedge fund down. He was a global macro trader who relied on fundamentals for decision making. Robertson had a close relationship with another global macro trader, Louis Bacon. Bacon was extremely secretive to the extent that it was nearly impossible to find out his performance numbers unless you were a client. Although Bacon did not advertise himself as a trend follower, he was focused on price action:

      “If a stock goes from 100 to 90, an investor who looks at fundamentals will think maybe it’s a better buy. But with Louis [Bacon], he will figure he must have been wrong about something and get out.” Contrast that, say, with [Julian] Robertson, who, even after shutting down his firm, was doggedly holding on to massive positions in such stocks as U.S. Airways Group and United Asset Management Corp… [Bacon made the comment] in an investor letter that ‘those traders with a futures background are more sensitive to market action, whereas value-based equity traders are trained to react less to the market and focus much more on their assessment of a company’s or situation’s viability.’”56

      Every successful trader is a trend follower even if they don’t use the technique, admit it, or know it.

      Trend followers know to pick the trend start is a masochistic exercise. When trends start they often come from flat markets that don’t appear to be trending anywhere – it’s choppy, up-and-down, trendless, go-nowhere market action. The solution is to take small bets early to see if the trend will mature and get big enough to ride.

      An executive at trend following pioneer Graham Capital Management clarifies, “The ability of trend following strategies to succeed depends on two obvious but important assumptions about markets. First, it assumes that price trends occur regularly in markets. Secondly, it assumes that trading systems can be created to profit from these trends. The basic trading strategy that all trend followers try to systematize is to ‘cut losses’ and ‘let profits run.’”57

      I asked Charles Faulkner to expand:

      The first rule of trading is to, “Cut your losses, and let your profits run.” And then, that it’s the hardest thing to do. Seldom do any of them wonder why, and yet this is exactly where the efficient market theory breaks down, and the psychological nature of the markets shows through. When we lose or misplace something, we expect to find it later. The cat comes back. We find our car keys. But we know a dollar on the street will not be there with the next person who passes by. So experience teaches us that losses are unlikely and gains are hard. “A bird in the hand is worth two in the bush.” This is when I tell them that they earn their trading profits by doing the hard thing – by going against human nature. This is where the discipline comes in, the psychological preparation, the months of system testing that give the trader the confidence to actually trade against his natural tendencies.

      If cutting losses and letting profits run is the trend following mantra, it is because harsh reality dictates you can’t play the game if you run out of money. No money, no honey! Trend trader Christopher Cruden sarcastically builds the thought: “I would prefer to finish with a certain currency forecast, based upon my own fundamental reading of the market and one that underpins my personal investment philosophy… The only problem is I can’t tell you when this will happen or which event will be first. On that basis alone, it seems best to stay with our systematic approach.”58

      A good example of not letting profits run can be seen in trading strategies that take profits off the table before the trend is over. For example, one broker told me one of his strategies was to ride a stock up for a 30 percent gain and then exit. That was his strategy. Let it go up 30 percent and get out. Sounds reasonable. However, a strategy that uses profit targets is problematic at a root level. It goes square against the math of getting rich, which is always without question to let your profits run. If you can’t predict the end or top of a trend, don’t get out early and risk leaving profits on the table – you will need the biggest winners after all to pay for the smaller losers.

      For example, let’s say you start with $50,000. The market takes off and your account swells to $80,000. You could, at this point, quickly pull your $30,000 profit off the table. Your wrong thinking is if you don’t take those profits immediately, they will be gone.

      Trend followers know that a $50,000 account may go to $80,000, back to $55,000, back up to $90,000, and from there, perhaps, all the way up to $200,000. The person who took profits at $80,000 is not around to take the ride up to $200,000. Letting your profits run is tough psychologically. But understand in trying to protect every penny of your profit you never make big profits. Those are the stark choices for the big boy game.

      You are going to have ups and downs in your trading account. Get over it. Losses are a part of the trading game no matter the strategy. If you want no losses, if you want positive returns every month, well, you could have had your money with the Ponzi scheme of Bernard Madoff and his fake monthly 1 percent performance, but you know how that turned out. You can’t make money if you are not willing to lose. It’s like breathing in, but not willing to breathe out.59

      Think of it this way: If you don’t have losses, you are not taking risks. If you don’t risk, you won’t ever win big. Losses aren’t the problem. You must always cut them. Ignore losses with no plan, let them build up, and they will come back to wipe out your account.

      Theoretically, really big losses rarely befall trend following strategy because it eliminates or reverses positions as soon as the market goes against it. The rationale for hanging in is that any price move could be the beginning of a trend, and the occasional big breakout justifies a string of small losses.60

      Surf the Waves

      I am fortunate to have learned from trader Ed Seykota starting in 2001 with our first Virgin Islands meeting, through a 2012 panel with Larry Hite, and up to his 2016 podcast appearance. But early on he told me a story about being in Bermuda with a new trader who wanted secrets. “Give me the quick-and-dirty version of your magical trading secrets,” the neophyte beamed.

      Seykota took the new trader out to the beach. They stood there watching the waves break against the shoreline. The newbie asked, “What’s your point?”

      Seykota

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