Trend Following (Michael Covel) 2 comments

My first impression of this book was that it was about technical trading, which would have turned me off because I hate seeing charts and the patterns they attempt to decipher out of it. Well, flipping through it subsequently, I found that it was about technical trading based on trend-following systems, but it focused more on the general philosophies behind it as well as debunking a few myths of conventional finance theory. It's one of those books that is more interesting than originally thought.

Trend following is actually a mechanical trading approach employed by many futures traders in commodities, currencies, stock and bond indices. Mechanical as opposed to discretionary: the latter is based on trading decisions at the "discretion" of the trader, whereas the former is based on an objective and automated set of rules. In effect, mechanical systems believe that the harm done by emotional trading outweighs the benefits that experienced human judgment can bring to the table.

I happen to believe in discretionary trading, but then of course part of the reason is because I don't have the skills nor infrastructure nor inclination for devising and implementing an automated trading system. And besides, the difference between the two categories is actually academic: a mechanical trading system must have been programmed using human experience and judgment as well, wasn't it? So it's the underlying trading philosophies that's important.

And the underlying philosophy is actually quite interesting and sound, and I have always felt it's important to get new perspectives on the market and not stick to one single view all the time. The author questions the following conventional views:

1) The definition of risk. Is it really volatility? Are mutual fund managers shunning volatility and adhering to benchmarks when volatility is in fact, natural, and tends to lead to better returns? Large drawdowns is a feature of trend following.

2) Decision-making process. How much of fundamentals is actually programmed into the market price of an asset already? Are the market professionals really chasing the wrong alley by trying to absorb as much fundamental information as possible and then trading on them? Trend following adheres to so-called one-reason decision-making --- and that reason is based on price.

3) Buy-and-hold. That's the approach of unit trust managers, and they point to Warren Buffett. Trend followers scoff at the buy-and-hold approach; they have strict cut-loss rules and attempt to ride the trend, whether upwards or downwards (of course, such a flexible approach is easier to adopt in futures, where one can long or short with equal ease).

The author also makes a distinction between "predictive" technical analysis that attempts to forecase significant market events, and "reactive" technical analysis which is what trend followers adhere to. The idea is that trend followers take trading positions with no knowledge that an event/crisis will occur; they take their positions as markets move. The fact that these particular small, initial price trends lead to big trends that lead to big events is not something anyone can predict. In essence, this approach is a "riding the wave" approach, as opposed to "calling the bottom/top".

I can actually identify with trend-following at its core, simply because it is difficult to see how far a trend can go (just look at oil prices now, for example). This, in my view, is especially so for financial assets which are subject to complex demand-supply dynamics which, like macroeconomics, are composed of a thousand moving parts and might prove difficult to decipher fundamentally and might be more subject to short-term momentum and sentiment. On the other hand, my approach is that my entry into a stock should be fundamentally-driven; it is trend-following as well, except that I follow a fundamentals trend.

At the end of the day, the approach one takes is a function of one's beliefs and the tools availabe at his disposal. There is no single best approach. The book devotes one chapter listing the various successful and well-known trend followers: John W. Henry, Ed Seykota, Richard Dennis etc, probably as evidence of the viability of trend-following. Sure (though we don't know how many have failed using this approach), but if more and more people adopt trend-following, it might lose its viability. Such is how the market operates.