what is trend following and why it works
Russell Sands says: "I was wrong ! trend
following still works!"
Russell sands, an original turtle trader/teacher who was one of the first 14
chosen by Richard Dennis & William Elkhart, reports on a method everyone
has an opinion about however little knowledge of.
for the full
story of the turtles,
click here.
 yes,
trend following and turtle trading still work just fine, and if you are
willing to give me a few minutes, i am going to tell you why.
let me be the first to admit it,
when i make a mistake, i sure do make a big one. i let my emotions and
personal feelings get the better of me.
i listened to the opinions of
others, instead of having more faith in my own analysis. i should have known
better, however i didn’t. i thought the markets had "changed", however in reality,
some things never change.
turtle trading and the whole
trading style that we can call long-term trend following is a proven method
that has been working for years and years.
there is an extensive library of
both technical and fundamental analysis and data to help explain why this
type of trading methodology is not only statistically valid, it is just
plain common sense.
of course, even among things that
may work forever in the big picture, it is still quite likely that nothing
is going to work all the time. trend following, just as all other types of
trading, has periods when it works well, and periods when it doesn’t.
and the truth is, that when trend
following "doesn’t" work, it can sometimes be pretty ugly for a while.
however, for anyone that has the
patience and discipline to sit through the rough times, i just cannot think
of a more profitable way to extract money from the markets. and of all the
different ‘trend following’ approaches, i (obviously) think the turtles
methods are among the best.
so what happened ?
well, after years of close to
triple digit returns throughout the 1980’s and 1990’s, all of the trend
following programs hit a rough spell. in actuality, it was the same kind of
drawdown caused by choppy non-trending markets that we have seen before,
except this time the drawdowns seemed to go just a little bit deeper and
last a little bit longer than they had in previous years.
shouting drivel
certainly, non-trending periods
had occurred many times in the past and every one of those times, all the
pundits rushed forward to proclaim that ‘trend following was dead’.
of course, as soon as enough of
them started shouting this drivel loudly enough for the markets to hear, we
all know what inevitably happened.
however this time, it was going to be
different. this was a new age, and the markets had structurally and
fundamentally (and yes, permanently) changed. every institutional firm's
trading desk, and even individual traders, had faster and more powerful desk
top computers that were instantaneously analyzing value changes in all the
markets, so that even small pricing discrepancies would quickly be
arbitraged away and ‘corrected’.
prices of all market tradeables
(stocks, commodities, etc.) would now have a much stronger tendency to just
trade within a range, and revert to what the economists considered "fair
market value".
 they
said you could no longer make money with ‘long term’ position trading. you
now had to be either the quick or the dead.
trading had in many ways become a ‘fastest finger’ video game. bill
Eckhart, who was Richard Dennis’ partner and co-teacher of the turtles, had
predicted this very phenomenon at a trading conference i attended about five
years ago. he said that long term trend following would become a dinosaur as
the communication and information flow among market participants improved
and increased in speed.
and of course, the "official" death bell of trend following, and of the
turtles style of trading, was wrung in September of 2000, when Richard
Dennis himself shut down his money management firm, after suffering many
months of prolonged losses due to choppy, non-trending markets.
when that happened, it sure made headlines in the trading community and
all of a sudden everybody ‘knew’ that general trend following, and
specifically the turtles style of trading, obviously didn’t work any more.
well guess what ? they were wrong too !
of course, i didn’t know it at the time as i was losing money also and
getting pretty caught up in the negative mental attitudes as well. one or
two other turtle ctas that i knew as well as several other trend following
style of money managers had suffered losses and gone out of business.
all the explanations about permanent fundamental market changes due to
faster computers and everything all certainly sounded pretty reasonable. not
only to me, however to many other people as well, including both asset
allocators, who no longer wanted to invest with people like us, as well as
current clients, who wanted to pull out of the programs and look for greener
pastures.
however i kept going for a while after richard dennis quit because i firmly
believed they were all wrong. after all, i had been taught that trend
following had always worked in the past and would always do so in the
future.
i was also taught that most people will give up at precisely the wrong
time whether it be on an individual trade or a general concept. so after
2000 ended sort of quietly for the markets, i resolved to keep trading.
tossed in the towel
well, 2001 turned out to be a very small losing year for both my managed
funds and the turtle computer model. still, it was the first official losing
year in 20 years since we had learned these methods and since i had been
testing it on the computer.
so maybe they were right after all. maybe things had finally changed.
after all, nothing good lasts forever.
so i threw in the towel. i wrote a letter to all my investors and other
clients, saying that i felt long term trend following, turtle style or any
other kind, would no longer work in the ‘new’ market environment.
and since i
couldn’t figure out how to tweak the system, or come up with something else
to gain an edge and beat the markets, i just flat out quit, and walked away
from it.
i spent a year
doing some other things in my life however deep down, i still felt like i was
missing something.
of course, i was
the last guy to quit. right at the bottom (of the equity curve). in 2002,
all trend following systems in general, and the remaining active turtles in
particular, had a banner year.
the computer model
finished right around 100% for the year. the turtle ctas, all of whom traded
public funds with a much more conservative money management approach than
the computer model, turned in performances of anywhere from 20% to 50%
profit for the year. all of a sudden, trend following was back !
or had it ever
really left ?
alternating cycles
that was the big
question, and i think after being away from the markets for a year, and thus
being able to look at the whole situation with a more detached point of
view, the answer has to be no.
trend following is
something that has been around for a very long time, and will most probably
be around for a long time yet to come. the bottom line is simply that all
markets move in alternating cycles. sometimes they move directionally, and
sometimes they move sideways.
there are
technical, fundamental, and psychological reasons for this type of movement
and price action, however the movements will never change, primarily because the
underlying reasons will never change.
before even
talking about trend following as a methodology to trade the markets, or the
‘trends’ themselves as a price action phenomenon, perhaps we should start
with a short basic discussion of what exactly is the ‘market’, and how and
why do prices move to begin with. and of course, prices have to move in
order for anybody to make any money, if the price was always the same, you
would never have the opportunity to buy something cheaper and sell something
higher and make a profit.
in its most
simplest form, the "market" is basically just one big auction place, where
various buyers and sellers bid and offer and compete for prices of different
tradeable products, such as the shares of stock in public companies, or a
fixed quantity of a physical commodity like copper or soybeans.
and obviously, the
buyers want to buy things at the lowest possible prices, while the sellers
want to sell things at the highest possible prices.
in pure economic
terms, one of the main purposes of the marketplace, any marketplace, is ‘to
facilitate trade’. in other words, the buyers and sellers need to have a
place to come together and meet and do their business. and whether this is
going to be a physical meeting floor, or an electronic one, is not really
important.
compromise on prices
of course, when
these buyers and sellers meet, it’s for the purpose of transacting business,
exchanging goods for services, or money for goods. they may not always do
any trading because they may not always have a meeting of the minds on a
mutually fair price however if they weren’t going to at least try, then they
wouldn’t bother to show up in the first place.
in order to make
these trades or exchanges, both the buyers and the sellers are usually going
to have to compromise a little on the prices at which they are willing to
transact their business. the price of a good or commodity (or share of stock
for that matter) will thus move up and down in a "trading range" (an
appropriate name, don’t you think ?).
the
boundaries of this range will be defined by the absolute last resolve of the
buyers and sellers. the upper boundary will be the highest price at which
buyers are willing to pay. any higher, there are still obviously going to be
a lot of eager sellers however no buyers willing to take them up on those higher
prices.
conversely, the
lower boundary of the trading range will be lowest price at which the
sellers are willing to part with their goods. any lower, there are plenty of
bargain hunting buyers however no sellers willing to give up what they have at
such a cheap price.
and so, prices
tend to continually move in this trading range, with small changes in the
upper and lower boundaries, as the different buyers and sellers, with
perhaps slightly different agendas and/or price objectives, continually
enter and leave the marketplace.
however of course, as
i said before nothing lasts forever.
root cause
eventually, the whole trading range picks itself up and shifts to a
different level. sometimes it just keeps on going and going, like the
energizer bunny, and that’s what we call a ‘trend’.
now, what causes this shift, you may ask ? and the answer, although
really quite simple, probably deserves a little bit of detailed explanation.
even though i’m a diehard technical analyst, i know (and so should you),
that it is not ‘technicals’ that move the market. the technicals may be used
to describe or measure or predict (or all of the above) the price movements
of the markets, however that is not the underlying root cause.
the root cause, the fundamental reason that all things move and change in
price, is obviously … supply and demand.
and so, with apologies to those who may find this all too obvious, and
perhaps even boring, let’s go back to economics 101 for a moment. i am not
going to spend a lot of time here reminding you about the supply curve
sloping up and to the right, and the demand curve sloping down and to the
left, and the point where they intersect being the fair market price at
which both buyers and sellers are willing to meet.
all you have to remember for now is that when either the supply line or
the demand line moves, it causes a change in the intersection point.
as i said before, while technicals may help to illustrate how the market
moves, it is fundamentals that cause the move. and when the market price
moves and keeps moving, that is a trend.
as we will see in just a moment, trends will tend to proliferate more in
commodity markets than in equity markets, which means trend following
methods will work better in commodities and futures than in equities,
although they will also sometimes work pretty strongly in equities as well.
so let’s walk through some examples, first from the fundamental point of
view, then from a human emotional and psychological standpoint, and finally
from a technical perspective.
to begin with, it is important to realize and understand the simple basic
laws of economics. specifically, if demand increases while supply stays
constant, the price will rise, and if demand decreases while supply stays
constant, the price will fall. on the other hand, if supply increases while
demand stays constant, the price will fall, and if supply decreases while
demand stays constant, the price will rise.
we can start by thinking of a physical commodity, while keeping in mind
that the same scenarios can be extended to other physical products, to
financial products such as bonds or currencies, and to a slightly lesser
extent, to stocks and even stock indices as well.
let’s take coffee. brazil and other agricultural countries keep growing
the crop at a pretty steady rate and most of the rest of the world keeps
drinking the stuff on a pretty regular basis as well.
let’s assume that most economic conditions are in equilibrium, i.e. the
amount of land available to grow crops is all in use, and the technology for
harvesting the plants is mature and not undergoing any improvements.
now, assuming the supply is pretty steady and constant as just mentioned,
what do you think would happen if, all of a sudden, some reputable research
scientists discovered that drinking five cups of coffee a day would greatly
reduce the chances of ever getting a heart attack ? well, the demand for
coffee, and thus the price of it, would go through the roof.
other side of the coin
let’s say people decided that coffee was now worth $2 or even $3 per cup,
instead of the $1 it used to cost. and, the price is not going to jump that
much all at once overnight, it is going to move up gradually, until some
buyers start thinking it is getting too expensive, even given this new
wonderful medical benefit, and the demand starts to slack off.
okay, let’s look at the other side of the coin.
after years of extensive research, scientists one day discover or
conclude that drinking too much coffee will increase your chances of getting
a heart attack. people will get scared, demand will decrease, and the price
will drop so fast that perhaps you won’t be able to give the stuff away for
free.
now let’s look at the supply side situation, which is perhaps the most
obvious one to experienced commodity traders. you and i and the rest of the
world are going merrily along drinking our morning cups of coffee every day,
and then one day, all of a sudden, out of the blue, a cold weather front
hits the major coffee growing regions in brazil and columbia, and half of
this year's crop freezes and dies on the vine.
since most of us need our morning coffee to start the day, (i.e. the
demand remains pretty constant) and now all of a sudden the supply has been
greatly reduced, with no immediate hope of replacement, prices are going to
go through the roof in one of the greatest bull market uptrends that you
will ever see in your life (ps - just hope you used ‘technicals’ to get on
board this move early, because it can be locked limit up for a week in a row
and you may never get a second chance.)
and of course, in the last of our four possible market scenarios, where
the worldwide demand remains constant however the overall supply increases,
perhaps due to some new technological innovation that improves harvesting
efficiency, the extra glut of supply that will be coming into the market
will start to send prices into a sharp selling spiral, i.e. a downward
trend.
to summarize, as long as the supply and demand (of anything) are
reasonably constant, and market economics are in equilibrium, the price of
that item will remain in a relative trading range, subject to the
interactions and the slight changing perspectives or agendas of the various
buyers and sellers.
however once either the supply or the demand (or both) fundamentally changes,
even if it is temporary as opposed to permanent, the price will move out of
that old trading range, and the market will seek to find a new level of
equilibrium.
this move to a new level may happen either quickly or gradually however as
the market tends to be continuous instead of discrete, it will usually not
happen all in one quantum jump.
earth shattering events
and it is precisely this movement, going through a various range of
prices, that we would commonly call a ‘trend’. this same exact scenario, or
should i say, these four scenarios, can be extended to other all tradeable
items, not just physical products like coffee.
if we were to examine what are the reasons that cause these large
fundamental (permanent or temporary) shifts in supply and demand curves, and
thus ultimately in market equilibrium, we would find that the answer is
usually some large important earth shattering event.
different kinds of weather patterns, such as floods or droughts or cold
freezes can most certainly wreck havoc with the supply side of physical
commodities and crops such as coffee or soybeans or orange juice.
alternatively, some new scientific health or medical discovery may cause
major shifts in the demand side of the equation.
however it’s not just the physical crops, i.e. the old style ‘commodities’
that we are talking about here. many major political events, such as a war,
election, assassination, etc, will undoubtedly have an effect on financial
markets such as currencies and interest rates.
the supply, demand, or both can be affected.
think about what happens when a country finds itself with a trade deficit
that needs to be corrected, or they need to raise money to finance a war.
they go out to the capital markets and borrow money to finance their
problems by issuing bonds (debt instruments), thus increasing the supply of
bonds, and driving down the prices. if the deficit is not controlled, or the
war goes on longer than expected, more money needs to be borrowed, and the
downtrend of bond prices will continue.
as for currency markets, i’m sure most of you know of the hyperinflation
of 1930s germany, where just the perception of their money no longer being
valuable caused such a lack of demand that the currency deteriorated to
being worthless. that must have been some downtrend in deutschemark futures
or, if you were a bank currency trader, it would have been a super bull
uptrend in dollar/mark.
sometimes it is not even a major event however just the thought or fear or
even perception of one that is enough to move and shake the markets. look at
the political uncertainty in the middle east. before the invasion of iraq,
even the thought of war caused major trends (i.e. equilibrium price shifts)
in several markets such as gold, crude oil and the us dollar.
i, for one, do not know if or when or where these price moves will end,
however they are certainly creating profitable opportunities for many trend
following traders these days.
decent profits
as trend followers, we used to say that we would probably lose money when
things were nice and quiet and normal in the world, however when some big
upheaval or disaster struck to throw the world out of whack, even for a
short period of time, well, that was the time we would make some decent
profits.
as long as we don’t have perfect control over the environment and all
aspects of our lives, as long as we mortal humans are subject to the whims
of mother nature or some depraved dictator somewhere in the world, there
will be economic shifts in marketplaces, and periods of trending markets
will continue to exist.
to a lesser extent, the reasons for which i will explain in a minute, we
can see these same fundamental scenarios taking place in the equity markets.
let’s say that a scientific study comes out that shows a much stronger
correlation between cigarette smoking and lung cancer than was previously
thought to exist. or that certain common household appliances emit a new
unknown form of radiation which can cause skin cancer if you stand too
close.
what do you think would happen to the stock prices of philip morris or
general electric?
 on
the other hand, what if merck or johnson researchers finally found a cure
for the common cold. what would happen to the price of their stock?
note that these examples all tend
to be demand related. however, in most of the commodity markets as well as
in many real world scenarios, it’s the supply side of the equation that is
less price elastic and causes larger shifts. for example, no amount of
increased demand consumption for coffee or orange juice will cause the price
to appreciate nearly as much or as fast as a good old fashioned freeze
hitting the crops and cutting down the available supply.
with stocks, however, the supply side can be manipulated, at least more
so than with commodities. the available supply of coffee or gold, for
example, is limited by the amount on the trees or in the mines, and by the
available technology for harvesting it or digging it out. and this is
usually not going to change very radically over a short period of time.
however the supply of outstanding shares of stock of a particular company in
the marketplace can be quite easily increased or reduced merely by the
stroke of a pen. more certificates can be printed up and shares issued, or
existing shares can be repurchased or redeemed.
thus, equities are not quite as subject to free open market behavior as
commodities. in other words, there is a greater potential ‘behind the
scenes’ vested interest in keeping stock prices more orderly and controlled,
and thus more prone to stay in established trading ranges, rather than
seeing them have permanent or even temporary equilibrium shifts (trends).
and of course, there is the psychological perception that our leaders
want to give to the general public, i.e. that the stock market is orderly
and conservative, while commodities are wilder and more volatile and
unpredictable.
however, testing has still shown that there is enough of a trendiness
component that exists in equities to make trend following a profitable
trading strategy.
and of course, all we have to do is look at the run of many of the nasdaq
issues of the 1990s, first up, and then down, to know that both individual
stock issues, as well as stock index composites, can have major sustained
trends, in either direction.
which brings us to another issue, that of the "human element".
logic vanishes
when we talk about "the market" (any market), what we are really talking
about is the sum weighted composite values or opinions of all the many
individual participants that make up that marketplace. and sometimes these
people are well informed and make analytical and rational choices and
decisions about things, and sometimes they don’t.
sometimes, when human emotions come into play, logic goes right out the
window. however as we shall see, this will also often validate the concepts of
trend following, and lead to potentially profitable trading opportunities.
people will many times tend to believe exactly what they want to believe,
whether it is true or not. and often times, especially in a small closed
community such as a marketplace, once a few people start believing in
something, they can have the ability to convince others, even if they don’t
want to or are not trying to.
what i am talking about here is commonly referred to as the ‘herd
mentality’. if you have ever seen a cattle stampede - even just in old
western movies - then you know what i mean. and once that herd starts
running, you had better join in, or get the hell out of the way.
sometimes the stampede is fundamentally justified, such as when the
supply of a crop or other commodity is diminished by some natural event, yet
the users of that product have a constant need and demand for it. these
buyers will then fall over each other continually driving the price higher
and higher until it reaches some new equilibrium level, at which time the
frenzy will die down and prices will stabilize.
other times, there will be absolutely no rhyme or reason for the price
movement of something, aside from what charles mackay once called ‘popular
delusions and the madness of crowds’.
many writers and traders point to the 16th century dutch tulip bulb
phenomenon as the classic example of the first major price trend. at the
peak of that market euphoria, tulip bulb prices were selling for what would
be the equivalent of well over $100 per flower today.
i think it could be fair to say that even if tulips were found to cure
the common cold, or the black plague, one flower would probably not be worth
that much money.
prices escalated beyond all reasonable values, and then kept going even
further, simply due to what can be called the herd mentality of the
marketplace.
or maybe it was just the ‘greater fool’ theory, which is an idea that
basically says, i am going to buy something today, and i really don’t care
if it’s worth the price i pay or not, as long i can turn around and make a
profit by selling it back to somebody else at a higher price tomorrow.
and you know, almost everybody makes money in these cases, except for the
very last guy who bought at the top. he’s the one that gets stuck.
fear of missing out
however by any name you want to call it, this is a concept that (still)
exists in the real world, validates the methodology of trend following, and
allows traders to make money. it’s human nature, and it will never change.
the fear of missing out on a good thing, as well as the greed of wanting
to get even more, these things will never change. what’s that you say,
people are smarter ? more sophisticated ? this could never happen in modern
times ? well, sure it does, only now we have a brand new name for it. this
time around, courtesy of mr. alan greenspan, it’s called ‘irrational
exuberance’.
perhaps the most telling example i can think of is a stock called cmgi.
to tell you the truth, i don’t even remember now what the letters stand for
(perhaps i never knew to begin with).
however what i do know is that this network dot com darling (again, i’m not
even sure exactly what it was they actually did), came on the scene about 10
years ago, worth a few dollars per share, and from mid 1998 to early 2000,
proceeded to run up from about $3 a share to over $160, all the while never
really showing any earnings or making any money for their shareholders.
just why it ran up so high, nobody really knows. however i do know that ‘day
traders’ were buying this stock and selling it a day later (sometimes even
an hour later) to make a few points profit.
and they didn’t know any more about it than i did. of course, when people
‘came to their senses’, and the nasdaq bubble finally burst beginning in the
latter half of 2000, cmgi plummeted straight down from it’s high of $165,
and within less than a year, was trading under ten bucks a share (today, i
think it’s under a dollar !)
there was never really any solid fundamental reason for the run-up, which
is of course why it came crashing back down eventually.
however i’ll tell you what, trend followers of all time frames, both long
term traders and day traders, made a hell of a lot of money during both the
big rally and the subsequent decline.
turtle cotton trades click the chart
in fact, in this example, and others like it, the trend followers made money
at the expense of other types of traders. people who traded counter trend
and believed that trading ranges and support and resistance levels would
hold up got crushed. value investors, who saw no reason for the run up and
sold into the move, or sold short too soon, got crushed.
many analysts and
economists and some other very smart people just couldn’t see the big
picture, which was simply jump on the trend and run with the herd, and don’t
stop to think too much about it.
so there you have
it. prices of all things sit in an equilibrium level type of trading range
for a while, then something happens to change that level of equilibrium, and
the whole price range moves to a new level. sometimes there are valid
underlying economic or fundamental reasons for the change, and sometimes
there are none and people are just hallucinating about the whole thing.
however either way,
the price does move, often times picking up more momentum along the way, and
the trend followers jump on board and earn a nice living because of it.
this is the way
the real world works, it has been this way for hundreds of years, and will
probably continue for hundreds more. basic laws of economics and basic laws
of human nature will never change. maybe technology changes, however the
markets, and the people that make them up, don’t change.
people who
heralded the death of trend following just a few years ago pointed to faster
computers and better communications and thus more efficient markets. however the
structure of market price movements, including trends, have not changed
today from the days when prices were marked by hand by a guy standing on a
ladder and writing on a chalkboard.
finding an advantage
and moving from a
chalkboard to a keyboard thirty years ago was certainly a much more
revolutionary technological change than going from 286mhz desktop computer
to a 500mhz one.
so now that we
understand how markets work and how prices change and move, and the
fundamental, economic, or psychological reasons that cause these (mostly
temporary, however sometimes permanent) shifts in the supply and demand curves
and thus the intersecting fair market values, we have to figure out how to
take advantage of all this in order to make some money.
however, the
problem has always been that although it’s the fundamentals that move the
market, they are hard to measure, and sometimes impossible to identify,
before it is too late.
it is fair to say
that almost all individual traders, and even most firm trading desks, are at
a huge informational disadvantage compared to the producers or suppliers of
any given commodity (or even a stock).
let’s go back to
one of my favorite examples, the coffee market. and let’s assume that our
scientific technology is so far advanced that we can get reliable weather
reports giving us advance warning that a cold front is heading towards
brazil.
well, the price of
coffee may start to rise, as people anticipate a drop in available supplies
however nobody is going to know exactly what the new fair market price should be
until they actually know how much of the crop was damaged and what is the
remaining crop yield.
at this point, the
folgers and starbucks of the world will have their people out in the fields,
meticulously checking to see exactly how many plants were damaged and what
remains available to harvest. they will know long before we do the net
change in supply figures, and thus their bean counters or in-house
economists will be able to calculate what the new prices should be.
we, sitting at our
trading desks, are not privy to, and cannot compete with, that information.
and they are certainly not going to tell us, the general public, at least
not until they have had time to adjust their own trading positions first.
the same thing can
be said of most financial markets. let’s say a country needs to borrow
money, or wants to increase or decrease the relative value of its currency
on world markets to solve an internal fiscal or monetary problem.
the political and
financial leaders of that country will be figuring out exactly how much more
currency to print, or how many more bonds to sell or redeem, so as to
successfully solve their problem.
however the sharpest
traders on the major bank desks, let alone you or i sitting at home are just
not going to know what those numbers are with a high enough degree of
accuracy to successfully take a position in advance of the new equilibrium
curve.
because we just
don’t know this information, and cannot effectively or efficiently obtain it
on a timely basis, we "infer" the answer by the use of technical analysis.
in the simplest of
cases, if we look at daily (or any other timeframe) price charts, and see
the price of a stock or commodity is moving, we become aware that "something
is up".
crystal ball
we may not know
exactly what it is, however we can still take advantage of it. at some point, if
the anomaly continues enough, it sets off some sort of trigger or signal in
our brain (or in the trading system on our computer), and we sit up and take
notice.
we (sort of)
arbitrarily define in advance just what it’s going to take to get us to
notice, i.e. the price of something goes higher than it has in the last 20
bars of a daily chart, or the price crosses over the 50 day moving average
of itself. and then we (hopefully) react.
 technical
analysis can take many different forms, some good and some bad. in my
opinion, the ‘bad’ forms tend to be predictive, as if to say there is a
crystal ball telling us what is going to happen next.
however i personally
do not believe that anybody can predict the future, when it comes to the
markets or anything else.
on the other hand,
‘good’ forms of technical analysis tend to be more reactive, we notice
something is happening and we then react appropriately.
as a trend
follower, i will never buy something because i think the price is going to
go up. in fact, i shouldn’t be thinking that way to begin with, because i
really have no idea, and i shouldn’t even kid myself that i do. i wait for
the price to go up by a certain amount first, and only then i buy, because i
assume it is going to continue.
and the truth is,
i really have no idea either if it is going to continue going up or not, however
i sort of rely on newton’s law of physics, which says that something in
motion tends to stay in motion.
we also have a
whole set of technical language which we use to describe and/or quantify the
underlying economic fundamentals that we have been talking about previously.
for example, i have explained that when supply and demand are in
equilibrium, prices will tend to stay in some sort of trading range.
when something
happens to change that existing balance of supply and demand, prices will
shift to a new level in order to reflect that change of fundamental market
conditions. some things are fairly stable and constant their entire lives
however when it comes to prices and values in the financial markets, we know
that nothing remains the same forever.
whatever range we
may be in presently, that whole price curve can move and be somewhere else
in the future.
in the language of
technical analysis, these conditions of equilibrium and shifting are known
as periods of consolidations and trends. and it is pretty much a fact of
life that both types of conditions will exist at some point during the life
of any commodity or stock issue.
during
consolidations, i.e. periods of equilibrium, prices remain in a trading
range. often times, price starts moving up or down, and it looks like there
is going to be some kind of a breakout from the current range. however in a true
consolidation, if the price gets too high (or too low), the breakout fails
and the price will fall (or rise) back inside the trading range.
react appropriately
needless to say,
during these times trend followers lose money. of course there are other
times when breakouts succeed and trends do successfully develop.
the supply-demand
equilibrium, and thus the fair market value or price, has indeed shifted to
a different level, maybe due to some fundamental structural change in market
conditions, or maybe just due to the psychological perception of one.
it is important to
once again emphasize that we as traders do not really care why the move is
happening, all that matters is that we react appropriately in order to take
advantage of the move and make some money for ourselves.
it is also
important to emphasize that nobody can predict when a breakout is going to
successfully develop into a trend, and when it is going to fail and drop
back into the consolidation range.
if anybody knew
this, then trading would be easy, i.e. be a trend follower when the
breakouts are going to work, and be a counter trend trader when the
consolidation is going to hold up.
many traders and
system developers think they have found some method to identify or predict
these potential changes in market conditions, however the truth of the matter is
that the only way you are ever going to know it is after the fact, not
before.
on the other hand,
if alternating periods of consolidation and trend are a fact of life in the
markets, then it just takes a little common sense to assume something such
as the longer that the market has already been in a consolidation, the more
likely it is that conditions may soon be changing, and the next breakout to
come along might be a successful one.
in this scenario,
with every new (potential) breakout having a slightly greater chance of
working, you might consider taking each subsequent signal a little bit more
aggressively.
however having a
little bit higher probability is not the same as being able to predict a
sure thing.
sometimes it’s
just uncanny how well technical analysis works. of course, sometimes it’s
very frustrating how wrong it can be too, however we will address that issue in
a moment.
however i certainly
have seen things happen that i just could not explain to someone who wasn’t
there.
i can clearly
recall one big move in orange juice about twelve years ago. the market had
been in a long, tight narrow consolidation for about eight months, and
volatility had dried up to less than one cent per day. the chart looked like
a coiled spring, ready to explode.
and then one day,
all of a sudden, without any warning, the market had a big day on the
charts, breaking out of its range and rallying to six month highs. the trend
followers who were quick to react got on board, while many other market
participants were shaking their heads trying to figure out what had
happened.
meanwhile, the
next day, the market just kept going higher. about two weeks later, a cold
freeze hit the florida growing regions, causing major crop damage. it was
just inconceivable to me, because even the most astute weather analysts and
forecasters could not have seen something like this coming so far in
advance. and even if they did, nobody could possibly have any idea of how
badly the trees might be damaged.
biggest trends
another good
example along the same lines took place in the energy markets in the early
1990s. after being in a long trading range with a slight bias towards the
downside for several months, all three of the major commodities, i.e. crude
oil, heating oil, and unleaded gas made upside breakouts and new life of
contract highs within a day or two of each other.
and this was
perhaps a month before saddam hussein fired his first scud missile.
technical
analysis, including an extra proprietary indicator used by the turtles,
showed that these breakouts had a good possibility of developing into a
major bull trend. yet for all purposes, at the time of the breakouts, the
u.n. was still engaged in peaceful negotiations, and the popular consensus
was that a war would not take place.
as many of you
probably remember, these breakouts indeed turned into the biggest trends of
the entire year.
i would say that
unless saddam had called all his generals into a private meeting, gave them
plane tickets to fly to new york, told them to rent seats on the nymex, and
start buying up all the energy contracts they could because he was indeed
planning to start a war, there is just no way that anyone could have known
in advance what was going to happen.
however the market
knew. because, in a sense, the market always knows everything after all, the
market is the collective intelligence of all the players, who else would
possible know more?
the point is,
sometimes even before the fundamentals present themselves to the public and
often even before they are known to the market ‘insiders’ themselves,
technical analysis will give you a clue as to what is going to happen next.
all you have to do
is pay close attention and listen to what the market is telling you. and
then take the appropriate responsive action.
as i’ve said
earlier, there are both good and bad kinds of technical analysis. quite
obviously, i think the turtle system is one of the 'good’ kinds. besides
looking at consolidations and trends and breakouts from the appropriate
perspective, we do much more.
everything the
turtles do has been historically tested in a very robust setting, including
a large and comprehensive sample size of data, and it has stood the test of
time.
one of the biggest
continuing problems of current technical analysis is that most people do not
have a good understanding of how to test ideas or indicators to see if they
really do work or not.
it was noted
earlier that one of the ‘explanations’ for the demise of trend following was
that the markets had somehow fundamentally and technologically changed.
well, of course they changed. in a sense, all things always change. that is
called progress, or evolution. of course, sometimes, the more things change,
the more they stay the same.
curve-fitting trap
while technology
and communications have changed dramatically in the past several decades,
the laws of economics and human behaviour have not.
on a different
level, there are just so many unknown and interrelated variables that it
becomes literally impossible to account for everything. yet time and again,
system developers fall into the same ‘curve fitting’ trap they should have
learned to avoid.
as soon as the
markets start behaving differently for a while, all of a sudden, everybody
thinks that things have changed, the old rules get tossed out the window,
and we must figure out new ones to replace them.
people try to
develop new and better systems based on smaller (and arbitrary) sets of
data. yet the safest course of action, for either a trader or money manager
or system developer or anyone else, is to look at things over one huge
continuous set of data, and not even try to break it up into different
(arbitrary) time periods with different sets of conditions.
the turtles have
used, and continue to use, systems and indicators that have been both
developed and tested over as much data as possible. the fact that there may
be some rough periods when this methodology does not perform well, or as
well as another (possibly curve fitted) system over some small data set such
as a year or two of prices, does not at all compromise the long term
validity and profitability of the methodology.
although i think
it’s fair to say that all good traders will make small adjustments and
refinements based on continuing research, there have never been any major
changes to our systems since we started.
in other words,
show me a system that has been profitable over the past twenty years, albeit
with a few of rough spots, rather than an alternative that has had superior
performance however only been around a couple of years.
money management
one other thing we
need to talk about is money management. trend following is indeed a valid
and profitable methodology, yet markets are in consolidations or trading
ranges about 70 percent of the time.
since we don’t
know when markets are going to trend or when they are going to consolidate,
we have to trade the same way all the time. thus, you might be inclined to
trade counter trend, because then you would be right 70 percent of the time.
however, it turns
out that this idea is actually wrong, and that trading like a trend follower
is a much better strategy to follow in the long run.
in order to
consistently make money by following a trading strategy that only works 30
percent of the time, it becomes obvious that your winning trades have to be
larger than your losing ones. therefore, knowing when and how long to ride
your profits, as well as when and how quickly to cut your losses, is an
integral part of this or any other similar trading strategy.
the turtles actually have two different (and independent) sets of money
management rules.
the first group is
related to position size in terms of portfolio theory and market volatility,
and tells you how aggressively to load up on each new signal that comes
along in order to make the most amount of raw profit with the highest degree
of efficiency on any given trade.
the second, and
totally independent set of money management criteria, are derived from risk
of ruin tables and statistical probability theory, and are designed to keep
you in the trading game for the long run, regardless of how choppy things
might be in any short term period.
the complete
turtle system is so strong, that despite some historically very bad, choppy,
non-trending market periods, we have had only one (small) losing year in the
past 20 years.
our key is that
even when the markets are giving false signals and there are no trends of
which to take advantage, the two money management overlays just mentioned
are good enough at controlling the losses and keeping you in the game, to
the point that as soon as one good trend comes along, and one always will if
you have enough patience (and discipline and capital), that you can pull
yourself right out of the hole and get back to the profitable side of the
ledger.
in fact, i have
had people with almost no interest at all in commodity futures, from equity
hedge fund managers to professional players, want to learn the turtle course
just for the money management parts of the system.
i overreacted
when i shut down
my offshore pacific turtle fund during the summer of 2001, and wrote a
letter to my investors that trend following wouldn’t work any longer, i
guess in hindsight it’s fair to say that i overreacted.
while one of the
reasons for closing the fund was a prolonged period of choppy markets there
were other considerations as well. the turtle system was strong enough that
the fund was holding its own and not losing money based on poor trading
results.
unfortunately,
there are high administrative costs associated with managing such a vehicle.
in a large fund, these fixed dollar costs are more spread out, and will not
amount to anything significant. however in a small fund such as this one, the
annual management costs, as a percentage of total assets, became quite
prohibitive.
when the largest
investor decided to redeem his shares in order to go play in the stock
market instead, the administrative costs became overbearing on the remaining
investors and the fund closed.
at that time, in
mid 2001, there had not been any major trends in the futures markets for a
while and several other large trend following ctas, including, as i
mentioned, richard dennis, had recently shut their doors.
in retrospect,
knowing that its always darkest before the dawn, this should have been a
clear indication to me that the end (of the disappointing period) was near,
and that our trading style would start working better again soon, just as it
had done in the past.
instead, i let all
my emotional frustrations get the better of me and i found myself looking
for different reasons, or should i say, rationalizations to just throw in
the towel.
i became tired and
frustrated about not earning any money. my own trading had gone sideways for
a while, as had my managed accounts, for which i primarily was paid only an
incentive fee.
as more and more
people in the industry, including some whom i highly respected, kept saying
that things had changed, i felt like i was fighting an uphill battle.
maybe they were
all right, and i was wrong to keep banging my head against the wall. of
course, i should have remembered that old adage, "the majority is always
wrong", however i fell into the same classic trap as everyone else and gave in
to the herd mentality.
however, i was
still not entirely sure the game was over and i wanted to keep at least one
foot in the door just in case. i obviously didn’t feel right managing money
for people in a fund with a prohibitive cost structure and i was so burned
out from trading that it wasn’t fun any longer to sit by my screens every
day trading my own account.
pleasing results
however i still had
several market hotline subscribers who had paid me for an annual service
some of whom wanted to keep getting the daily reports instead of taking a
pro-rated refund. i also had one or two people who had contracted for the
rights to market my course and teach the turtle system to others, and i had
to honour those agreements as well.
as it turned out,
as the calendar year 2002 progressed, even though i wasn’t actively trading
any more, i kept getting phone calls and e-mails about the markets and about
the turtle system.
some came from
brand new customers that i hadn’t even known about, telling me how pleased
they were with the initial results they were getting, and some came from old
or established customers telling me how the system had finally started
working again.
all of a sudden,
thanks to a couple of good old fashioned catastrophes, like economic
depressions in several industrialized countries, and the threat of a new war
revolving around terrorism and the middle east, the supply-demand curves for
several markets, including a few agriculturals, several financials and even
some equities, were now suddenly shifting, and nicely trending markets,
along with trend following trading styles, were back again.
or perhaps, more
accurately, they had never really permanently left to begin with. so, i
guess i was wrong after all. welcome to the new millennium where some things
are still the same.
or, as the great
yogi berra once said: "it’s deja vu all over again."
if you would like to see how the turtles returns are
visit
the following link on my website
click here>>.
russell sands
florida usa
www.turtletrading.com
ps i have placed a free report on one of my trading campaigns in coffee at
the adest site for you to view. click here
to read it
pps in the text above i have put charts of
some of the markets that contributed to the 2003 success of the turtles
- just click on them and have a look: the turtles nabbed some
aussie dollars. your aussie dollar has provided a gold mine. look at the
money the turtles took from the pockets of traders like the ones at the
national australia bank.
if the nab were
trading the turtles way they they would have been up over $300 million not
down it! a very nice market for this year - making a change from previous
years.
it seems as if the
commodities are running for a few years. here's a market that worked great
for our smaller traders - we have found a way to get the smaller guys
trading the turtles. soybeans has been called the "millionaire maker". this
was a trade that was started during my Australian seminars in august 2003.
it was a beauty.
i will be in Australia and Asia for a series of seminars
in March.
i look forward to meeting you then.
russell sands can
be contacted through his website
www.turtletrading.com where you can also obtain a free article on
trading coffee the turtle way and your first turtle trading lesson.
return to newsletter
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