Michael Covel: How to Make Millions with Trend Following

Hi, My name is Dave
Goodboy, I am Executive Producer of Real World Trading. Today I will be talking
with Michael Covel, author of Trend Following: How Great Traders Make
Millions In Up Or Down Markets. Michael has studied many of the great
trend-following traders and has distilled their wisdom in his book. Trend
following seems like a simple concept, but Michael was the first person to
actually absorb years of trend following experience, organize it and present it
in an easy-to-understand format. Although I don’t agree with everything in his
book, there is much knowledge contained in its pages. This interview will
provide you the core lessons of the Trend Followers. Lets get started!

DAVE: Hi Michael,
Welcome to Real World Trading.

MICHAEL: Nice to be here.

DAVE: Lets get
started by defining the term ‘Trend Following.’ What exactly do you mean?

MICHAEL You know, there is a good
definition in the book by Van Tharp. I will simplify the definition even more.
If a market is trending up, you want to be long that market, trading that market
as it goes up, as far as it might go up, so you’re following that trend. On the
flip side, if the market reverses and goes South, you want to be following it
that way. It’s the idea to follow the trend of the market, up or down.

DAVE: That sounds
simple enough, but how does it differ from a buy-and-hold philosophy? Markets
have a long-term up-trending bias. Why not just call Trend Following “buy and
hold”?

MICHAEL: Jerry Parker, one of the great
trend followers profiled in my book, calls “buy and hold”, “buy and hope”. Buy
and Hold is totally different from Trend Following.

DAVE: OK, explain
the difference to me.

MICHAEL: When you say “buy and hold,” you
are really saying “OK, I’m going to make a bet on the market, I’m going to get
in.” However, you don’t have an exit strategy if you are wrong. Warren Buffet is
one of the kings of buy and hold He is tremendously successful, but he is not a
Trend Follower. Think of the little old lady from Omaha that bought
Drugstore.com in the spring of 2000 on a buy-and-hold approach and then it
cratered. So I think it’s the not having an exit strategy that what really
causes problems for traders.

DAVE: It’s having
an exit strategy that differentiates your concept of Trend Following from the
basic Warren Buffet type “buy-and-hold” idea. Is this correct?

MICHAEL: That’s one. I think another thing
is that Warren Buffet talks a lot about value, and trying to ascertain the value
of an asset that you might be investing or trading in, where trend followers
say, gosh, I really don’t care the name of this market–what it is, I don’t care
about the fundamentals–just let me ride that trend.

DAVE: Your book
reads like a who’s who of famous traders. Are all the traders profiled in the
book trend followers?

MICHAEL: Most are, one example of a
gentlemen who I quote from is Jim Rogers. He is not a trend follower per se, but
I would argue that the money he has made has been made by riding some mammoth
trends.

DAVE: Right, he
is sort of a trend follower by default. Is this what you mean?

MICHAEL Correct, but he is obviously a
fantastic trader in his own right.

DAVE: One of the
primary concepts in the book is that price tells one everything they need to
know about how to trade. Can you elaborate?

MICHAEL Well, a lot of decision-making
theory and behavioral finance theory emanating from the universities is now
starting to back up what trend followers have always known. Which is, you can’t
fit a world filled with so many variables. I mean, let’s say you want to trade
Microsoft. What do you focus on to trade it? Do you focus on the news reports on
CNBC? Do you focus on Bill Gate’s statements, PE ratios, some type of metric
that you’ve determined, so how in the world, where you got all these
variables, can you condense it to one variable where you can make all of
your decisions off one variable, a variable that encompasses everything you need
to know about that particular market in real time? In real time the only thing
that any of us can know on any given day is the price of that market. It
reflects all the fears, hopes, directional biases, whatever is reflected in that
one number. For trend followers, they want to say I want to follow the trend of
that market. I’m going to look at that market price to tell me the trend, I’m
not going to try to predict that trend, can’t predict it, how can I predict it,
none of us can predict anything, but trend followers say I’m going to look at
that market price each day and if that market price each day starts at ten and
it goes to twelve and it goes to fifteen and it goes to twenty, well that price
is telling you something.

DAVE: OK, do
trend followers use any other indicators other than price to determine trend?
Something like a moving average?

MICHAEL Well, the trend followers I discuss
in the book are obviously technical traders by nature.

DAVE: Right.

MICHAEL When analyzing price, they will use
various indicators to get themselves into a trade. It could be a moving average,
it could be a break out. Most of them probably prefer a breakout, you know,
something that’s not delayed, or not a lag, so looking at that price movement
right then and there. The trick is with trend followers, they don’t look at an
indicator and say ”I’m going to use x, y and z indicator which will predict
further movement.” Trend followers say, “OK, when our indicator moves in a
certain direction we will react to either the up or down price movement in real
time to take a position, but we’re not looking at a moving average and saying to
ourselves that it’s going to predict how far that move is going to go because no
one knows how far the move is going to go. Me, you, the guy behind the tree, no
one knows.”

DAVE: Regarding
Trend, you quote Paul Tudor Jones’ ex chief technical guy —Peter Borish. Peter
is extremely intelligent. What are his views on price?

MICHAEL: Peter believes that price makes
news, not the other way around.

DAVE: All right,
so this goes back to your idea that price is all you need to know. Can you give
us an example of price making news?

MICHAEL: Well sure, look at last year. Last
year we had all the cattle, cattle went up by the time cattle got the highs
people were blaming it on mad cow, or the Atkins diet and so forth. You know the
price had gone up and then they invented the news stories to fill in why the
price had gone up.

DAVE: I tend
to agree with that. It’s an interesting perspective. I think that you were
probably the first person that’s ever really tried to quantify trend following
and I found that really fascinating. You took a list of performance data and
applied it to these famous trend following traders. Can you elaborate on this?

MICHAEL: I think you hit something, you hit
you hit the nail on the head there and I think when you have that light bulb go
off and you can look at several different examples. Look at Long Term Capital
Management. They started to have real trouble in the summer of 1998 and it’s all
over the news, the major publication, the feds involved, all the major New York
banks are involved, but nobody was really writing the story at the time of guess
who’s making billions.

DAVE: Right.

MICHAEL: The performance data reflects that
the trend followers were reaping the rewards of the LTCM debacle.

DAVE: OK, moving
on here, is volatility a friend or enemy of the trend-following trader?

MICHAEL: Volatility is really a friend of
almost any trader. If you don’t have volatile markets, there is no movement.
Volatility could also be the precursor to movement, but you know, trend
followers need volatility, they need movement.

DAVE: You also
put forth the concept that trend following reflects and profits from the fact
that markets are a zero-sum game. What do you mean by this?

MICHAEL: Well I think, in its truest sense,
the idea of a zero-sum game is two players playing the game and there’s going to
be a winner and a loser and the wins will come from the losers. A really great
example of this in the last ten years, a really stark example would be John
Henry and Barings Bank.

DAVE: Do you mean
the Nick Leeson, the “rogue trader”example? Where he almost busted the Queen’s
bank?

MICHAEL: Yes, that is what I am referring
to. John Henry was the leader in this win. He basically was on the other side of
Leeson’s trades. By following his trend system, Henry was able to capture much
of Leeson’s losses. People don’t like talking about the markets being a zero-sum
game since many feel that it is wrong .

DAVE: Wrong? You
mean like unethical?

MICHAEL: Correct. I know you mentioned your
friend Jonathan Hoenig before we started the interview. I am sure he has a few
comments on this issue.

DAVE: For sure.
Any objectivist, Libertarian would have an issue with the concept of zero sum
being unethical.

MICHAEL: The markets are just a creation
where we can all and play. The market has rules and I mean sometimes people will
say, oh the shorts sellers, those short sellers messed everything up. You can go
long in the market, you can go short in the market. Those are the rules. And
doing my research, my homework, you just got to look at this and say
objectively, why would you criticize somebody because they went into the market
and they just happened to be a little better than you at it, they worked a
little bit harder, they studied a little bit more, and they just knew they could
play the game a little better than you, so when they happened to beat you, all
you can do is turn around and criticize them for winning.

DAVE: Yes, I
think that criticism of winners is unfortunately part of the culture today.

MICHAEL: Responsibility is not a
positive word anymore, blame seems to have become the word of the day and it’s
unfortunate but you know from a market standpoint, from a trend-following
standpoint, its just not our issue.

DAVE: I would
take the zero-sum game idea one step further, saying the markets are actually a
negative sum game. This is due to the vig, or commissions on every transaction.

MICHAEL: Good point.

DAVE: When you
lose, you lose what you decided to bet, plus the commission. When you win , you
win minus the commission or vig.

MICHAEL: Absolutely correct.

DAVE: And you
actually win less than you win.

MICHAEL So it means you have to account for
the extra part.

DAVE: Right.

DAVE: So you’re
actually behind the 8 ball from the beginning.

MICHAEL: I think you bring up a good point
in the sense that most people probably don’t like to think of the fact that when
they make a decision in the marketplace that their correct decision could
invariably be taking money from the person that made the incorrect decision.

DAVE:
Unfortunately, that is the nature of the market. If someone feels this way, they
should not be trading.

MICHAEL: Sure.

DAVE: I know you
mention Victor Niederhoffer and his questioning of trend following. Victor’s
fund has been performing extremely well lately, and most of the trend followers
you profile are having tremendous draw downs currently.

MICHAEL: I was not aware of Niederhoffer’s
recent performance, but yes, you are correct, several of the big-name trend
followers are having a draw down this year.

DAVE: Why is
this? If these guys follow the trend, they are obviously on the wrong side of it
now. Can you explain this seeming contradiction?

MICHAEL: Drawdowns are not uncommon for
trend followers. It’s the nature of the beast. For example: one of the greatest
trend followers–Bill Dunn of Stewart, Florida–is notorious for having
drawdowns. He is having one right now. However, when you look at Bill’s
performance data, you say okay, do I want to be with a man you know that can,
from an equity peak drawdown 30 or 40 percent, but then when he recovers, he
goes up another 100 percent? See, that’s the thing with trend following—