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Trend Following

Contributed by Michael W. Covel

Answer the following five questions below and you have the core components of a trend following trading system:

1. How does the system determine what market to buy or sell at any time?
2. How does the system determine how much of a market to buy or sell at any time?
3. How does the system determine when you buy or sell a market?
4. How does the system determine when you get out of a losing position?
5. How does the system determine when you get out of a winning position?

Although these five questions are seminal to trend following, no less critical is your attitude. Don't forget to ask yourself: What do you really want? Why are you trading? What are your strengths and weaknesses? Do you have any emotional issues? How disciplined are you? Are you easily convinced? How confident are you in yourself? How confident are you in your system? How much risk can you handle?

Let's jump into a few of those questions.

When do trend followers enter?

After a trend has begun. Why? Trend followers have no ability to predict when a trend will start. The only way to know a trend has started is when it starts to move either up or down. For example, let's say Apple is trading between $200 and $220 for six months. All of a sudden Apple jumps, or breaks out, to a price level of $230. That type of upward movement from a range is a trigger for trend followers. They say, "I might not know that Apple is going to continue upward, but it's been going sideways for a while, and all of a sudden, the price has jumped to $230. I'm not in this game to try and find bargains or cheap places to buy. I'm in this game to follow trends, and the trend is up."

This approach is counter-intuitive for many. One trend trader outlined the simplicity:

"As our systems are designed to send a buy or sell signal only when a clear trend develops. By definition, we never get in at the beginning of a trend or get out at the top."

If your goal is to ride a trend that starts at $50 and perhaps goes to $100, does it really make a difference whether you got in at $52 or $60 or $70? Even if you got in at $70 and the trend went to $100, you still made a lot, right? Of course if you got in at $52 (and how you think you might predict the bottom, I will never know), you made more money than if you got in at $70. There are plenty of traders out there who think, "Oh, I couldn't get in at $52, so I don't get in at all, even if I have the chance to get in at $70."

Famed trader Richard Dennis elaborates:

"Anytime the market goes up a reasonable amount, say a strong day's work - after you've put on a position, it's probably worth adding to that position. I wouldn't want to wait for a retracement. That is everyone's favorite technique - to buy something strong that retraces. I don't see any justification in the statistics for that. When beans are at $8.00 and go to $9.00, if the choice is to buy them at $9.00 or buy them if they retrace to $8.80, I'd rather buy them at $9.00. They may never retrace to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement."

Even if people are familiar with Dennis' approach to trading, they still focus on entry - a misdirection of energy and focus. Another great trend trader dead-panned:

"The entry is a big concern before it happens, a small concern thereafter."

He is saying after you are in a trade, the entry price isn't important. You have no idea how high the market is going to go, right? You should be concerned about protecting your downside in case the market goes against you as opposed to creating dramas associated with entry. How long can trend following trades last? Another trend trader opined:

"Positions held for two to four months are not unusual, and some have been held for more than one year, says a spokesman. Historically, only 30-40 percent of trades have been profitable."

The words of great baseball player Ted Williams immediately come to mind: "Hitting a baseball, I've said it a thousand times, is the single most difficult thing to do in sport. If Joe Montana or Dan Marino completed 3 of every 10 passes they attempted, they would be ex-professional quarterbacks. If Larry Bird or Magic Johnson made 3 of every 10 shots they took, their coaches would take the basketball away from them."

However analogous it is to baseball, only 40 percent winners is hardly a percentage worth most people would think wise to emulate. So how is it possible to make money with 40 percent of your trades winners? Jim Little of trend follower Campbell and Company was clear: "Say, for example, on the 60 percent, you lose 1 percent of your capital, but on the 40 percent winning trades you make 2 percent. Over longer periods of time, say a year or more, this would net 20 percent on a broadly diversified program."

In other words, winning and losing trades over time are blended together. Winners make up for small losers. Trend followers rules to enter and exit are driven by what many call technical indicators. The technical indicator for trend followers is price action. However, most traders remain preoccupied with the hundreds upon hundreds of other indicators that promise 'prediction.' They discuss and debate which is better: MACD or Bollinger Bands? Which is more profitable: ADX or Williams %R?

Of course the answer is: none of them. Technical indicators are small components of an overall trading system and are not a complete system. They are like a couple of tools in a toolkit, not the kit itself. A technical indicator accounts for typically 10 percent of the overall trading success of a trend following system. When traders say, "I tried Indicator X and found it was worthless" or "I tried Indicator Y and found it useful," they make no sense. These statements imply an indicator is the actual trading system. By itself, a technical indicator is meaningless. Bottom line, because trend followers never know which trend will be their big winner, they accumulate small losses trying to find it. It's like sticking the toothpick in the cake to find out if it's done. They are testing the market to find out if the little trend will grow into a big trend. Hence, you can end up with the 60-percent losing trades.

All this said what is a concrete example of entry?

The famed trend following "Turtles" learned two breakout variants or 'systems.' System One (S1) used a four-week price breakout for entry and a two-week price breakout in the opposite direction of the entry breakout for an exit. If a market made a new four-week high, the Turtles would buy. They would exit if/when it made a two-week low. A two-week low was a ten-day breakout - counting trading days only. While the System One entry rule is straightforward, the Turtles were taught extra rules to confirm whether or not they should take the four-week breakout. The extra rules were called 'filters,' and they were designed to increase the odds that when the Turtles took a four-week breakout signal, it would continue as a potentially big trend. The filter rule: The Turtles ignored the System One four-week break-out signal if the last four-week breakout signal was a winner. Even if they did not take the last four-week breakout signal, or even if it was just 'theoretically' a winning trade, the Turtles still didn't take the System One breakout. However, if the trade before a current four-week breakout was a 2N loss, they could take the breakout ('N' was simply their measure of volatility). Additionally, the direction of the System One four-week breakout was irrelevant in terms of the filter rule. If their last trade was a short losing trade and a new long or short breakout hit, they could take that breakout and get in. But this filter rule had a built-in problem. What if the Turtles skipped the entry breakout (since the last trade was a 'winner') and that skipped breakout was the beginning of a hugely profitable trend that roared up or down? Not good to be on the sidelines with a market taking off! If the Turtles skipped a System One four-week breakout and the market kept trending, they could and would get back in at the System Two eleven-week breakout. This fail-safe System Two breakout was how the Turtles kept from missing big trends that were filtered out. System Two was the Turtles' longer-term trading system. It used an eleven-week breakout (fifty-five days) for an entry signal and a four-week breakout (twenty days) in the opposite direction for an exit.

So what is another good example of trend following specifics? The nitty gritty?

In the quest for trading success, many traders are seduced into a fruitless search for a perfect entry or exit technique. While they hunt in vain, they miss some very simple strategies that enhance trading returns yet do not involve entry or exit. One strategy most traders overlook altogether is risk equalization. Risk equalization allows a speculator to make proportional adjustments to their account while staying within their tolerance for risk. Risk equalization means you adjust the number of contracts or shares to stay within predetermined risk guidelines. For instance, a trader wouldn't trade a Corn futures contract the same as he would trade an S&P 500 futures contract. The two contracts are dissimilar in size and move differently.

Frequently however, traders get a 'lot size' mentality. They are comfortable trading one contract of many markets, but get skittish at the possibility of having 10 contracts on one instrument and 2 on another. Many traders become anxious if they have different contract sizes in different markets. If you suffer from this anxiety don't let it get you down. Professional and seasoned traders get caught in this trap.

Consider a trading program that did not risk equalize their portfolio. During 2003 this program returned north of 40%. Money under management quickly blossomed from less than a million dollars to over $20 million in just (Figure 1 & Figure 2) a month period.



All indications pointed to a very promising future. But a while back I noticed they were trading one CME Eurodollar contract and one CBOT Ten Year Note contract concurrently. A trader with just a few months of experience realizes, in terms of risk, one Eurodollar is not equal to a single Ten Year Note contract. In comparison with the Ten Year Note, Eurodollars typically have a smaller margin requirement and smaller daily fluctuation. The trade ended with Eurodollars up and Ten Year Notes down. Since risk was not equalized, the two positions netted a loss. If risk had been equalized then the trades would have netted to nearly break even.

This program ended down more than 50% and their assets under management quickly dwindled back to a few million dollars. There is no doubt that inadequate risk management, specifically risk equalization, shortened the life of their program.

The good news? There are several methods you can use to equalize risk on your own. For example, what if you're a futures trader? Futures traders have a distinct advantage due to margin. Exchanges and brokerage firms factor in market volatility to set margin requirements. Simply stated, markets with high margin have a larger daily monetary fluctuation than those with a low margin requirement. A market with a $500 margin requirement will move slower than a market with a $5,000 margin requirement. Recall the Eurodollar/Ten Year Note example. At the time CME Eurodollars have a margin requirement of $400 and CBOT Ten Year Notes' margin is around $1,200 You can quickly see it takes 3 contracts of Eurodollars to equal one contract of Ten Year Notes. Another method of risk control involves measuring the risk you want to take on each trade or fixed fractional trading. Fixed fractional trading simply means you trade the same percent of your account on each trade. For instance 5% risk per trade on a $25,000 account means you use a maximum of $1,250 per trade. (Figure 1) As the account increases in value so does the risk per trade. At $35,000 5% risk per trade equates to $1,750. (Figure 2) Risk for each market does not exceed 5% of the total account size in either example.

Your personal situation may be different, but the math works the same. The risk in dollars fluctuates as the account increases or decreases in size; however risk is always contained to a fixed percent per trade. This method is versatile enough to accommodate stock traders too. Your monetary risk is the distance between entry price and the stop setting. For example: if you own a stock at $50.00 per share and use a stop of $46.00 then monetary risk is $4.00. If you wanted a maximum risk of $1,250 then divide $1,250 by $4.00 to get the number of shares, or 312 for this example. Implementing this type of risk control allows you to take advantage of your trading capital without becoming over extended on one trade. Both novices and veterans must fight the temptation to become married to one trade. This temptation can force you to take a larger position because you feel a trade will work out regardless of short-term fluctuations. Most times the trade never works out as expected and losses mount, the unenviable position of most investors who simply buy and hold. You may even be forced into retirement with extreme losses. Having a clearly structured money management scheme you adhere to allows you to promptly size up risk and control it. Manage risk or it will manage you. Don't be a trader who is afraid to take bigger positions in smaller markets. Subscribe yourself to the old trading axiom, trade all markets equally and equally trade all markets.

What are some of the top reasons to trade as a trend follower?

Profit in Up and Down Markets:
Trend following doesn't swear an allegiance to a bull or bear market. It follows trends to the end. No matter how ridiculous trends might appear early and no matter how insanely extended they might appear at the end, follow trends. Why? Because they always go further than anyone expects. Ignore momentum at your peril.

No More Buy and Hold, Analysts or News:
Trend following decision-making doesn't involve discretion, guesses, "gut" feels or hunches. It's not day trading or buy and hold (hope). It doesn't involve passive indexing, in and out trading or fundamental . No more 24-hour news cycles, daily turbulence or sensational hype. No black boxes or magic formulas either. Hope is the most addictive drug. Let go of the Holy Grails.

No Prediction:
Trends exist everywhere, always coming and always going. Whether fashion, business or whatever, we all want to find trends and ride them as far as they can go. Markets are no different: they trend up and down too. That said, no one can predict a market trend, you can only react to them. Trend following never anticipates the beginning or end of a trend. It only acts when the trend changes. However, there is no need to figure out "why" a market is trending - just follow it. You don't need to understand electricity to use it!

The Big Money of Letting Profits Run:
Trend following aims to compound absolute returns. It doesn't shoot for "average." Do you really want to be exactly like your neighbor? The goal is to make the big returns, not generate passbook savings returns. Trend following also has the unique ability to lie in wait for "targets of opportunity." That means "outlier" events (read: unpredictable surprises like the 2008 market crash) can make you huge money.

Risk Management is Top Priority:
Trend following always has defined exit protocols to control "injury" to your account. Stop losses and proper leverage usage are standard practice. Trend following also has low to negative correlations with most other investment opportunities. It eliminates exposure to group think and toxic assets. Eliminating exposure is a winning move whereas hedging can actually increase your exposure. Trend following is the best protection for when bubbles pop and everyone starts running for cover.

Takes Advantage of Mass Psychology:
Markets, which are always changing, are only our subjective expectations reflected objectively. Interestingly, people's reactions to change always remain the same (i.e., they bet wrong as a group). Trend following takes advantage of "panicky sheep" behavior to make money. How? Strict discipline minimizes behavioral biases. It solves our eagerness to realize gains and reluctance to crystallize losses. Let's face it: too many people believe what pleases them and social conformity means that even if the group is wrong, we go along. Most behaviors are simply driven by the impulsive moment of now. They aren't purposeful, thought-out choices. Trend following wins because of that.

Scientific Approach to Trading:
Trend following doesn't require a belief, but rather it relies on unwavering principles proven over decades. It has a defined edge just like the MIT card counting team that beat Vegas casinos (read: mathematical game theory from the movie "A Beautiful Mind"). Be the casino and not the hapless player! How? Trend following uses hard rules rooted in numbers (think process not outcome). And remember, frequency of correctness does not matter, the magnitude of correctness matters! "Winning percentage" means zilch. How much time will trend following take? No staring at the screen drinking Red Bulls! Once you are setup, minutes a day is all you need when you approach trading like an engineer.

Strong Historical Performance in Crisis Periods:
Trend following prepares for the worst at all times. It is adaptable to differing climates and environments performing best during periods of rising volatility and uncertainty. Guess what? The unknown will happen again! Are you ready? You have to be able to ride the bucking bronco while also riding the storm out. But that said, the day you have to do something, you are screwed. Trend following, like a lion waiting to strike wounded prey, is very patient.

No Traditional Diversification:
Trend following is not restricted to any single market or instrument. A focus on "price action" allows trend following to be applied to an exceptionally large variety of markets. Price is the one thing all markets have in common. That means a system for treasury bonds will work on the Euro too. And if you switch it over to coffee, something totally different than treasury bonds, it still works. Trend following is robust! But don't expect the "tape" to lecture you. You have to trust your buy and sell signals and follow all rules.

No Government Reliance:
Forget Social Security, bailouts, stimulus plans and roads to nowhere. Those won't help you to make money, but they might help you to lose money. When the Fed takes the "training wheels" off the economy will you be ready to mint cash or will you just sit there and take it again? If your portfolio is grounded in sound principles you can win, but the government has nothing to do with sound anything.

Is all this really needed? Yes.

There will be another fall 2008. Guaranteed. When? Who knows. But it will come. And there is only ONE strategy capable of making money when the unpredictable hits the fan. There is only one strategy that has strong historical performance during crisis periods: Trend following. That's it.

But being ready for it, being prepared for that risk, is hard for many reasons. Charles Faulkner (in my film 'Broke') has talked of the problems inherent in the "Socialization of Risk":

"Everyone thinks..."
"The street says..."
"It's only/just..."
"Don't worry ..."
"It always does this..."

Do you think like that? Well, when the next crash happens you will be toast. Dead and buried. Broke? No doubt. Why does trend following do well during rough times? Consider wisdom from trend trading pro Ken Tropin about those unpredictable "events" that sink mutual fund holders (edited down some):

"The reason trend following performs so well when equity markets perform worst is both straightforward and almost tautological: some of the best trends occur in financial markets when equity markets perform poorly. Trend following has a high negative correlation to equity markets during periods of perceived crisis in those markets...because a global consensus emerges about macroeconomic conditions which cause various markets, particularly currencies, interest rates and equities to move in tandem. When this consensus is further confronted by an event, such as a major country default, the event will reinforce the crisis mentality already in place and drive those trends toward their final conclusion."

Further:

"Events do not happen in a vacuum. They are often defined as events because markets are already preconditioned to fear bad news. This is the reason trend following rarely gets caught on the wrong side of an event."

Read Chapter 4 of my book Trend Following again. Event, after event, after event. All unexpected, all trend following winners.

Look at this performance:



That is an "old pro" trend following index (equal weight of trend following legend traders Dunn WMA, JWH F&M and Millburn) compared to buy and hold stock investing. That's a nutso comparison. In fact, it's no comparison.

Don't forget, no matter what the market is doing (up, down or sideways), risk lies dormant, but always "alive". And when the chaos appears in full force again, and it's always coming again, will you be extremely profitable or just looking to the government for a handout?

That's the way to start trading like a trend follower.

About the Author:

Michael W. Covel is the author of the bestselling books "Trend Following" and "The Complete TurtleTrader." He also directed the documentary film "Broke." He is an acknowledged expert in the field of trend following trading and training. His unique vision, along with his blue ocean executive decisions, allowed an initial hunch to grow into one of the most respected educational providers in the world. Covel's firm, Marylebone Holdings, Ltd. (d.b.a. TurtleTrader), is a privately-owned trend following trading consultancy and publishing company that has been training clients since 1996 across 73 countries. The firm is the market leader in fulfilling the lifelong education needs of self-directed trend following investors and traders.
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Support Tip
How do the different order types affect the price at which a trade is entered?

Contributed by Equis Support

For MetaStock versions 8-11

There are four order types used in the Enhanced System Tester:

Market Order: Market uses whatever price was set in the system tester options for the current simulation.

The remaining three allow you to specify a price for a hypothetical trade. Each of the three, react to the prices differently.

Limit: The order seeks the best price available above or below (depending on the Order Type) the given limit price.

Stop: The order seeks the best market price available once a given limit price has been met or exceeded in a direction defined by the Order Type.

Stop Limit: The order seeks the best price available above or below (depending on the Order Type) a given limit price once that limit has been met or exceeded in a direction also defined by the Order Type.

To show those differences, three examples are detailed below. For all the examples, assume a price bar with a High of $27.20, a low of $26.04, a close of $26.82, and that the trade is a long trade.

If the order price is set to $26.00:
A limit order will not be executed
A stop order will enter at $26.82
A stop limit order will not be executed

If the order price is set to $27.00:
A limit order will enter at $27.00
A stop order will enter at $27.00
A stop limit order will enter at $27.00

If the order price is set to $28.00:
A limit order will enter at $26.82
A stop order will not be executed
A stop limit order will not be executed

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MetaStock Features
QuoteCenter Review

Contributed by David Derricott
Thomson Reuters is very well known worldwide as a news and data provider. QuoteCenter is the premier news and data feed program available to the individual trader as part of the MetaStock product line. QuoteCenter is more than just a data feed for MetaStock; it is a full program encompassing news and analytics of its own. Even if you are familiar with QuoteCenter, you may not be fully aware of its extensive capabilities and how valuable it is in today's market.

In fact, it is so powerful and comprehensive, that there are customers using QuoteCenter as a standalone product. Take a closer look at QuoteCenter and you may be very surprised at the extraordinary resources available. It is, by far, one of the most powerful tools available to the individual trader.

QuoteCenter provides professional level real-time data for worldwide markets, Stocks, Commodities, Options, and FOREX. 17 years of fundamental data is available for various countries, and an amazing 10 page daily markets called "The Day Ahead" (This alone could cost you hundreds of dollars from any other company). News is delivered from Reuters, Dow Jones, Factiva and other sources to keep you abreast of the most current developments affecting the markets you follow.

Access to vital information provides an incredible advantage to traders. But the news features of QuoteCenter are only the beginning. To name just a few other highlights:

MarketWatch: A dynamic quote screen of over 700 data fields tracking information basics such as last sale, bid, ask, volume, percentage change for the day, etc. You can also monitor data such as fundamentals and indicator values in your watchlist. Additionally, MarketWatch allows you to import your own portfolios, database files, and add headings to keep track of securities by group or industry.

Dynamic Times and Sales: A dynamically updating display allowing you to watch and track every trade for an instrument throughout the day.

Athena Graphics: Basic charting with built in indicators and charting styles.

OptionsWatch: Easy monitoring of option lists. Best of all the OptionWatch does not take away from the built in symbol limit of 500 simultaneous symbols.

Data depth and breadth: We provide historical data on fundamentals, tick, intraday, daily data, and a robust news offering.

These and many other features are included with each QuoteCenter subscription. Additionally, your QuoteCenter desktop is highly customizable.

This program can be used by day, swing, position and end of day traders.

QuoteCenter is a professional level resource. As an individual trader, you may want to take another look to see its full potential and how it may powerfully impact your trading decisions.