Have you ever wondered how certain trend traders have managed to build such incredible fortunes? You’ve heard the stories. Take Ed Seykota, for example. He turned an initial $12,000 investment into $15 million over twelve years. And then there’s Michael Marcus, who turned $30,000 into $80 million in less than twenty years. Then there is the U.K.’s David Harding. He launched his fund in 1997 with $1.6 million in assets and less than twenty years later had over $30 billion under management.
So how did these people do it? Believe it or not, these traders weren’t just lucky, or brilliant. They simply mastered the principles of trend-following trading, a system based not on understanding fundamentals driving the market but on what the market is actually doing – its trends. History has shown, time and again, that trend-following trading works – if you have the discipline and the detachment to follow the trends further than you may think is necessary. But you may still be wondering, is it safe? Can I master this too? In this article we’ll look at how trend-following trading started, how the theory of trend-following trading has grown over time, and how it has developed into an attractive strategy for investors everywhere.
A key tenet of trend-following theory is that it’s best to buy a stock when the price is on an uptrend, and to sell the stock when its price is on a downtrend. If price is rising in one general direction, with higher swing lows and higher swing highs, then there is an uptrend. If price is falling in one general direction, with lower swing lows and lower swing highs, then there is a downtrend. Here is where it gets a little tricky for some: trend-following trading doesn’t look at what the market may do. It’s only concerned with what the market is actually doing. Any trend trader will tell you that you can’t predict a trend, you can only react to one. The established wisdom from successful trend traders is that it’s best to follow a trend to the end because it will always go further than what you’d expect.
You could say that trend-following is inherent in human nature – all of us are trend followers to a certain degree, not just in matters of money, but of fashion and culture. But studying the movements of the market, determining trends, and deciding when to enter, exit, and hold, based on those movements, is something that has developed over time. The history of trend-following trading begins with those investors who knew how to “hang on” to a trend. David Ricardo, who was a successful trader and economist in early nineteenth century London, is widely considered to be one of the first trend-following traders. He coined the famous expression “Cut short your losses, let your profits run on.” One hundred years later in Chicago, Arthur Cutten, the commodity speculator, extolled the virtues on “hanging on” to a trend: “Most of my success has been due to my hanging on while my profits mounted…Do with it what you will.” For any advice or expertise related to initiations or liquidations, however, one has to skip ahead to the early part of the twentieth century. This is when a methodology called the Dow Theory was created, refined, and put into practice. Charles Dow, who along with Edward Jones and Charles Bergstresser founded Dow Jones and Company, created the idea of a bull and bear market and by doing so, the foundation of a trend-following strategy. One buys on the emergence of a high, and sells on the emergence of a low.
The first trader to study the ideal points for entering and exiting the market, however, was Jesse Livermore, whose personal fortune peaked, depending on how you measure it, at between one and fourteen billion dollars in today’s money. Livermore’s contribution to the practice of trend-following trading was to record “pivotal points” – or intermediate highs and lows – and then initiate or liquidate holdings based on movement away from these pivotal points. He wrote that his favored method was to “become a buyer as soon as a stock makes a new high on its movement, after having had a normal reaction.” Another one of his great quotes is “Markets are never wrong. Opinions often are.” Translation: never argue with the stock market. Even if you are completely convinced that the stock will move in a certain direction, you must pay attention to what it is actually doing. (It’s worth studying all of his famous quotes – they are a lesson in trend-following theory in and of themselves.) Later, in the nineteen fifties, William Dunnigan advanced trend-following theory when he observed that the law of inertia could be used to assume that a trend would continue indefinitely into the future.
Studies that have looked at the performance of trend-following trading since 1880 report that it has delivered mostly strong positive returns. Its laws of “time series momentum” – to go long with recent positive returns and short with recent negative returns – have resulted in profits for all equity index funds, fixed income futures, commodity futures, and currency forwards, according to a recent study conducted by AQR Capital Management. Modern-day trend-following traders have made millions through the strategy. In 1970, Ed Seykota conceived and developed the first commercial computerized trading system for clients in the futures market while he was working as a broker. He later took one client’s account from $5,000 to $15M in twelve years. His protégé, Michael Marcus, turned an initial $30,000 investment into $80M dollars over twenty years using trend-following techniques. Marcus in turn trained Bruce Kovner, an investor and founder of CAM Capital, a global hedge fund. Kovner’s personal fortune is approximately $5.3 billion, which he grew by applying rigid trend-following trading theory to his investments. Kenneth Tropin, a hedge fund investor and trend-following trader, made $120M in 2008. As he puts it, the “art and science of this system is to be able to stay out of the noise and get involved in the right trends, hold those positions in the right trends until they ultimately fail, and….to be able to say that when the trend fails, you have taken away some profit.”
Trend-following strategy isn’t for the undisciplined, but history shows us that it is a solid theory that can lead to appreciable profits if applied with rigor and without the distraction of too much emotion. Adding some trend-following commodities to your portfolio may be exactly what you need to invigorate your holdings and start realizing the kind of gains that you know your investments deserve. By studying the market, and stepping far enough away from what Tropin referred to as the “noise,” a shrewd investor (and a good broker) may not only be able to observe certain trends but know exactly when to exit and enter the market based on calculatable movements. Speak to your broker about how to add some trend-following futures to your holdings – slow and steady, after all, wins the race.