The science & success of trend following: Part I

Trend followers are not concerned with balance sheets or income statements, they are not interested in supply and demand, they are not anxious to hear the outcome of every central bank meeting. In fact, they are not interested in financial news at all. They care only about price and its direction.

Trend followers do not rely on buy and hold, index funds, CNBC, Jim Cramer or Warren Buffett. They rely on their own set of trading rules and their discipline to follow them.

Trend following is a scientific approach to trading that has proven extremely successful for many traders. This two part article examines what trend following is, where it came from, and how it works. It also tries to answer the question: why aren’t more traders trend followers?

What is trend following?

Trend following is a systematic approach to trading that attempts to capture the major part of a market move by using a strict set of rules.

Crucially, trend followers do not try to predict market movements. In fact, they acknowledge that such predictions are not possible, at least not on a reliable basis. Instead, a trend follower waits for a trend to begin, and then simply follows that trend until it reverses.

The ancient Chinese philosopher, Lao Tzu, who is thought to have lived in the 6th century BC, once said, “Those who have knowledge don’t predict, and those who predict do not have knowledge.” This wisdom lies at the heart of trend following.

“I knew I could not predict anything, and that is why we decided to follow trends, and that is why we’ve been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends.” John Henry, owner of the Boston Red Sox and a legend in the field of trend following.

Put simply, trend following seeks to capture the majority of a market trend, whether it be up or down, and therefore profit from it.

Ed Seykota, a commodities trader and trend follower who turned $5,000 into $15 million over a period of 12 years, describes trend following as, “an exercise in observing and responding to the ever-present moment of now.”

Where did trend following come from?

One of the earliest known trend following traders was Jesse Livermore. In 1893, at age 16, Livermore quit his job at Boston stockbroker Paine Weber & Co. and began trading full-time in the city’s bucket shops. By age 20 Livermore had accumulated his first $10,000 using his method, and he went on to have one of the most famous careers in stock market history.

It is said that over a period of forty years of trading he accumulated and lost millions of dollars several times over, earning him the nickname the Boy Wonder.

Although the trading rules used by Livermore are similar to those used by modern day trend followers, it was not until much later that the theory of trend following was documented in detail.

Important contributions were made by Richard Schabacker in 1932, H.M. Gartley in 1935 and Robert Edwards & John Magee in 1948. Edwards said, “profits are made by capitalising on up or down trends, by following them until they are reversed”. However, is wasn’t until Richard Donchian published his article “Trend Following Methods in Commodity Price Analysis” in the Commodity yearbook in 1957 that trend following entered the mainstream.

Donchian is widely considered the father of modern day trend following techniques. Donchian developed basic moving average crossover systems, and simple rules on buying break-outs, many of which remain largely the same as those used by today’s investment managers. Donchian is also credited with operating the first real managed futures / trend following fund – Futures Inc. – in 1948.

In the 1980s the reputation of trend following improved significantly thanks to a famous experiment which was devised to settle a bet between Chicago commodities trader Richard Dennis, and his partner William Eckhardt.

By 1983, Dennis had turned an initial stake of less than $5,000 into more than $100 million, and had gained considerable recognition for his trading success. He and Eckhardt had frequent discussions regarding what it took to be a successful trader, and while Dennis firmly believed that successful trading methods could be taught, Eckhardt believed that such success came from innate skill which you either had, or you didn’t.

In order to resolve their dispute, Dennis recruited 14 people to be trained as commodities traders using his methods. The recruits, referred to by Dennis as “turtles”, were from all walks of life, with some having had no previous trading experience.

In, 1983, after receiving just two weeks of training Dennis gave the turtles $1 million of his own money, and they were told simply to follow the rules they had been taught. The results were astounding and are still talked about today.

According to former turtle, Russell Sands, the two classes of turtles personally trained by Dennis earned more than $175 million in just five years.

The experiment, which is covered in detail in the books The Complete Turtle Trader by Michael Covel, and Way of the Turtle by Curtis Faith, proved that almost anyone, regardless of their background, could be turned into a successful trader using trend following techniques.

In The science & success of trend following: Part II, I reveal how trend following works. I also try to answer the question: If trend following is so profitable, why aren’t more traders trend followers?

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