The Realities of Trend Following
Learn How to Trend Follow
Andrew Abraham
Risk Disclaimer
THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD BE AWARE OF THE FOLLOWING: IF YOU PURCHASE A COMMODITY OPTION YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIUM AND OF ALL TRANSACTION COSTS. IF YOU PURCHASE OR SELL A COMMODITY FUTURE OR SELL A COMMODITY OPTION YOU MAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS AND ANY ADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO ESTABLISH OR MAINTAIN YOUR POSITION. IF THE MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE CALLED UPON BY YOUR BROKER TO DEPOSIT A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT NOTICE, IN ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE THE REQUIRED FUNDS WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FOR ANY RESULTING DEFICIT IN YOUR ACCOUNT. UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR IMPOSSIBLE TO LIQUIDATE A POSITION. THIS CAN OCCUR, FOR EXAMPLE, WHEN THE MARKET MAKES A “LIMIT MOVE”. THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR, SUCH AS A “STOP LOSS” OR “STOP LIMIT” ORDER, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE INTENDED AMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO EXECUTE SUCH ORDERS. A “SPREAD” POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG” OR “SHORT” POSITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS.
YOU SHOULD ALSO BE AWARE THAT THIS COMMODITY TRADING ADVISOR MAY ENGAGE IN TRADING FOREIGN FUTURES OR OPTIONS CONTRACTS. TRANSACTIONS ON MARKETS LOCATED OUTSIDE THE UNITED STATES, INCLUDING MARKETS FORMALLY LINKED TO A UNITED STATES MARKET MAY BE SUBJECT TO REGULATIONS WHICH OFFER DIFFERENT OR DIMINISHED PROTECTION. FURTHER, UNITED STATES REGULATORY AUTHORITIES MAY BE UNABLE TO COMPEL THE ENFORCEMENT OF THE RULES OF REGULATORY AUTHORITIES OR MARKETS IN NON-UNITED STATES JURISDICTIONS WHERE YOUR TRANSACTIONS MAY BE EFFECTED. BEFORE YOU TRADE YOU SHOULD INQUIRE ABOUT ANY RULES RELEVANT TO YOUR PARTICULAR CONTEMPLATED TRANSACTIONS AND ASK THE FIRM WITH WHICH YOU INTEND TO TRADE FOR DETAILS ABOUT THE TYPES OF REDRESS AVAILABLE IN BOTH YOUR LOCAL AND OTHER RELEVANT JURISDICTIONS.THIS COMMODITY TRADING ADVISOR IS PROHIBITED BY LAW FROM ACCEPTING FUNDS IN THE TRADING ADVISOR’S NAME FROM A CLIENT FOR TRADING COMMODITY INTERESTS.YOU MUST PLACE ALL FUNDS FOR TRADING IN THESE TRADING PROGRAMSDIRECTLY WITH A FUTURES COMMISSION MERCHANT.
Trading futures and options involves substantial risk of loss no matter who is managing your money and is not suitable for all investors.
Past performance is not necessarily indicative of future results.
TOPICS COVERED
Introduction……………………………………………………………………………………….…….
Compound Your Way to Wealth…………………………………………………………..…..
Your Curve is the Key……………………………………………………………………………..…
The Mathematics of Compounding………………………………………………………..…
Curves, Curves, and More Curves……………………………………………………………
What It Takes to Succeed…………………………………………………………………………
KISS (Keep it Simple Stupid)…………………………………………………………………...
4 Possibility Thinking………………………………………………………………………………
Why Commodities?......
What You Should Focus On…………………………………………………………………….
It’s Simple, But it Ain’t Easy…………………………………………………………………….
Blueprint for Success………………………………………………………………………………
Introduction
Albert Einstein called the power of compounding “the greatest mathematical discovery of all time” and deemed it to be the eighth wonder of the world. Richard Russell of the famed Dow Theory Letters declared that compounding is the “royal road to riches.”
I agree with both of them.
Combining realistic annual returns with the power of compounding is a powerful recipe for building wealth- But How????Unfortunately, most investors are unable to consistently achieve the investment returns necessary to compound their accounts. The problem is that most investors simply do not understand how to formulate a plan that will accomplish this.
The purpose of this book is to provide a solution to that problem “ Trend Following”.My solution to the problem is to present to you Richard Donchian who is considered by many to be the father of trend following. Donchian was an investor during the Great Depression and he lost everything while investing in the Stock Market during this period. However by the 1940s he learned from his mistakes and started the concept of trend following. He would buy breakouts and look to stay with a trade as long as it was moving in the direction he placed his trade. Donchian continued trend following for almost 53 years thereafter.Donchian’strend following strategy worked in the past and will likely continue to be successful in the future. There are many commodity trading advisers who have been trend following & compounding money over time for decades such as Campbell & Company, Abraham Trading Group, Clarke Capital, Tactical, Chesapeake and many others.
Do not think that Trend following is retirement in a box. There will always be periods of losing money and periods that are not profitable. As much as trend following gives you the possibility to compound money and build wealth over time there are substantial risks with trend following and one must determine if this is a strategy is appropriate for them. Trend following and commodity trading is not suitable for all investors.
There have to be other solutions for ways to compound money over time and I am not claiming that trend following is the only solution to compound money over time, but I do know that it has benefited mepersonally over many years. I remain confident that trend following will continue to work well, regardless of the market conditions. While there are no guarantees where the future is concerned, I do believe that trend following puts the odds of success in the investor’s favor. Investors need to take into account that trend following takes time. Trend following is not a get rich quick scheme. It is similar to a marathon. Marathons are grueling and hard. When someone commits to the strategy there are no short cuts. There will always be drawdowns and long periods that profits are elusive. More so there will be periods that are just plain ugly and trading accounts diminish in value.
For most of the past 17 years, when asked what I did for a living, my typical response was that I was in the commodity futures business. A better answer is that I want to teach a strategy to put the odds in the investor’s corner. I attempt to achieve consistent investment returns over time utilizing the commodity futures markets. My goal is to create upward sloping equity curves enabling investors to compound wealth. This is the goal but in reality one must understand that they will go through some ugly drawdowns and periods that they do not make any money.
Trying to build wealth is a serious challenge. People do not know if they should be invested in stocks, bonds, real estate, gold, commodities, or any of the other alternative investment vehicles available today. As the financial markets are perpetually in motion, this is an ongoing problem.
My solution to this problem starts by understanding the following:
- Compounding money is the key to building wealth
- Creating an upward sloping equity curve will enable one to compound their money
- Trading with the trend
- Cutting losses
- Letting your profits run is my way to build an upward sloping equity curve
The benefits of my solution and what it means for you:
- Your equity curve will be upward sloping and you will be compounding your account at reasonable rates of return - YOU WILL BE BUILDING WEALTH!
- You will have a plan and you will know what you are supposed to be doing or not doing
- You will be invested in areas that offer profitable opportunities because they are trending
- You will avoid large losses by being on the wrong side of major trends – for example: dot.com bubble in 2000, real estate in 2006, stocks in 2008, etc.
However please realize as I have stated there will be many losing periods while trying to compound money.
Someone once asked “if you don’t know where you are going, how are you going to get there?” Therefore the first step in acquiring wealth is to understand what we are trying to accomplish. We were all taught about the magic of compounding back in our school days. However, as I already stated, the great majority of investors are unable to formulate a plan to enable their investments to compound.
My goal in writing this book is twofold:
- Explain WHAT we want to do. (Compound our way to wealth by building an upward sloping equity curve)
- Teach you HOW to do it.
The most successful trend followers have the following in common:
- They understand the power of compounding and their goal is to compound their accounts over time
- They are NOT big risk takers and are actually more risk averse than one might suspect
- They have a detailed plan of exactly what they are supposed to be doing at all times
- They follow that plan
- They understand what challenges they will likely encounter - meaning they are mentally prepared
While the specific details of each trendfollowers plan vary, there are great similarities in their plan’s key components. Many people claim that trading is a game. If this is true, and I believe that it is, then there are specific rules that one must follow to “win” the game. My solution has detailed rules which will increase the likelihood of winning this trading game. It is essential to have a rulebook that will stand the test of time. The rules of these consistently successful traders are remarkably similar. However even with these rules there is no way to mitigate the inherent risks when investing and futures trading might not be suitable for everyone. There are substantial risks while utilizing the strategy of trend following and commodity trading is not suitable for everyone.
An equity curve is a graph that reflects the changes in the value of an account over time. It is a picture that shows you how much money you are making or losing. An upward sloping curve is an indication of profits while a downward sloping curve indicates that there are losses.
Someone who is successfully compounding their way to wealth clearly has an equity curve that is sloping upward. Therefore, it is essential that we focus on our curve, and take the necessary steps to increase the likelihood of building our own profitable curve. Do not think that being a trend follower or investing in one gives you an easy 45 degree equity curve. There will be flat periods in which you do not make any money as well as numerous periods in which you will see your equity curve dip. Regardless of the most stringent risk parameters there will be numerous losses. The goal is to try to keep them small and manageable.
Below is a chart which reflects the effect of compounding over a long period of time:
This is an ideal equity curve not found in the real world. There are always drawdowns and losing periods.
Below is an example of a real world equity curve:
You will notice there are losing periods and flat periods where there are no profits. As well as you notice over time money was compounded.
My plan to build an upward sloping equity curve is actually quite simple. However / please do not be fooled into thinking that this means it will be easy to do / because nothing could be further from the truth. To be consistently successful one should have reasonable expectations / a great deal of patience / and a good understanding that the power of compounding is the key to building wealth.Richard Russell began writing the Dow Theory Letters back in 1958. According to him, the most popular piece he ever wrote was titled “Rich Man, Poor Man.” In that article Russell stated that “compounding is the royal road to riches.” He also said “compounding is the safe road, the sure road, and fortunately anybody can do it.”
Russell believed that in order to compound successfully you need the following:
- Perseverance
- Intelligence to understand what you are doing and why
- Knowledge of mathematical tables in order to comprehend the amazing rewards that will come if you faithfully follow the compounding road
- Time to allow the power of compounding to work for you
- Compounding ONLY works through time
Below is a table detailing what would happen to a one hundred thousand dollar ($100,000) investment if one were able to compound that initial investment at an annual rate of between 10% and 20%.
$100,000.00 / 10% / 5 yrs / $161,051.00$100,000.00 / 10% / 10 yrs / $259,374.25
$100,000.00 / 10% / 15 yrs / $417,724.82
$100,000.00 / 10% / 20 yrs / $672,749.99
$100,000.00 / 15% / 5 yrs / $201,135.72
$100,000.00 / 15% / 10 yrs / $404,555.77
$100,000.00 / 15% / 15 yrs / $813,706.16
$100,000.00 / 15% / 20 yrs / $1,636,653.74
$100,000.00 / 20% / 5 yrs / $248,832.00
$100,000.00 / 20% / 10 yrs / $619,173.64
$100,000.00 / 20% / 15 yrs / $1,540,702.16
$100,000.00 / 20% / 20 yrs / $6,814,608.25
The chart tells us that a $100,000 investment compounding at 15% would grow in excess of $400,000 over a 10 year period. If that investment continued to compound at 15% per year it would grow to over $800,000 five years later.
Below is a chart which reflects an equity curve showing what would happen if one were able to compound money at a 10%, 15%, or 20% return without ever incurring any losses. Of course this would be an ideal curve that investors would be happy to own but this is not the real world. In the real world there are losses and drawdowns.
The problem is that these equity curves DO NOT EXIST in the real world. All trades have uncertain outcomes, and losses are simply an unavoidable part of trading.
Using simple math we also learn that it is exceptionally difficult to compound money over a long period of time after suffering a large decline in our portfolio.
Below is a table reflecting the mathematics of recovering from losses:
Starting Portfolio Value / If Your Portfolio Drops / New Value of Portfolio / % Gain Needed to Recover$100,000 / 10% / $90,000 / 11%
$100,000 / 20% / $80,000 / 25%
$100,000 / 30% / $70,000 / 43%
$100,000 / 40% / $60,000 / 67%
$100,000 / 50% / $50,000 / 100%
This table actually shows us that the less you lose, the more you have when things get better. The lesson we learn is that it is very difficult to recover from large losses. While “come from behind” victories are exciting in the athletic arena, compounding wealth after suffering large losses is exceedingly difficult.
Below is a chart from American Century Investments that shows an equity curve of a portfolio that suffered a 50% decline. This chart indicates just how difficult it is to recover from large losses. A positive 8% compounded return for 8 years will only bring your account back to even after initially suffering such a large loss. It is simply not easy to recover from large losses, and yet all markets will likely suffer 50% declines at some point in time. The power of compounding can work for you only if you do not suffer large losses.
Below are actual equity curves for investors who have compounded their money over time via trend followers who have been trading for decades ( Abraham Trading Group, Chesapeake, Eckhardt, Tactical, EMC, Hawksbill, and many others).
While these charts may reflect an upward trending equity curve, one can easily see that there are numerous periods where the curves are either declining or going sideways ( Losing money or at best not making any money).
These curves represent what someone might actually experience if they utilize trend following to build wealth.
All of these charts are from the website which tracks numerous commodity trading advisors. You can search yourself and find even more trend followers.
Abraham Trading Group has been trading since 1988. They have a CAROR of 19.30% and a worst peak to valley draw down of 31.96%. They have returned over 6,100% over all of these years.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THE RISK OF LOSS IN TRADING COMMODITY FUTURES, OPTIONS, AND FOREIGN EXCHANGE ("FOREX") IS SUBSTANTIAL.
Chesapeake Capital has been trading since 1988. Chesapeake has a CAROR of 12.86% over these years. Chesapeake’s worst peak to valley drawdown has been 26.66%. Chesapeake has returned over the years 1750%.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THE RISK OF LOSS IN TRADING COMMODITY FUTURES, OPTIONS, AND FOREIGN EXCHANGE ("FOREX") IS SUBSTANTIAL.
Clarke Capital has been trading since 1996. Clarke Capital Worldwide program has returned CAROR of 15.76% over the years. The worst peak to valley draw down was 26.06%. They have returned over 830% over the years.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THE RISK OF LOSS IN TRADING COMMODITY FUTURES, OPTIONS, AND FOREIGN EXCHANGE ("FOREX") IS SUBSTANTIAL.