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Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael Covel

January 6th, 2009
Trend Following Michael Covel

Trend Following Michael Covel

Buy From Amazon:
Trend Following: How Great Traders Make Millions in Up or Down Markets
by Michael W. Covel
Published in 2005

Key Takeaways

I’ve read a lot of investing books.  And this may well be the worst.  All fluff and no substance.  Reminded me of a bad high school English paper that spams the reader with superfluous words and narrow margins to meet a page count requirement.  After 150 pages, I seriously considered abandoning the book and moving on. But its in my DNA to finish any book I start, so I tortured myself skimming the last 250 pages of uselessness.

Trend Following is an excellent trading strategy and deserves to be studied.  But Covel, in Trend Following, is not the way to learn.  Covel goes in circles gushing about how great Trend Following is and about how great the Hedge Fund managers are that employ Trend Following.  But he sounds much more like a starstruck high school girl with a teenage crush than a trading guru.  He never gets around to giving us the beef.

Definitely don’t buy this book, you can get what you’re looking for in this post where I profile the techniques he covers, or you can read my post on ‘The Slow Turtle Trade‘ from James Altucher‘s book How to Trade Like a Hedge Fund.  When I find a good Trend Following book, I will update this post.

The one thing Covel did well was collect some excellent quotes on Finance, Trading and Investing.  He included at least two quotes per page (presumably to make up for lack of original material and to boost his page count).  For this, I was grateful and have provided the best in my post on Finance Quotations.

Page 266 – Trend Following Systems

(Yes, it took Michael Covel until 266 pages into his 400 page book to write anything worth remembering.)

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average

  • Buy the index when the Fast SMA (50 day) crosses over the slow SMA (100 day)
  • Sell and then go short when the fast SMA (50 day) crosses under the slow SMA (100 day)
  • Set a stop loss of four times the Average True Range (ATR) of 10 days

Note: The stop loss risk control avoids a loss of more than 2% of equity

Note: The True Range is the absolute value of the greatest of the following:

  • The distance from today’s high to today’s close
  • The distance from yesterday’s close to today’s high
  • The distance from yesterday’s close to today’s low

The Average True Range calculates the Simple Moving Average to the True Range.

Results:
Backtesting this trade from November 2001 to March 2002 results in a an average annualized return of 19.6% with a maximum drawdown of 46%.  But less than 40% of the system’s trades are profitable.  Using sensitivity analysis for the number of days to use in the Fast and Slow SMA, combinations in the 40 – 60 fast SMA days and 100 – 120 slow SMA days provide the best results.

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average with Pattern Entry

This system combines trend following and countertrend concepts.  It is called Trend with Pattern Entry (TPE) and was first introduced by Dion Kurczek and Volker Knapp in Active Trader Magazine in April 2003.  The premise is that prices above the SMA indicate a bull trend, but should only be bought on countertrend pullbacks.  Similarly, prices below the SMA indicate a bear trend, but should only be sold short into countertrend rallies. The prices wait for three consecutive countertrend (down or up) days before entering the market.

  • Buy the index if the price is above the 100 day SMA and the closing price decreased over the last three days.
  • Exit the position (sell) if the price reaches the trailing stop, which is 4 times the ATR of 10 days subtracted from the current closing price.
  • Then short the index if the price is below the 100 day SMA and the closing price increased during the last three days.
  • Exit the position (buy to cover) if the price reaches the trailing stop, which is 4 times the ATR of 10 days added to the current closing price.

Results:
Backtesting this trade from October 2000 when the market experiences a strong up-move three times in a row while still below the SMA.  The system starts short and finally ends in early 2002.  The system generates 21.8% annualized returns, but experiences several drawdowns of over 20% and one of 49%. Indeed, large drawdowns are the biggest challenge for Trend Following systems.  The large drawdowns are why investors are instructed to Trend Follow a basket of uncorrelated assets and commodities.  If an investor were to get hit by highly correlated large drawdown across all investment classes, it could wipe them out.

There are several variations to these techniques such as Pyramiding, or adding to a position shortly after the trend is validated and proved profitable.

Remember, the best part of the book are the quotes Covel collected, so be sure to visit my post on Financial Quotations.

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