Money Life India Book Review of The Bible of Trend Following
Book Review: The Trend Following Bible
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DEBASHIS BASU | 19/01/2013 11:33 AM |
A practical path for traders to make money with patience and discipline
There is a variety of ways to trade the markets, of which the most popular one, perhaps, is trend-following. Often, prices of overall markets, commodities, currencies and stocks tend to trend, from a few days to a few months, subject to dips. Trend-followers try to identify a rising or a falling trend and latch on to it. Sounds simple. Indeed, the chart of any traded financial instrument will show trends. But it is extraordinarily difficult to get into and out of a trend. The reason is not that trends are a mirage. Many great traders, like Ed Seykota, Richard Dennis and Paul Tudor Jones, have made millions through trend-following systems. Unfortunately, few people have the deep belief, patience and discipline to stick to the rules of trend-following.
There are many books on trend-following (some of which have been reviewed here). Andrew Abraham has written another one. But this is one book that stands out—and not just because Andrew himself is a disciplined and a successful trader. The great thing about this book is that it does not over-emphasise ‘setups’—charts that show how huge your gains would be if you follow this or that technique. The book describes the performance of many traders who have done well by going with the market trends. But the really important part of the book is in the second half. He starts by emphasising the importance of planning, which entails the creation of rules based on strategies that have worked in the past, while being fully aware that, often, they will not yield positive results.
The more developed and stringent a trading plan, with all potential outcomes pre-planned, the greater the potential for success, over time. “There will be times you will think to violate your trading plan. You try to justify your decision to violate your plan. No one is standing over you and asking you why are you breaking your own rules? You just do it, wrongly though. Ironically, Mr Market might even reward you for breaking your own rules. This is even worse for your psyche! Breaking your own rules becomes a slippery slope… You just bought yourself a one-way ticket to the 90 percent club of failed traders who lose money. The only way you can even hope to join the 10 percent club of consistently successful traders over time is being consistent in your trading plan. Consistent means seeing the same type of trade, recognizing it, and taking action. This is repetitive in nature.”
Even with a great plan, there will always be problems and surprises which is why you need risk control. As for identifying trends and making the best of them, Andrew offers seven rules:
1. Identify the strongest markets and the weakest markets via a smoothed rate to change. These should be the only markets where you look for a trade.
2. When you get a trend breakout signal, confirm the breakout risk is not more than 1% of your core account size; if so, go to the next step. In most cases, Andrew risks even less.
3. Trade only in the direction of the MACD (a trend identification indicator available in any charting software). If long, confirm you are above the zero line. If short, confirm you are below the zero line.
4. Do not exceed more than 10 longs and 10 shorts.
5. Do not take a commodity trade if the dollar risk exceeds $2,500 a contract, regardless of account size.
6. Do not take the trade if you have already allocated 5% of your account in that sector.
7. Do not take the trade if you have already have 20% of your total core equity in open profits.
These are simple and clear rules for entry and risk control. Another gem from Andrew is: “As I believe any trade is 50/50, you never know which trade will work. Too many traders are looking for certainty. Certainty does not exit in the markets. Traders want to know when trends start and stop. The reality is you never know. The flipside of the 50/50 is that you do not know how bad a trade can go against you.” Which is why he also suggests taking every trade that your method throws up.
Andrew explains in detail the the single most important factor to consider in trading—the risk involved. Indeed, many believe that creating a winning system is not that important. What is really important is how to cut your losses and manage to stay in the game when you are losing. “If losses get out of control, one can easily be overwhelmed financially and emotionally.” Risk control is a complicated process and Andrew delves into the arithmetic of risk management such as risk per trade, over-confidence, fixed-dollar-amount risk, margin to equity, risk per sector and behaviourial aspects of risk such as dealing with over-confidence.
As I said, the book is all about practical aspects of trading. As Andrew points out, “A vast majority of traders spend all of their time and energy trying to predict or guess what will occur in the markets. Bloomberg and CNBC are based on predictions. Everyone wants to be smart and show they know the future. Successful trend followers have internalized that it is nothing about being right or predicting… it is to identify where they are located currently in relation to the trend and just take the trade if they have one.”
On the reverse of his business card, he has printed the four tenets of successful trend following: trade with the trend; cut your losses; let your profits run; and don’t let the big profits get away. Andrew shows you how. If you are a novice or a struggling trader, this book will put you on the right path. The book is expensive (it could have been priced cheaper, if it were printed in black and white) but definitely worth it.