How Professional Traders Compound & Manage Risk
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Today we look at the book: The Trend Following Bible by Andrew Abraham.
The subtitle of the book reads; How Professional Traders Compound Wealth & Manage Risk, two highly important concepts we look to learn from in this review.
But before we begin, and for those new to the channel, please consider subscribing, and for those that find value please hit the like button…
Author Andrew Abraham has over 30 years of experience, his major focus is not just on total returns but rather the amount of risk taken to achieve such returns, a correlation often overlooked.
The foundation of the book’s philosophy is built upon minimising losses and compounding returns, a message we have heard many times over on this channel.
We start with this table showing the importance of limiting losses, and how letting a drawdown grow out of control could mean game over.
This example provides us with five levels of account drawdown, from 10% through to 50%, each with a starting balance of $100,000.
If we experienced a 10% drawdown lowering our equity to $90,000, we would only need an 11% gain to take us back to our original balance. If however we experienced a 50% drawdown, we would need to achieve a 100% return just to get us back to our starting balance, a scary proposition indeed.
To exaggerate the importance of mitigating losses further, be it a trading or investing account, we are presented with this chart.
If we assume a 50% drawdown, and an expected future annual return of 8%, it would take a full 10 years to get back to our starting balance.
“There always exists a draw down that can stop you from trend following. If you want to make trend following a lifetime strategy you must include strict risk & money management”.
An interesting point the book makes, aligned to risk management, is that of realistic expectations, alluding to the survivorship bias of renowned investors and traders alike.
A prime example is that of Larry Williams, who in a trading contest took a $10,000 account and turned it into one million dollars. Larry later wrote a book to encouraged traders, and during the year after its release he lost a million dollars following the same method.
The lure of such great returns through the focus on these famous ‘surviving’ traders can be dangerous to eager participants. Little focus is given to the 1000’s of traders who failed before and after them.
“The dangers of unrealistic expectations are more than prevalent, instead of focusing on all the dangers of trading, too many are focusing optimistically on their new‐found easy wealth”.
With a basic understanding of the importance of managing risk and expectation, we move onto discipline and patience, traits which Abraham believes are not only the foundations of a great trend following concept, but traits to get a step closer to the holy grail.
These two traits combined allow us to get to the secret sauce of trend following, that is, compounding.
Compound interest was famously named the 8th wonder of the world by Albert Einstein, to which he added:-
“He who understands it, earns it, he who doesn’t, pays it”.
Famous trader Jesse Livermore also shared his thoughts on compounding when he said: -
“Patience is what can make money”.
Abraham talks of a trend following dentist who invested $200,000 into a strong trend in 1979, and years later pulled out over 17 million dollars. He had a simple robust methodology, and when combined with discipline, patience, and the consequential compounding effect, he became a multi-millionaire.
To quickly demonstrate the power of compounding we use a chess board with 64 squares.
If we placed a cent on the first square, and then doubled the value on each of the next squares we can see the incredible exponential growth.
By the time we get to square 20 we would have a million cents, and at square 40 we would have a billion cents. At square 64 we would have a number I’m not sure I could even pronounce...
This is clearly an unrealistic expectation in relation to the stock market, but simply demonstrates how consistent compounding (a core component of trend following) can dramatically enhance your returns.
The book provides another table which perhaps shows a more realistic compounded growth rate.
I would be more inclined to use the 20% rate of return for an active trend follower. We can see here how a $100,000 account would grow over time, using 20 years as the example we would have grown the account to just under 7 million dollars. Another example of patiently and consistently compounding the returns.
A useful tool investors often use is the rule of 72, which simply estimates how long a specific rate of return would take to double an investment.
Again using 20% as the compounded rate of return, we can estimate that it would take just over 3 and a half years to double an account. The simple calculation is made by dividing 72 by the annual interest rate.
To summarise this chapter, Abraham says:-
“The key to success or compounding money over time is the ability to stay focused, stay disciplined, follow the plan, and have patience. This is the holy grail”.
Having covered the basic concept of trend following and hypothetical returns through compounding, let’s move onto real returns and strategy application.
First, we look at the trading returns of a well-known trend follower, Elizabeth Cheval.
Cheval gained notoriety when she took part in the Turtle Trading Program, a review we covered previously.
The Trend Following Bible discloses a breakdown of her results, showing monthly and annual returns from 1985 through to 2012. You can see how each month the results vary considerably. Using 1995 as an example we can see four months of excellent results followed by another four months of poor results. Overall however the year ended with a 21% return.
This demonstrates the importance of discipline and patience, how many people would have stopped trend following or any trading strategy when they suffered a string of monthly losses….
The annual returns can be seen here, with the largest gains seen in the earlier years when Cheval applied more risk.
If we took $100,000 and invested with Cheval from 1995, the account would have grown to over $360,000 seventeen years later, perhaps a more realistic expectation of trend following returns from a large fund. It is however worth pointing out that Cheval manages a fund worth more than 200 million, whereas smaller retail trend followers could get better returns due to their superior agility, unlike a huge fund.
Cheval operates under her company EMC Capital Management.
I managed to find this chart showing her fund performance through each of the major market crashes, taking us up to the recent global pandemic.
Notice how the S and P 500 saw some significant drawdowns, but Cheval’s fund made positive returns. The most noticeable was the credit crunch in 2008 when the index saw a 50% drawdown, whereas Cheval’s trend following fund returned a positive 18%. This is a key characteristic of trend following, we not only follow the trend up, but we also follow the trend down.
This means in a down trending market the trend follower would sell the market short, therefore returning profits whilst the markets fall.
Now we look at the trend following approach used by author Abraham which has similarities to my personal approach. He calls it the Trend Breakout.
His first filter is to focus on the strongest markets, if for example the US markets are trending strongly, he would focus on ideas within this market.
Next, he looks for a trend breakout. His idea of a trend breakout was devised by the legendary works of Richard Donchian, known as the father of trend following, and a methodology used by many since his passing in 1993.
His idea is as robust as it is simple, buy the 20-day high, and sell the position at the 10-day low.
The same rule applies to catching a down trend, sell short at the 20-day low, and use the 10-day high as protection to buy and close the short position. A simple concept that keeps you in the prevailing trend.
Abraham adds an additional criterion to keep him in the trend, which is also a favourite of mine, that is the mack dee indicator. He says:-
“I will only consider taking the buy or sell if I am trading in the direction of the mack dee”
Without going deep into the technicalities of the mack dee indicator, we can see its application and theory.
The blue line is the mack dee and the red is the signal line.
Abraham applies the indicator to the daily chart and would only consider buying or going long a position if the blue mack dee line is above the signal line, and only sell or go short a position if the mack dee line is below the signal line. Additionally, for a long position the mack dee line must be above the zero line, or under for a short position.
Using this method ensures you remain in the trend with momentum in your sails. I personally use the same mack dee concept for stock selection, but I prefer the weekly chart.
Abrahams strategy of combining the Donchian breakout and the mack dee indicator can be seen in the Silver trade example provided.
Remember we need to see a 20-day high which we identify here, we also check to ensure the mack dee line is above the signal and zero line. Once we enter the trade we sit and wait for a 10-day low, we see this a few days later and exit the trade at a loss.
The next 20-day high appears, with the mack dee line above the signal and zero line. We then await a 10-day low to exit the trade which on this example we are yet to see.
This is one of many trend following strategies available, the key is to be consistent with the strategy you choose.
Abraham says: -
“Successful trend followers are consistent in their plan and execution, they do not have any magical indicators nor are they gurus, in simple terms, they have a plan and focus on executing the plan”.
The tenets of a successful trend following strategy can be written on the back of a business card. Trade with the trend, cut your losses, let your profits run, and don’t let the big profits get away.
Abraham adds: - “When combining these tenets one puts one’s self in the position to potentially create extreme wealth”.
Like any form of trading or investing, trend following should be treated as a business and although the benefits of trend following outweigh those of a business, there is a certain commonality, that is cashflow and the risk of ruin.
Having enough equity to follow your business or trading plan, whilst avoiding the risk of ruin, is arguably the most important consideration to make.
Clearly the higher percentage per position risked, the higher the risk of ruin. Abraham recommends using a range of between 0.75% and 1.25%.
Personally, I would rather know certain criteria before making a judgement on positional risk. Win rate, market environment and asset being considered would all need to be determined first.
In the link below we have a trading simulator which enables us to determine the appropriate level of risk in consideration to our expected strike rate. The simulator can run hundreds of simulations providing worst- and best-case scenarios.
Before entering any trading endeavour, I highly recommend running such a simulator to ensure you do not run the risk of ruin.
Understand the impact of drawdown.
Be realistic with your expectations, remind yourself of survivorship bias and don’t be lured into unnecessary risk.
Be disciplined, patient and allow the power of compounding to work for you.
Follow the trend to avoid or take advantage of major market downturns.
Pick your strategy and ensure you understand the risks.
And of course, hit the like button and please consider subscribing.
Thanks for listening.