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What Is the Source of Trend Following Profits?

“No matter what the models say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes.”
Roger Lowenstein
When Genius Failed: The Rise and Fall of Long-Term Capital

People are always curious about the source of trend following profits. It helps to start with the “losers” for an answer. Ponder these excerpts from Feburary 17, 2004 of The Econimist :

In the autumn of 1998, Buttonwood was at a conference organised by Credit Suisse First Boston in-appropriately enough-Monte Carlo, when Allen Wheat, the then head of the investment bank, stood up after dinner and delivered a breathtaking mea culpa. Some sort of apology certainly seemed in order given the huge sums the bank had just lost from extravagant punts on Russia in particular and financial markets in general. The bets went spectacularly wrong after Russia defaulted, financial markets went berserk, and Long-Term Capital Management (LTCM), a very large hedge fund, had to be rescued by its bankers at the behest of the Federal Reserve. CSFB eventually admitted to losses of $1.3 billion, though the bank’s official figures and the numbers bandied about by insiders were somewhat at variance. To cut to the chase: had they Mr Wheat’s balls, Buttonwood thinks that the bosses of many a big bank will be making a similar speech before the year is out. The reason is simple: the size of banks’ bets is rising rapidly the world over. This is because potential returns have fallen as fast as markets have risen, so banks have had to bet more in order to continue generating huge profits. The present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the very risk-management models that banks use. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because-as all past financial crises have shown-the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time.

Walking off a cliff is not fun. It doesn’t have to happen. However, the large banks don’t seem to care or want to care. They compete against benchmarks. They never focus on absolute returns. The misguided notion that you can collect easy quick profits never dies:

By regulatory fiat, when banks’ positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become more than a little crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences. It could well happen again. There are any number of potential flashpoints: a rout in the dollar, say, or a huge spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to get out of. Think, if you will, of the extraordinary rise in the price of emerging-market debt and junk bonds. “I used to sleep easy at night with my VAR model,” said Mr Wheat in his speech in Monte Carlo. Suffice to say that he suffered a sleepless night or two when that model was found wanting-and that bank bosses could be in for many a sleepless night this year.

When the herds rush for the exit, trend followers are there with a plan. They know what to do. They let the panicked bankers push the market trend. The Dunns, Seykotas, Henrys and Parkers of the world just ride the wave. When the chaos (trends) is over and Trend Followers (again) are seen as the winners…they will be critiqued as the “evil” speculators that “hurt” the economy. Of course, that is not true. Trend followers are just playing the game like everyone else — except they play better.

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