Praise for Trend Following

“The way I see it, you have two choices—you can do what I did and work for 30‐plus years, cobbling together scraps of information, seeking to create a money‐making strategy, or you can spend a few days reading Covel’s Trend Following and skip that three‐decade learning curve.”

—Larry Hite, profiled in Market Wizards

“Michael Covel’s Trend Following: Essential.”

—Ed Seykota, profiled in Market Wizards

“Trend Following by Michael Covel? I’m long this book.”

—Bob Spear, Mechanica“

[Trend Following] did a superb job of covering the philosophy and thinking behind trend following (basically, why it works). You might call it the Market Wizards of Trend Following.”

—Van K. Tharp, PhD, profiled in Market Wizards

“[Trend Following] documents a great deal of what has made trend following managers a successful part of the money management landscape (how they manage risk and investment psychology). It serves as a strong educational justification on why investors should consider using trend following managers as a part of an overall portfolio strategy.”

—Tom Basso, profiled in The New Market Wizards

“I am very pleased to see Michael Covel’s updated version of Trend Following; one of my favorite trading books out of the hundreds that I have read. He has doubled the size of this edition and expounded on the process used by legendary trend following traders. The traders in this book made millions by getting on the right side of trends and managing risk in diversified markets. This book should be studied by any serious trader or investor.”

—Steve Burns, NewTraderU.com

“Trend Following: Definitely required reading for the aspiring trader.”

—David S. Druz, Tactical Investment Management

“A mandatory reference for anyone serious about alternative investments.”

—Jon Sundt, Altergris

“Michael Covel does an excellent job of educating his readers about the little‐known opportunities available to them through one of the proven best hedge fund strategies. This book is like gold to any smart investor.”

—Christian Baha, Superfund

“Covel has created a very rare thing—a well‐documented and thoroughly researched book on trend following that is also well written and easy to read. This is one book that traders at all levels will find of real value.”

—John Mauldin, Mauldin Economics

“I think that Michael’s Trend Following is an outstanding read from which all investors can learn to trade markets better by limiting their risks and maximizing their profits through a more disciplined approach to investments.”

—Marc Faber
Managing Director, Marc Faber Limited
Editor, “Gloom, Boom & Doom Report”

Cover design: Wiley

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The fourth edition of Trend Following was published by FT Press in 2009.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 646‐8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging‐in‐Publication Data:

Names: Covel, Michael W., author.

Title: Trend following : how to make a fortune in bull, bear and black swan markets / Michael W. Covel.

Description: Fifth edition. | Hoboken : Wiley, 2017. | Series: Wiley trading | Revised edition of the author’s Trend following. | Includes bibliographical references and index.

Subjects: LCSH: Investments. | Stocks. | BISAC: BUSINESS & ECONOMICS / Commodities.

Classification: LCC HG4521 .C82 2017 (print) | LCC HG4521 (ebook) | DDC 332.6—dc23

LC record available at https://lccn.loc.gov/2016056666

Contents

Foreword

Preface

Section I Trend Following Principles

1 Trend Following
1. Speculation
2. Winning versus Losing
3. Investor versus Trader
4. Fundamental versus Technical
5. Discretionary versus Systematic
6. Hiding in Plain Sight
7. Change Is Life
8. Follow the Trend to the End When It Bends
9. Surf the Waves
10. Summary Food for Thought
2 Great Trend Followers
1. David Harding
2. Summary Food for Thought
3. Bill Dunn
4. Summary Food for Thought
5. John W. Henry
6. Summary Food for Thought
7. Ed Seykota
8. Summary Food for Thought
9. Keith Campbell
10. Summary Food for Thought
11. Jerry Parker
12. Salem Abraham
13. Summary Food for Thought
14. Richard Dennis
15. Summary Food for Thought
16. Richard Donchian
17. Summary Food for Thought
18. Jesse Livermore and Dickson Watts
19. Summary Food for Thought
20. Note
3 Performance Proof
1. Absolute Returns
2. Volatility versus Risk
3. Drawdowns
4. Correlation
5. Zero Sum
6. George Soros
7. Berkshire Hathaway
8. Summary Food for Thought
4 Big Events, Crashes, and Panics
1. Event 1: Great Recession
2. Event 2: Dot-com Bubble
3. Event 3: Long-Term Capital Management
4. Event 4: Asian Contagion
5. Event 5: Barings Bank
6. Event 6: Metallgesellschaft
7. Event 7: Black Monday
5 Thinking Outside the Box
1. Baseball
2. Billy Beane
3. Bill James
4. Stats Take Over
5. Summary Food for Thought
6. Note
6 Human Behavior
1. Prospect Theory
2. Emotional Intelligence
3. Neuro-Linguistic Programming
4. Trading Tribe
5. Curiosity, Not PhDs
6. Commitment
7. Summary Food for Thought
7 Decision Making
1. Occam’s Razor
2. Fast and Frugal Decision Making
3. Innovator’s Dilemma
4. Process versus Outcome versus Gut
5. Summary Food for Thought
8 The Scientific Method
1. Critical Thinking
2. Linear versus Nonlinear
3. Compounding
4. Summary Food for Thought
9 Holy Grails
1. Buy and Hope
2. Warren Buffett
3. Losers Average Losers
4. Avoiding Stupidity
5. Summary Food for Thought
10 Trading Systems
1. Risk, Reward, and Uncertainty
2. Five Questions
3. Your Trading System
4. Frequently Asked Questions
5. Summary Food for Thought
11 The Game
1. Acceptance
2. Don’t Blame Me
3. Decrease Leverage, Decrease Return
4. Fortune Favors the Bold

Section II Trend Following  Interviews

12 Ed Seykota
13 Martin Lueck
14 Jean-Philippe Bouchaud
15 Ewan Kirk
16 Alex Greyserman
17 Campbell Harvey
18 Lasse Heje Pedersen

Section III Trend Following Research

19 A Multicentennial View of Trend Following
1. The Tale of Trend Following: A Historical Study
2. Return Characteristics over the Centuries
3. Risk Characteristics over the Centuries
4. Portfolio Benefits over the Centuries
5. Summary
6. Appendix: Included Markets and Relevant Assumptions
20 Two Centuries of Trend Following
1. Introduction
2. Trend Following on Futures since 1960
3. Extending the Time Series: A Case-by-Case Approach
4. Trend over Two Centuries
5. Conclusions
6. Notes
21 Trend Following
1. Overview
2. Introduction to Different Trend Following Models
3. Diversification between Different Trend Following Models
4. Aspect’s Approach to Trend Following
5. Aspect’s Model Compared to Other Trend Following Models
6. Conclusion
7. Chart Disclaimer
8. Note
22 Evaluating Trading Strategies
1. Testing in Other Fields of Science
2. Revaluating the Candidate Strategy
3. Two Views of Multiple Testing
4. False Discoveries and Missed Discoveries
5. Haircutting Sharpe Ratios
6. An Example with Standard and Poor’s Capital IQ
7. In Sample and Out of Sample
8. Trading Strategies and Financial Products
9. Limitations and Conclusions
10. Note
23 Black Box Trend Following—Lifting the Veil
1. Synopsis
2. The Strategies
3. Performance Results and Graphs
4. Sector Performance
5. Performance of Long versus Short Trades
6. Stability of Parameters
7. Are CTAs a Diversifier or a Hedge to the SP500?
8. Summary
9. Note
24 Risk Management
1. Risk
2. Risk Management
3. Optimal Betting
4. Hunches and Systems
5. Simulations
6. Pyramiding and Martingale
7. Optimizing—Using Simulation
8. Optimizing—Using Calculus
9. Optimizing—Using the Kelly Formula
10. Some Graphic Relationships Between Luck, Payoff,  and Optimal Bet Fraction
11. Nonbalanced Distributions and High Payoffs
12. Almost-Certain-Death Strategies
13. Diversification
14. The Uncle Point
15. Measuring Portfolio Volatility: Sharpe, VaR, Lake Ratio, and Stress Testing
16. Stress Testing
17. Portfolio Selection
18. Position Sizing
19. Psychological Considerations
20. Risk Management—Summary
25 How to GRAB a Bargain Trading Futures . . . Maybe
1. Introduction
2. How to GRAB a Bargain Trading Futures
3. Following Trends Is Hard Work
4. Figuring Out How the Pros Do It
5. A Computer Model of the Pros
6. A Terrible Discovery
7. Solving the Mystery—Why Does the GRAB System Lose?
8. Often It Is Out of Sync with the Market
9. Worse Still, It Misses the Best Moves!
10. Maybe Being Profitable Means Being Uncomfortable?
11. GRAB Trading System Details
12. Buys on Break of Support, Sells on Break of Resistance
13. Testing Reveals Some Behavior I Do Not Expect
14. Difference between Parameter Values Defines  Character of GRAB System
15. GRAB Trading System Code
16. Indicator Setup
17. Position Entry
18. Position Exit
19. Position Sizing
20. Note
26 Why Tactical Macro Investing Still Makes Sense
1. Introduction
2. Managed Futures
3. Defining Managed Futures and CTAs
4. Where Institutional Investors Position  Managed Futures and CTAs
5. Skewness and Kurtosis
6. Data
7. Basic Statistics
8. Stocks, Bonds, Plus Hedge Funds or Managed Futures
9. Hedge Funds Plus Managed Futures
10. Stocks, Bonds, Hedge Funds, and Managed Futures
11. Conclusion
12. Appendix A
13. Appendix B
14. Appendix C
15. Review of Skewness and Kurtosis
16. Note
27 Carry and Trend in Lots of Places
1. Carry and Trend: Definitions, Data, and Empirical Study
2. Carry and Trend in Interest Rate Futures
3. Trend and Carry across Asset Classes
4. Carry and Trend across Rate Regimes
5. Conclusions
6. Note
28 The Great Hypocrisy

Epilogue

Afterword

Trend Following Podcast Episodes

Bibliography

Acknowledgments

About the Author

Index

EULA

List of Tables

Chapter 2

Table 2.1
Table 2.2
Table 2.3
Table 2.4
Table 2.5

Chapter 3

Table 3.1(a)
Table 3.1(b)
Table 3.2
Table 3.3(a)
Table 3.3(b)
Table 3.4
Table 3.5
Table 3.6

Chapter 4

Table 4.1
Table 4.2
Table 4.3
Table 4.4
Table 4.5
Table 4.6
Table 4.7
Table 4.8
Table 4.9
Table 4.10
Table 4.11

Chapter 5

Table 5.1

Chapter 8

Table 8.1

Chapter 9

Table 9.1

Chapter 10

Table 10.1

Chapter 19

Table 19.1
Table 19.2
Table 19.3
Table 19.4

Chapter 20

Table 20.1
Table 20.2
Table 20.3
Table 20.4
Table 20.5
Table 20.6
Table 20.7
Table 20.8
Table 20.9

Chapter 26

Table 26.1
Table 26.2
Table 26.3
Table 26.4
Table A-1
Table A-2
Table A-3
Table B-1
Table B-2
Table B-3

Chapter 27

Table 27.1
Table 27.2
Table 27.3
Table 27.4
Table 27.5

List of Illustrations

Chapter 2

Figure 2.1: Dunn Capital Management: Composite Performance 1974–2016
Figure 2.2: Dunn Capital’s Japanese Yen Trade
Figure 2.3: Dunn Capital’s British Pound Trade
Figure 2.4: Henry South African Rand Trade
Figure 2.5: Henry Japanese Yen Trade
Figure 2.6: Hypothetical $1,000 Growth Chart for Campbell & Company

Chapter 3

Figure 3.1: Drawdown Chart

Chapter 4

Figure 4.1: U.S. Dollar Short Trade
Figure 4.2: : Long Gold Trade
Figure 4.3: :Long Five-Year Notes Trade
Figure 4.4: Crude Oil Short Trade
Figure 4.5: Nikkei 225 Short Trade
Figure 4.6: British Pound Short Trade
Figure 4.7: Long December 2008 Euribor Trade
Figure 4.8: :Long December 2008 EuroSwiss Trade
Figure 4.9: Short December 2008 Lean Hogs Trade
Figure 4.10: Short January 2009 Lumber Trade
Figure 4.11: Short January 2009 Robusta Coffee Trade
Figure 4.12: Long December 2008 U.S. Dollar Trade
Figure 4.13: Abraham Trading Compared to the S&P
Figure 4.14: Trend Followers and the S&P Chart, January 2002–December 2002 
Figure 4.15: Trend Followers and the Dollar Chart, January 2002–December 2002 
Figure 4.16: Trend Followers and the Yen Chart, January 2002–December 2002  
Figure 4.17: Trend Followers and the Euro Chart, January 2002–December 2002
Figure 4.18: :Trend Followers and the T-Bond Chart, January 2002–December 2002
Figure 4.19: Trend Followers and the FTSE Chart, January 2002–December 2002
Figure 4.20: :Trend Followers and the Euro-Bund, January 2002–December 2002
Figure 4.21: Trend Followers and the DAX, January 2002–December 2002
Figure 4.22: Enron Stock Chart
Figure 4.23: Natural Gas Stock Chart
Figure 4.24: Trend Followers and 10-Year T-Note, May 1998–December 1998
Figure 4.25: Trend Followers and U.S. T-Bond, May 1998–December 1998
Figure 4.26: Trend Followers and German Bund, May 1998–December 1998
Figure 4.27: Trend Followers and S&P, May 1998–December 1998
Figure 4.28: Trend Followers and Swiss Franc, May 1998–December 1998
Figure 4.29: Trend Followers and Eurodollar, May 1998–December 1998
Figure 4.30: Trend Followers and Yen, May 1998–December 1998
Figure 4.31: Trend Followers and Dollar Index, May 1998–December 1998
Figure 4.32: Nikkei 225 September 1994–June 1995
Figure 4.33: Crude Oil Futures, February 1993–February 1994

Chapter 7

Figure 7.1: Process versus Outcome²⁵

Chapter 9

Figure 9.1: Weekly Chart Nikkei 225, 1985–2003

Chapter 10

Figure 10.1: Trend Following Entry/Exit Example: The Middle Meat

Chapter 19

Figure 19.1 A standard price index for tulip bulb prices
Figure 19.2 A historical plot of the S&P 500 Index and S&P 500 Total Return Index from 1800 to 2013 in log scale
Figure 19.3 The number of included markets in the representative trend following program from 1300 to 2013
Figure 19.4 Cumulative (log) performance of the representative trend following portfolio from 1300 to 2013
Figure 19.5 The GFD Long-Term Government Bond Yield Index from 1300 to 2013  
Figure 19.6 A composite annual inflation rate for the United States and the United Kingdom from 1720 to 2013
Figure 19.7 The Dow Jones Industrial index during the 1929 Wall Street Crash (Black Monday)
Figure 19.8 Cumulative performance for the representative trend following system pre and post the 1929 Wall Street Crash (Black Monday). The data period is October 1928 to October 1930.
Figure 19.9 Average monthly returns for the representative trend following system during down periods in equity and bond portfolios
Figure 19.10 Average monthly returns for trend following when the equity index is down. Conditional performance is plotted for both with and without a long bias to the equity sector.
Figure 19.11 The “CTA Smile”: Quintile analysis of trend following for 1913–1962 and 1963–2013. Returns are sorted by quintiles of equity performance from 1 (worst) to 5 (best).
Figure 19.12 The “CTA Smile”: Quintile analysis of trend following for 1913–1937, 1938–1962, 1963–1987, and 1988–2013. Returns are sorted by quintiles of equity performance from 1 (worst) to 5 (best).
Figure 19.13 The maximum and average of the largest five relative drawdowns as a percentage for trend following relative to the buy-and-hold portfolio. The maximum drawdown of trend following is 75 percent of the magnitude of the maximum drawdown for the buy-and-hold portfolio.
Figure 19.14 The relative size of the longest duration and average duration of the longest five drawdowns for trend following relative to the buy-and-hold portfolio. The longest drawdown duration is less than 10 percent of the length of the longest drawdown length for the buy-and-hold drawdown.
Figure 19.15 Sharpe ratios for individual asset classes including equity and combinations of the three asset classes from 1695 to 2013

Chapter 20

Figure 20.1 Fictitious P&L, as Described in Equation 2.2, of a Five-Month Trend-Following Strategy on a Diversified Pool of Futures
Figure 20.2 Global Debt of the U.S. Government (a) in Billions of U.S. Dollars and (b) as a Fraction of GDP
Figure 20.3 Trend on Spot and on Futures Prices
Figure 20.4 Aggregate Performance of the Trend on All Sectors
Figure 20.5 Fit of the Scatter Plot of Δ(t) = p(t + 1) – p(t) as a Function of s_n(t), for n = 5 Months, and for Futures Data Only
Figure 20.6 Recent Performance of the Trend
Figure 20.7 Ten-Year Cumulated Performance of the Trend (Arbitrary Units)
Figure 20.8 Performance of a Three-Day Trend on Futures Contracts since 1970

Chapter 21

Figure 21.1 Simulated Performance of Trend Following Models: January 1999 to June 2016
Figure 21.2 Simulated Risk-Adjusted Performance of Trend Following Models: January 1999
Figure 21.3 Simulated Correlations between Trend Following Models: Jan 1999 to Jun 2016
Figure 21.4 Simulated Performance of Trend Following Models and Average across all 13: Jan 1999 to Jun 2016
Figure 21.5 Simulated Average Information Ratios from Combining Different Trend Following Models: January 1999 to June 2016
Figure 21.6 Aspect’s Trend Following Model Simulated Performance Improvements: January 1999 to June 2016
Figure 21.7 Simulated Performance of Trend Following Models versus Aspect’s Trend Following Model: January 1999 to June 2016
Figure 21.8 :Simulated Performance of Trend Following Models versus Aspect’s Trend Following Model: January 1999 to June 2016
Figure 21.9 Simulated Impact on Aspect’s Model Information Ratio from Adding Other Trend Following Models: Jan 1999 to Jun 2016

Chapter 22

Figure 22.1 A Candidate Trading Strategy
Figure 22.2 Two Hundred Randomly Generated Trading Strategies
Figure 22.3 Panel A: False Trading Strategies, True Trading Strategies.  Panel B: False Trading Strategies, True Trading Strategies.

Chapter 24

Figure 24.1 A Luck-Payoff matrix, showing six outcomes For now, however, we return to our basic coin example, since it has enough dimensions to illustrate many concepts of risk management. We consider more complicated examples later.
Figure 24.2 Simulation of fixed-bet and fixed-fraction betting systems
Figure 24.3 Simulation of equity from a fixed-fraction betting system
Figure 24.4 Expected value (ending equity) from 10 tosses, versus bet fraction, for a constant-bet fraction system, for a 2:1 payoff game, from the first and last columns of Figure 24.3
Figure 24.5 The Kelly Formula
Figure 24.6 Optimal bet fraction increases linearly with luck, asymptotically to payoff.
Figure 24.7 The optimal expected value increases with payoff and luck.
Figure 24.8 For high payoff, optimal bet fraction approaches luck.
Figure 24.9 The Lake Ratio = Blue / Yellow

Chapter 25

Figure 25.1 Trend Following System, E-Mini S&P 500 (Back-Adjusted)
Figure 25.2 E-Mini S&P 500 (Back-Adjusted)
Figure 25.3 GRAB System; Parameter Values 40, 80
Figure 25.4 GRAB System; Parameter Values 40, 80 Soybean Oil (Back-Adjusted)
Figure 25.5 GRAB System; Parameter Values 40, 80 Euro German Bund  (Back-Adjusted)
Figure 25.6 Near-Box Look-Back: 20 Days. Far-Box Look-Back: 100 Days, Corn (Back-Adjusted)
Figure 25.7 Parameters Far Apart: Near-Box Look-Back: 20 Days. Far-Box Look-Back: 200 Days, New York Coffee (Back-Adjusted)
Figure 25.8 Parameters Close Together: Near-Box Look-Back: 110 Days. Far-Box Look-Back: 140 Days Natural Gas (Back-Adjusted)

Chapter 26

Figure 26.1 Mean return of varying allocation between traditional and alternative portfolios, while changing the alternative portfolio’s Managed Futures/Hedge Fund composition, for the period January 2001–December 2015
Figure 26.2 Standard deviation of varying allocation between traditional and alternative portfolios, while changing the alternative portfolio’s Managed Futures/Hedge Fund composition for the period January 2001–December 2015
Figure 26.3 Risk-adjusted return of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period of January 2001–December 2015
Figure 26.4 Skewness of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period June 2001–December 2015
Figure 26.5 Kurtosis of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period June 2001–December 2015
Figure 26.6 Efficient frontier for portfolios ranging from 100% Traditional portfolio to 100% Alternatives portfolio in 10% increments for the period June 2001–December 2015
Figure A-1 Mean return of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period January 1990–December 2015
Figure A-2 Standard deviation of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period January 1990–December 2015
Figure A-3 Skewness of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period January 1990–December 2015
Figure A-4 Kurtosis of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for the period January 1990–December 2015
Figure B-1 Mean return of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for Kat’s study period of June 1994–May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom). Note: Our image looks different than Kat’s, primarily because he constrained the equity returns for the period and we did not.
Figure B-2 Standard deviation of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for Kat’s study period of June 1994–May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom)
Figure B-3 Skewness of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for Kat’s study period of June 1994–May 2001 (top, Kat’s original graphic;¹¹ ours is on bottom)
Figure B-4 Kurtosis of 50/50 portfolios of stocks, bonds, hedge funds, and managed futures for Kat’s study period of June 1994–May 2001 (top, Kat’s original graphic below;¹¹ ours is on bottom)

Chapter 27

Figure 27.1 Excess Return Index and Estimated Carry for Rolling U.S. 10-Year Note Futures
Figure 27.2 Decomposing History of U.S. 10-Year Note Futures by Carry  and Trend

Foreword

True story: Not long after the financial crisis of 2008–09, I was dragged to a posh Long Island country club for some terribly boring social event (those tony golf places are not my idea of fun). On my way out the door, I was introduced to someone—let’s just call him Trader Guy—who is described to me sotto voce as the wealthiest person in the club. The thinking apparently was “Hey, two finance guys! They should meet.”

We exchange small talk. Trader Guy’s diffidence makes it clear he has no interest in chatting. We are both heading out to the valet—these places won’t let you park your own car—and a rather memorable few moments ensued.

Trader Guy knows who I am. My book on the financial crisis had come out the prior year; I had already been a regular in the financial media for a while. He knows my name and, truth be told, he could not possibly have cared less. If only to be polite to the host who introduced us, I ask what sort of trading he does. Trader Guy actually sighs deeply—then says to me, “I trade everything, I am a trend follower, you wouldn’t understand.”

Oh, really?

“What a coincidence” I say. “A friend of mine wrote a book on trend following.”

By now, I have exhausted what little patience Trader Guy had with me to begin with. I actually heard his eyes roll.

“Listen, dude, it’s really cute you have a friend who wrote a book on this, but there is only one book on the topic, every other one is crap. Your pal wasted trees writing his. The definitive book on the subject, the only one that matters, is called Trend Following. Everything else is a waste of your time.”

I tried, I really tried so hard not to smirk.

As best as I could with a straight face, I casually say: “Yeah, that’s the one. That’s the book Mike—my friend Michael Covel—wrote. Trend Following.

Talk about an attitude adjustment: Trader Guy has a genuine come-to-Jesus moment, turning into a smitten schoolgirl: “OhmygodOhmygodOhmygod—you know Mike Covel? I love that book, I love Trend Following! I was a failing trader, about to get blown out of the business. I read that book, and it turned my whole life around. I owe that guy my entire career!”

Ahhh! The tables have turned. Now it is my turn to have a little fun:

“I keep telling Mike he needs to punch it up, make it more colorful, add a section on forecasting economic data, evaluating corporate management, and analyzing geopolitics. Make it fresh and interesting.”

Long pause as Trader Guy’s jaw drops.

It takes him a few seconds before he realizes that: a) I am totally kidding; b) I understand how irrelevant those things are to trend followers, and; c) I am busting his chops for being such a hard ass before.

Trader Guy laughs as I am now deemed worthy. We are suddenly best buds: We chat about what we were short during the crisis (AIG, Lehman, Bear), the equity rally off of the lows (strong), and the gold run (at risk of breaking), dollar trending. His car pulls up, we keep talking. My car comes around, and we are still talking. Mr. Diffident has morphed into Mr. Conversationalist.

All of which goes a long way towards explaining why the book in your hands, now in its fifth edition, has become one of the most popular trading books ever written.

What are the characteristics that make Trend Following so unique? I have my own biases. I see the inherent and natural flaws of human psychology as an investor’s biggest flaws. Like our inability to understand risk and data and statistics, our obsession to be right, and the ways our wetware constantly fool us into believing things that objectively are not true.

Hence, my top ten reasons I like Trend Following reflect all of that:

It is an objective, price-based approach.
News headlines, pundits, analysts, and opinions are not meaningful.
It has risk management built into it.
Specific views on “The Fundamentals” are not relevant.
It is methodical and systematic.
The same exact strategies apply across all asset classes.
It does not require any predictions.
Time frames are long-term in nature.
Economic data—Employment, GDP, Fed, etc.—are irrelevant.
It demands a very exacting personal discipline.

Readers may find that other aspects of trend following that resonate more for them. It depends on your own personality. But what does not vary for any trend follower is understanding the specific underlying philosophy, and having the discipline to follow that approach with unwavering, religious dedication.

I have a few complaints as well. It gives you nothing to talk about at cocktail parties or barbecues. It is less intellectually stimulating than say debating whether and when the FOMC should or should not (or will or will not) raise or lower rates next meeting. It can be boring. And, there are long stretches of time where the trend is neutral, and you are doing nothing.

Anyone can learn the methods Covel discusses here. Putting them into action requires commitment to the craft, and a military discipline. The Achilles heel of so many traders is a lack of precisely those qualities. As you will learn, Trend Followers must be willing to tough out some difficult sledding. It is an old joke but it’s true: If it was easy, everyone would be rich!

But it is not easy. Anyone who has lived with a major drawdown understands how your own body responds. Physical and emotional tolls are not insignificant. You lose sleep, you have a low-grade headache for days or weeks at a time, and some people respond with physical nausea. The biggest issue comes in the hit to self-confidence. Riding out the loss of capital leads traders to question themselves and to doubt their methodology. They wonder if maybe it really is different this time. Market structures have changed, the Fed is doing something unprecedented, high-frequency trading is new, or perhaps it is ETFs, they think something is different this time around. “Perhaps if I just tweak the approach a little here this once . . .” are famous last words.

To those who master the techniques described herein, there are profits to be had. But it is not for everyone, and if you are unable or unwilling to ride out the losses, accept drawdowns in capital, be bored through periods of tedium and inactivity, to have the discipline to follow your strategy, to you I say, “Move along. Trend following is not for everyone.”

For those who want to learn the craft of trading, have the personality and discipline, and are willing to do the heavy lifting, read on . . . you won’t regret it.

—Barry L. Ritholtz

Chairman, Chief Investment Officer, Ritholtz Wealth Management

Columnist for Bloomberg View and Washington Post

Host of Masters in Business radio podcast for Bloomberg

How to Make a Fortune in Bull, Bear, and Black Swan Markets