Michael Covel Podcast – Trend Following

Nick Radge and Michael Covel on Trend Following

Published August 13th, 2021

Michael Covel is renowned for digging deep into the world of trend following with insightful access to some of the world’s great traders. His book Trend Following has become the gold standard for anyone wanting to travel that journey.

Back in 2012, for episode #5, Michael Covel invited me onto his now very successful podcast, Michael Covel’s Trend Following Podcast. Today that same podcast has over 750 episodes covering many facets of trading, the markets and psychology.

You can listen to my discussion HERE:

Transcript of Nick Radge’s Michael Covel Podcast Interview

Recorded in 2012

How I became a professional trader

I was unwittingly introduced to trend following.

A friend worked for a big, well-established stockbroking firm, and he was looking for a clerk. So it ticked all my boxes; I got to catch a train to work, carry a briefcase, and wear a suit and work in a building. So I started as a clerk straight out of school, working in the commodities section of a stockbroking firm. They had a small dealing there that dealt in interest rate and bond futures, here in Australia.

One day I took a stroll around the office and I walked past the equity private client advisors. There was one guy and he had some chart paper in front of him –this is 1985 before computers. He was doing a five and ten-day moving average crossover of the share price index futures, which is the same as the S&P 500 futures. I’m looking at this chart and I asked what he was doing.

“When the blue line crosses the red, you buy. When it crosses down below the red, you sell.” And I could see it; I could see the trends on the chart. It made sense.

That afternoon I went down to the stationery store and I got some chart paper, I got a black pen to mark out the high/low close. I got a red and a green pen, and I started working out the moving averages. Then about two or three days later when I was really seeing these trends I decided to open a futures account. I was eighteen. I was earning twelve thousand dollars a year. I saw the office Manager, who was a wily old man who’d been around the block several times. I said I wanted to open a futures account and he just looked at me and shook his head.

He couldn’t believe that an eighteen-year-old on twelve grand a year wanted to trade futures. But he let me. He said, “If you want to place an order I’ll let you do that. But I’ve got to sign the ticket each time you do it, and then you phone it down to the trading floor.”

And that’s how I started. That was in 1985 when we had to send paper around the place, it wasn’t electronic. Before 1987 the stock market was moving along so quickly, that people were buying stocks and realizing they actually couldn’t pay for them. In that situation, the script desk would take ownership of the stock, and then they had two weeks to sell it. Running into 1987, the stock market was going up day after day. So you could sit on the stock without paying for it for two weeks, then sell and make a motza. So that’s exactly what we did.

Of course, it had to end…and it did in October 1987.

I was holding a tonne of stock that I hadn’t paid a cent for. I was earning twelve thousand dollars a year and by the end of the day my trading career had come to a very quick finish, and my father had to bail me out. That was a very expensive lesson.

That was my biggest lesson. It may sound odd, but I bought myself a diamond ring a couple days after that event. It’s a reminder not to be such an idiot, and I still wear the ring thirty years later.

I didn’t realise how much damage I’d done to my own account for about three or four days.

On the day of the crash I knew something was going on but I didn’t get the full gist of it until I went down to the Sydney Futures Exchange trading floor. That was my first time on the trading floor. What a way to start!

The bond and interest rate pit opened a little bit earlier than the stock indices. Everyone was sitting there waiting for the stock market to open. It was just horrific. Normally there was a one tick bid-offer spread. The traders had agreed that they would quote fifty tick bid-offer spreads before the market opened, and it just went one way as soon as the market opened. It was unbelievable. I vividly remember security guards came in within about one minute of the opening bell, and physically removed some of the option traders. These guys had been selling options for the last three or four years –these were the kinds of guys that had their Ferraris and their Porsches parked straight at the front door in a no standing zone. They were physically taken off the trading floor. They were bankrupt immediately. I was standing there as an eighteen-year-old, thinking, “Wow! This is quite amazing.” And that’s when it really started to sink in that something historic was occurring.

The share price index futures on a big day would move forty points. But this thing was gapping two hundred, three hundred points backwards and forwards.

It made me realise that I had no way to handle this; I had no strategy. I had no risk management in place.

Trend Following System

A trend following system has got rules.

Simple does work. It really does work. People tend to look for complexity.

People tend go for a strategy that has a higher winning percentage. But that’s wrong. Simplicity works best because simplicity is robust and it works exceptionally well. In my book ‘Unholy Grails’, towards the end I disclose a strategy called the 20% flipper. It’s remarkably simple.

Basically, if you buy (and it’s a long only trend following strategy) a stock that moves 20% from a low point buying with the momentum and buying with the trend, and you exit that position when it falls 20% from any specific high point, then on a portfolio of twenty individual stocks you’ve got an annualized return over the last fifteen years in excess of 20%. That’s a very simple yet robust strategy that works particularly well and it doesn’t matter what universe of stocks you trade it on.

The simple premise is, if a stock is going to double in price i.e. if it’s going to go up a 100%, it has to go up 20% first. It’s simple, it’s robust, and one of the things I try to get through to my clients is you need to intimately understand why your strategy will work. For trends to occur in the hundreds of percent, they must start by rising 20%.

I’m not a stock picker.

I’m not a stock picker. To give you an idea, over the last six or seven years my major trend following strategy here in Australia that trades long only equities, my win rate is about 49.6%. During that time, my compounded annualized return is about 18% compared to the market 2.7%. That’s only getting it right 50% of the time.

I don’t pick stocks, they pick me. Because they float to the top. I don’t have to pick the next best sector. I don’t have to time when the market is going to be good or when it’s going to be bad. I just have to be there when the time comes along. I think that’s a very good lesson, especially when you’re trading equities, especially on the long side. You can’t afford not to be involved during the good times.

To give you an idea, if you had stepped aside in the nine month period following March 2009, if you had said “It’s all too hard!” in early 2009 and stepped aside for nine months, your annualized return goes from 8.5% down to less than 1%. Just because you missed that nine month period of time where the market jumped 30-35%. That’s what happens when you get scared at the bottom and don’t participate. A lot of people did not participate in 2009 and are still too scared to participate in the market, and that is because they have got no way to get out when things turn sour again.

Trading the Trends in the Stock Market

Trends can’t not exist. The economy is always shifting back or forth, and human sentiment which is ultimately the driver of the market, is always shifting backwards and forwards –and therefore trends will always occur.

I had a run in with a very major Australian educator whom in 2009 came out and basically said in “Whatever strategy you’ve used for the last twenty years, will not work ever again.” And I took that to heart. I thought that was an absolute lie, Of course he had the answer right? He had the new paradigm that you had to use now, that hasn’t worked for the last twenty years. So his point was mainly to scare people and to sell something different. Maybe his strategy didn’t work anymore, and maybe it wasn’t robust enough to facilitate the current market. You can’t tell me that markets are going to stop trending. They just can’t stop trending.

I backpacked around the U.S. back in the early nineties and I was in New Orleans and I had ten dollars in my pocket. That’s all I had left, I had ten dollars in my pocket and we had to get to Florida. Now, I actually got in a cab, because it was pouring with rain. I said to the cab driver, “I’ve got ten dollars, can you take me out to the freeway and put me under a bridge?” and he did that. So there I am on a six lane motorway heading towards Florida. And I put my finger out and within two minutes a car stopped. Now that ride took me all the way around to Orlando in Florida. One ride, from New Orleans. It took about three or four days but the one ride took me the whole way, and finished off at spring break. So you just never know where that ride’s going to take you. As a trader, you want to get on the trend, you want to hitchhike or catch a ride on the trend and ride it as far as it will go.

Learning how to Trade the Stock Market

If we use an analogy; I was teaching my daughter how to drive. I use to have hair before I was teaching her how to drive. Now I have none. When you teach a teenager how to drive, the quantitative rules are pretty straight forward. Put your foot on the accelerator to move the car forward. Turn the wheel to the left to go left. Turn the wheel to the right to go right. Put your foot on the break to stop. They’re rules that can be repeated.

In trading we have the same kind of things. You have an entry mechanism, a stop loss, fixed fractional position sizing, an exit mechanism etc.. They are rules that can be taught and repeated into the future.

Then there’s a set of qualitative rules. Again, if we use the analogy of driving or teaching your teenage daughter how to drive a car… How do you teach a teenager to recognise a dangerous situation on the road? How do you teach a teenager to understand that driving in the wet creates more complications and it takes longer to slow down, so on and so forth? These are the kinds of things that you can’t teach. They have to be learned from experience.

It’s the same in trading. I can tell people that “at some stage we’ll have a drawdown of between 15% and 20%.” It’s going to happen. As soon as it happens they run for cover, they run for the hills. You have to experience that drawdown and come out of that drawdown, you have to experience it for yourself. But if you don’t ever allow yourself to experience losses, because you’re scared, then you’re never going to be a successful trader. I can’t teach people that. I can tell people, “you’re going to have ten losing trades in a row.” or “You’re going to suffer 15% drawdown.” And one thing I stress to people is that they can’t handle the level of pain (losses) they think they can. If someone says they can handle a 20% drawdown, chances are they can probably only handle a 10% drawdown. So, the rule is, if your pain threshold is a 10% drawdown then don’t trade a strategy where, at some stage, you can expect a 20% drawdown.

The one thing I do is a lot of time window analysis where I go back and find out exactly how many months or how many years it would take to get to a 100% probability of profits. My major trend following strategy out here in Australia, I can tell you that the probability of achieving a 100% probability of profit is at twenty-two months. In other words, if you can’t give me twenty-two months, I can’t guarantee you a 100% probability of profit. We get people coming to us saying they’ll give it a go for two months – that’s no good.

100% probability of making a profit. That profit might be 1% or it might be 100%. That’s not the point. It’s the probability of making a profit. We want to find out at what point we hit the 100% mark. With my longer term trend following strategy here in Australia, that comes in at twenty-two months.

So at six months I can tell you we’ve got a 60% probability of profit. At twelve months I think it goes up to about 83%, but at twenty-two months it hits 100% probability of profit, which means it doesn’t matter when you start. It doesn’t matter whether you start on January the first or December the thirtieth. It doesn’t matter when you start. What matters is that you give it twenty-two months. If you can’t give it twenty-two months, then you have a risk, however large, of actually coming up behind.

When trading or investing we always look at the bigger picture and we work in long time frames, we’re not looking one or two months from now. We’re investing and compounding over time.

I was talking at a trading and investing conference in Perth and this guy came up after my talk and said, “I’m probably the youngest guy that’s been in the talk today.” He was, seventeen or eighteen, but he knew he was in a good spot. He knew he was learning something that he could apply for the rest of his life If I could be seventeen again and know what I know now. I said to him, “You are in a cracker of a position. You’ve just got to put this to work and let it do its thing over the years. Go and get a job and have a career. Trade the Growth Portfolio on the side. Don’t focus on wanting to be a professional trader. Give it ten, fifteen years and you’ll be in a great position, way ahead of all your friends financially.

How to trade profitably

Many years ago I went around Australia and I did a seminar for people, showing them how to manage their risk appropriately. What I suggested to people is that the 2% rule is probably not appropriate for everybody. You know the 2% rule; you risk no more than 2% of your capital on any one trade. Everyone takes that for granted, and that’s what they use. But, if you have a strategy that has a win rate of 50% then mathematics at some stage you will have sixteen loses in a row. If you’re risking 2% per trade, then you’re going to have sixteen loses in a row, then your drawdown is going to be somewhere around 30% at some stage. If you can only handle a maximum drawdown of 10% then you should not be trading using 2%.

So risk is a function of how much pain you can withstand in order to keep trading that strategy over the long term. It is important that you trade the strategy over the longer term, and deal with the bumps along the way. If you can’t deal with the bumps, if you can’t deal with the journey, then you’re never going to make the destination.

Let’s again, go on the road. Say we’re going to go from New Orleans to Florida. We know that you’re going to have to stop to go to the bathroom and we know that you’re going to have to stop and have a bit of a rest, get some food, and you might have to take a detour. The thing is, when we get in the car and we’re faced with a journey like that, we intimately understand what the journey ahead is going to be like. When it comes to trading, nobody tells us what the journey is going to be like. No one tells us that there’s going to be losing trades in a row –ten, fifteen, losing trades in a row. No one says you’re actually going to, at some point, lose 15% of my capital. When the journey is plotted out for us, which is what I do for people, some people then aren’t happy. They’re going to say, “Well that’s not acceptable.” And that’s fine. Trading isn’t for them.

A lot of people come into this game, they don’t actually know what lies ahead, and as soon as they hit that first speed bump, then they get scared and they start looking for answers. They tend to throw it in, throw the strategy away, and then go look for a better strategy. Obviously when they get to that second strategy the same thing is going to happen. So it’s important for people to understand that risk is part of the journey.

There’s nothing wrong with risk. I think Liz Cheval summed it up: The volatility of your account is not about risk. It’s just about travelling the journey, and you’ve got to be able to do that. You’ve got to be able to ride that.

Obviously, there’s different degrees of volatility. I think the average person in my view could probably take a 20% drawdown in their stride. Once you go beyond 20% it becomes a little bit more difficult. But then you’ve got someone like Bill Dunn who’s been through a 60% drawdown.

I say to people, “With my strategy at some stage you’re going to have a 20% drawdown.” And they say, “Oh that’s not acceptable.” “But hold on, you’ve been a buy and hold investor and you’ve just suffered a 50% drawdown (2008). How does that relate? You’ve just lived through 50% and you’re still 30% under water, but you’re not willing to accept that 20% is doable.”

When a person gives money to a fund manager they stop taking responsibility for their losses. There’s  a disconnection. But when someone trades for themselves, they take responsibility for their losses. So I have people who come to me, do their own trading, follow my instructions and have a 20% drawdown and are not happy. Yet, by the same token they can put their money into a mutual fund and be down 50% and live through it. Go figure.

Are you prepared to lose 50% of your capital to make 10% return? I guarantee, if we ask two hundred people that question, you’re going to get two hundred people saying “absolutely not, that’s not acceptable.” Yet, out of those two hundred people, how many of them would actually take responsibility, take action, to do something better for themselves? I would say, not many. You get a few perhaps, but the majority will stick with what they’re doing, in the hope that it will come back. “Oh I’ll just wait for this to come good.” Well, it’s been five years since it was good. How long more do you want to wait?

People understand what the journey entails, if they really understand then they can travel the journey. I am constantly reminding our members of the most successful traders results like Salem Abraham, Dunn, and Campbell, and all these guys that have been in the market for twenty/thirty years and I get out their track records. In fact, one I use all the time is Liz Cheval. She’s had an annualized return of 22% over the last twenty-five years. And I say to people, “Tell me what you think a 22% annualized return for thirty years looks like?” And they visualise a perfect 45-degree linear equity curve.

Then I show them the month by month track record of someone like Liz Cheval, and they can’t believe that she had five losing years. Liz Cheval stood up to the plate every day, places orders, manages orders, every day and every week, every month, every year, for twenty-five years. She stood up to the plate because she knew she had an edge. She understood that over time, she couldn’t lose. All she had to do was keep placing the orders and ride the journey.

So when people understand that someone like Liz Cheval, who had been doing this for twenty-five years, and had a 22% annualized return for that period of time –actually has a losing year, let alone three losing months, then hopefully they understand that this is part of the journey.

A really cool tool I have is a random equity curve generator. I put in the statistics; let’s say a standard trend following strategy for example. Let’s say we put in a win percentage of 50% and a win/loss ratio of let’s say 3:1. Pretty standard stats for a trend following strategy.

The random equity curve has two equity curves. One of the equity curves consists of fifteen hundred trades. Now, if you can visualize those stats would generate a pretty good 45-degree line over fifteen hundred trade. Looks great. So I say to people, “Who here would like to trade this equity curve?” and I keep pushing the button that keeps generating a random equity curve, and they all look very similar. Everyone’s got their hand up in the air saying “let’s trade that one, that’s great.”

Then I flick across to the twenty trade, random equity curve generator, and I say to people, “I want you to tell me which one of these you don’t want to trade?” Now obviously the snapshot twenty trade, random equity curve, is a subset of the bigger one. All of a sudden people can see the lumpiness, the ups and the downs. People are willing to trade one, but they don’t want the other. Yet the other is a subset of the first one. You can’t have one without the other. It’s a great visual tool to show what the journey will look like.