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Golden Rules To Milk the Market
Debashis Basu 07 July 2017
Kate David Ricardo was one of the most influential of the classical British economists, along with Thomas Malthus, Adam Smith, James Stuart Mill and Jeremy Bentham. But Ricardo, famous for theory of trade, labour theory of value, theory of comparative advantage, etc, has another identity. He was perhaps the richest economist in history. He became a stockbroker at 21, when his wealth was around £800. By the time he died in 1823, 30 years later, his estate was worth £675,000 to £775,000 from which he enjoyed an annual income of £28,000. No other economist, not even the famous value investor, John Maynard Keynes, managed to garner such wealth. Keynes, apparently, amassed an estate worth £650,000 during the Great Depression—100 years after Ricardo. How did Ricardo do it? For one, much before he wrote scholarly pieces on economics, he sold British securities and then spread the false rumour as a stock-jobber that the French had won the Battle of Waterloo. This created market panic, after which he bought back the British securities at a steep discount, bought an estate in Gloucestershire, now owned by Princess Anne, and retired. 
 
Apart from that trick, Ricardo made his money, primarily, trading in government bonds. What was his strategy? He traded in and out of the bonds in the forward market which was much bigger than the cash market. A contemporary wrote of Ricardo: “He is said to have possessed an extraordinary quickness in perceiving the turns of the market.” He traded large volumes for the very short term, netting, typically, £200 to £300 a day. He wrote to a friend, “I play for small stakes, and therefore if I’m a loser I have little to regret.”  Apparently Ricardo followed two golden rules: “Cut short your losses” and “Let your profits run.” A certain kind of trader today would recognise these two rules instantly—the trend follower. 
 
There are multiple approaches to trading, of which the most popular one is trend following—the more academic name of momentum trading. The idea is simple. Prices of traded securities tend to trend. They keep rising over weeks and months, and then reverse and keep falling. Trend followers have dozens of different parameters to figure out when the trend has started and when it has ended. In markets, everything is probabilistic and, hence, many such buy signals tend to be wrong. When wrong, the trend follower will lose money. To guard against this, he should quickly exit when he thinks he is wrong. Conversely, when he finds himself in a sustained trend, he should continue to ride it. 
 
This sounds simple but is extremely difficult to practise because of three-factors: system, money management and behavioural traits. A trader has to create a system that tells him when to get in and when to get out. Even well-developed and robustly back-tested systems, often, send out wrong signals. But, mathematically, even if the system is right 50% of the time, the trader will be able to make a lot of money with the help of the two golden rules of Ricardo. The 50% of the time the trader is wrong, he will cut his losses; and the 50% of the time he is right, he will let his profits run. 
 
But this assumes that he will put equal amounts of money in all the trades. If he puts a lot of money in a trade and loses money and, out of fear, puts a small amount of money in the next trade and makes a small amount from it, he will not gain much. Calculating how much to bet on each trade is money management. The third aspect is sticking to all these calculations and assumptions. It is hard. Humans are emotional and irrational and mess their trades even after they have understood and fixed the first two factors. Those who have got all three right are fabulously wealthy. George Soros, Ed Seykota, David Harding, Bill Dunn, Keith Campbell, Richard Dennis… the list is long.
 
Michael Covel has been the most prolific and extensive chronicler of trend following and this is his sixth book, a magnum opus of 658 pages. 
 
Covel covers everything there is to cover: principles, the trading legends, nuggets (Ed Seykota’s averaged 60%, after fees, in his own account between 1990 and 2000), massive occasional losses (called draw-downs in the trade parlance) and lots of charts and tables. He ends with pages and pages of actual rules for building your own trend-following system. A massive tour de force and labour of love.
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