PREFACE

This book is in essence about a single trading strategy based on a concept that has been publicly known for at least two decades. It is a strategy that has worked remarkably well for over 30 years with a large number of hedge funds employing it. This strategy has attracted much attention over the past few years and in particular after the dramatically positive returns it generated in 2008, but it seems nevertheless to be constantly misunderstood, misinterpreted, and misused. Even worse, various flawed and overly complicated iterations of it are all too often sold for large amounts of money by people who have never even traded them in a professional environment. The strategy I am alluding to goes by many names, but it is in essence the same strategy that most trend‐following futures managers (or CTAs/Commodity Trading Advisors, if you prefer) have been trading for many years.

This book differs in many aspects from the more traditional way in which the trading literature tends to approach the subject of trend‐following strategies. My primary reason for writing this book is to fill a gap in that literature and to make publicly available analyses and information that are already known by successful diversified trend followers, but understood by few not already in this very specialised part of the business. It is my belief that most books, and therefore most people aspiring to get into this business, are focusing on the wrong things, such as entry and exit rules, and missing the important aspects. This is likely related to the fact that many authors don't actually design or trade these strategies for a living.

There have been many famous star traders in this particular sector of the industry and some of them have been raised to almost mythical status and are seen as kinds of deities in the business. These people have my highest respect for their success and pioneer work in our field, but this book is not about hero worship and it does not dwell on strategies that worked in the 1970s but might be financial suicide to run in the same shape today. The market has changed and the hedge‐fund industry even more so, and I intend to focus on what I see as viable strategies in the current financial marketplace.

This is not a textbook where every possible strategy and indicator is explored in depth with comparisons of the pros and cons of exponential moving average to simple moving average, to adaptive moving average, and so on. I don't describe every trading indicator I can think of or invent new ones and name them after myself. You don't need a whole bag of technical indicators to construct a solid trend‐following strategy and it certainly does not add anything to the field if I change a few details of some formula and call the new one by my own name, although I have to admit that ‘The Clenow Oscillator’ does have a certain ring to it. Indicators are not important and focusing on these details is likely to be the easiest way to miss the whole plot and get stuck in nonsense curve fitting and over‐optimisations. I intend to do the absolute opposite and use only the most basic methods and indicators to show how you can construct strategies good enough to use in professional hedge funds without having unnecessary complexity. The buy and sell rules are the least important part of a strategy and focusing on them would serve only to distract from where the real value comes.

Also, this is not a get‐rich‐quick book. If you are looking for a quick and easy way to get rich, you'll need to look elsewhere. One of my main points in this book is that it is not terribly difficult to create a trading strategy that can rival many large futures hedge funds but that absolutely does not mean that this is an easy business. Creating a trading strategy is only one step of many and I even provide trading rules in this book that perform very well over time and have return profiles that are marketable to seasoned institutional investors. That is only part of the work, though, and if you don't do your homework properly, you will most likely end up either not getting any investments in the first place or blowing up your own and your investors' money at the first sign of market trouble.

To be able to use the knowledge I pass on here, you need to put in some really hard work. Don't take anyone's word when it comes to trading strategies, not even mine. You need to invest in a good market data infrastructure, including effective simulation software and study a proper programming language, if you don't already know one. Then you can start replicating the strategies I describe here and make up your own mind about their usefulness, and, I hope, find ways to improve them and adapt to your own desired level of risk and return. Using someone else's method out of the box is rarely a good idea and you need to make the strategies your own in order to really know and trust them.

Even after you reach that stage, you have most of the work ahead of you. Trading these strategies on a daily basis is a lot tougher than most people expect, not least from a psychological point of view. Add the task of finding investors, launching a fund or managed accounts set‐up, running the business side, reporting, mid‐office, and so on, and you soon realise that this is not a get‐rich‐quick scheme. It is certainly a highly rewarding business to be in if you are good at what you do, but that does not mean it is either easy or quick.

So despite the stated fact that this book is essentially about a single strategy, I will demonstrate that this one strategy is sufficient to replicate the top trend‐following hedge funds of the world, when you fully understand it.

Why Write a Book?

Practically no managed futures funds will reveal their trading rules and they tend to treat their proprietary strategy as if they were blueprints for nuclear weapons. They do so for good reason but not necessarily for the reason most people would assume. The most important rationale for the whole secrecy business is likely tied to marketing, and the perception of a fund manager possessing the secret formula to make gold out of stone will certainly help to sell the fund as a unique opportunity. The fact of the matter is that although most professional trend followers have their proprietary tweaks, the core strategies used don't differ very much in this business. That might sound like an odd statement, since I have obviously not been privy to the source code of all the managed futures funds out there, and because they sometimes show quite different return profiles, it would seem as if they are doing very different things. However, by using very simple methods, one can replicate very closely the returns of many CTA funds and by tweaking the time horizons, risk factor, and investment universe, one can replicate most of them.

This is not to say that these funds are not good or that they don't have their own valuable proprietary algorithms. The point is merely that the specific tweaks used by each shop are only a small factor and that the bulk of the returns come from fairly simple models. Early on in this book I will present two basic strategies and show how even these highly simple models are able to explain a large part of CTA returns, and I then go on to refine these two strategies into one strategy that compares well with the big established futures funds. I present all the details of how this is done, enabling the reader to replicate the same strategies. These strategies are tradable with quite attractive return profiles just as they are, and I show in subsequent chapters how to improve upon them further. I will introduce more advanced concepts as well, such as how to exploit the unique futures effect of term structure and how to go about constructing counter‐trend strategies.

And why would I go and tell you all of this? Wouldn't the spread of this knowledge cause all trend‐following strategies to cease functioning, free money would be given to the unwashed masses instead of the secret guild of hedge‐fund managers, and make the earth suddenly stop revolving and fling us all out into space? Well, there are many reasons quantitative traders give to justify their secrecy and keep the mystique up and a few of them are even valid, but in the case of trend‐following futures, I don't see too much of a downside in letting others in on the game. The trend‐following game is currently dominated by a group of massive funds with assets in the order of US$10–50 billion, which they leverage many times over to play futures all over the world. These fund managers know everything I've written in this book and plenty more. The idea that me writing this book may cause so many people to go into the trend‐following futures business that their trades would somehow overshadow the big players and destroy the investment opportunities is a nice one for my ego, but not a very probable one. What I describe here is already done on a massive scale and if a few of my readers decide to go into this field, good for them, and I wish them the best of luck.

What we are talking about here are simply methods to locate medium‐ to long‐term trends typically caused by real economic developments and to systematically make money from them over time. Having more people doing the same will hardly change the real economic behaviour of humankind that is ultimately behind the price action. One could of course argue that a significant increase in assets in this game could make the exact entries and exits more of a problem, causing big moves when the crowd...