“The biggest secret about success is that there isn’t any big secret about it, or if there is, then it’s a secret from me, too. The idea of searching for some secret for trading success misses the point.” — Ed Seykota
Michael J. Mauboussin, with a little help, explains how rules should define your trading:
One of the characteristics of a complex system is that highly variable outcomes emerge from simple rules. Unless you deliberately replay a chess game, you’ll never see the same game twice. Herein lies the key to resolving the short-term versus the long-term tension. Companies should develop long-term decision rules that are flexible enough to allow managers to make the right decisions in the short term. In this way, the company is managing for the long run even when it has no information about what the future holds. No company knows how the business landscape will develop just as chess players don’t know how the board will develop — but decision rules provide action guidelines no matter what happens. Kathy Eisenhardt and Don Sull call this strategy as simple rules. They argue that companies, especially in fast-changing markets, should not embrace complex strategies but rather adopt and stick to a few straightforward, hard-and-fast rules that define direction without containing it.
Eisenhardt and Sull specifically suggest five types of rules:
- How-to rules spell out key features of how a company should execute a process. It answers the question: What makes our process unique?
- Boundary rules focus managers on which opportunities they should pursue and which are outside the pale.
- Priority rules help managers rank the opportunities they accept.
- Timing rules synchronize managers with the pace of opportunities that emerge in other parts of the company.
- Exit rules help managers decide when to pull out of yesterday’s opportunities. They argue that a company should have somewhere between two and seven rules, that young companies typically have too few, and that more mature businesses have too many. A decision rule to maintain accounting integrity (i.e., to avoid managing earnings per share versus managing the business) might also help reduce undue short-termism.
This strategy as simple rules approach is not only strongly analogous with successful chess playing, but it also resonates with other complex adaptive systems. Most important, it puts to rest the nonproductive debate about whether companies should manage for the short or long term. Companies that embrace simple rules can manage both for the next quarter and the next quarter century.
Why the Five Rule Types Map Perfectly to Trend Following
Eisenhardt and Sull developed their framework for business strategy. Mauboussin recognized its applicability to trading. The mapping is precise.
How-to rules in trend following are the entry, exit, and position sizing mechanics: buy when price exceeds the N-week high, sell when it falls below the M-week low, size each position as a defined percentage of current equity based on current market volatility. These rules spell out exactly how the system executes the process and what makes it unique compared to discretionary approaches.
Boundary rules define which markets the system trades and which it does not. A trend following system that trades liquid global futures across currencies, bonds, commodities, and equity indices has defined boundaries. It does not trade illiquid small-cap stocks, thinly traded derivatives, or private equity. The boundary rule keeps the system in its domain of competence.
Priority rules in trend following determine how positions are ranked and sized when capital constraints require choices. Volatility-adjusted position sizing is the priority rule: markets with lower volatility receive larger positions, markets with higher volatility receive smaller positions, so that each position contributes approximately equal risk to the portfolio regardless of how volatile the individual market is.
Timing rules define when to add to positions, when to reduce them, and how the system responds to changing market conditions. The Turtle protocol of pyramiding in defined increments as a trend develops, and reducing unit sizes during drawdowns, are timing rules that synchronize the system’s exposure with market conditions.
Exit rules are the most critical of the five. When does the system exit? When price falls below the M-week low or the 2N stop, whichever comes first. The exit rule is the one that prevents the catastrophic losses that Henry identified in Leeson, LTCM, and Livermore: all three refused to execute their exit rules.
Seykota’s opening quote completes the picture. The secret is not a secret. It is rules. Simple, defined, consistently followed rules. The system that operates from such rules navigates a complex, uncertain market environment better than any system that tries to process the full complexity of available information, just as the chess player who has internalized opening rules and positional principles plays better than the player trying to calculate every possible game tree on each move.
Frequently Asked Questions
Why do simple rules outperform complex strategies in uncertain environments?
Because complex strategies attempt to process information that cannot be reliably processed in environments of genuine uncertainty. They accumulate parameters that fit historical conditions but become brittle when conditions change. Simple rules with few parameters focus on the most persistent structural features of the environment and remain robust to change. In markets, the structural feature that persists is that prices trend. Simple rules designed to follow those trends outperform complex strategies designed to predict them.
How does the Eisenhardt/Sull framework apply specifically to trading?
Directly. How-to rules define the execution mechanics. Boundary rules define which markets to trade. Priority rules define position sizing across the portfolio. Timing rules define when to add, reduce, and hold. Exit rules define when to close. A complete trend following system has all five types, typically expressed in two to seven total rules, exactly the number Eisenhardt and Sull recommend for optimal strategy.
What is Seykota saying when he calls the secret “no secret”?
That the search for a secret — a special insight, a proprietary signal, a hidden pattern — misses the point. The framework for trading success is well-documented, widely available, and consistently applied by the most successful systematic traders over decades. The obstacle is not lack of information about the framework. It is the psychological difficulty of building simple rules and following them without deviation. There is no secret. There is discipline.
Trend Following Systems
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