The Little Book of Trading

Trend Following Strategy for Big Winnings

Michael W. Covel

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9781118063507
• eBook ISBN: 9781118143889
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

How to get past the crisis and make the market work for you again

The last decade has left people terrified of even the safest investment opportunities. This fear is not helping would-be investors who could be making money if they had a solid plan. The Little Book of Trading teaches the average person rules and philosophies that winners use to beat the market, regardless of the financial climate.

The market has always fluctuated, but savvy traders know how to make money in good times and bad. Drawing on author Michael Covel's own trading experience, as well as insights from legendary traders, the book offers sound, practical advice in an easy to understand, readily digestible way. The Little Book of Trading:

• Identifies tools, concepts, psychologies, and philosophies that keep people protected and making money when the next market bubble or surprise crisis occurs
• Features top traders in each chapter that have beaten the market for decades, providing readers with their moneymaking knowledge
• Shows how traders who beat mutual fund performance make money at different times, not just from stocks alone

Most importantly, The Little Book of Trading explains why mutual funds should not be the investment vehicle of choice for people looking to secure retirement, a radical realization highlighting the changed face of investing today.

Chapter One

Stick to Your Knitting

Gary Davis, Jack Forrest, and Rick Slaughter

While today Sunrise Capital is a very successful money management firm, it did not start that way. It began with three visionary men who dared to be different. They saw opportunity and chased it. One of the founders put it this way: They stick to their knitting. They follow their trading rules. I said this in the Introduction, but it bears repeating: To learn trend following trading, to make a great deal of money with this strategy, requires confidence. The best way to instill that confidence in you is to show you, start to finish, successful traders’ paths. As you read this book you may find yourself asking why it is relevant when these traders started. You may be asking why it is relevant to learn about their performance in the 1970s, 1980s, 1990s, and so on. It’s relevant because it shows consistency of strategy. This is not some “got lucky trading” method that works for one month, one year, or one decade. It has worked literally month by month for decades. In fact, by the time you finish this book I hope you look carefully at consistency of performance at all times for all strategies—not just trend following. If you find a strategy that doesn’t have performance proof behind it, you’re gambling. With that out of the way, let’s jump in.

If you learn anything from this book, let it be the simple lesson: Stick with it. There will always be distractions: Breaking news banners, surprises, and unpredictable chaotic events are everywhere, but you can’t let yourself be fazed. Here is one big secret: Top traders don’t pay attention to that stuff. They have found, through hard work, diligent study, and perhaps a little luck—that their ability to stick with a trading plan is far more important than knowing or worrying about what their neighbor is doing.

Go back with me to the mid-1970s. Jack Forrest, a doctor practicing and teaching in San Diego, had built up his savings to begin trading his own account. It wasn’t a lot of money, but it was enough to get going. He began investing in stocks, but it didn’t take long for him to see that commodity futures, and their big up and down moves, would be much more lucrative.

Like many, Forrest got his start trading with fundamentals—understanding balance sheets, supply, demand, and so on. He realized that his ability to analyze markets was not very good. He talked to local brokers and they had no clue either. No one seemed to have a logical or systematic approach—a trading system. Many were just gamblers. Others chalked up their trading to having a feeling for what was going to happen. We have all had those experiences. That’s how most everyone is initially exposed to the markets.

Some people say, “Boy, it really looks like fundamental analysis has a lot of potential.” If you ask why it has potential, the usual response is “It just does.”

But when you realize that a seat of the pants approach to the markets, otherwise known as using fundamentals, doesn’t work, what can you do? Head toward systematic techniques to trade the markets.

That means looking at what has happened historically. It starts with reading stories about famed investors such as Jesse Livermore, Dickson Watts, and Richard Donchian, and other great traders who have used systematic approaches throughout the years. There is no shortage of these kinds of books to check out. One major commonality from these authors and their decades ago wisdom: Get on the big move and stay with it.

The obvious questions: “Well how do you get on the big move?” “Try different things?” “What are those things?” “Buy a set of trading rules from someone else?”

Forrest started experimenting with technical trend trading ideas, and the idea of channel breakouts.

Channel breakouts occur when a stock or commodity is trading in a tight channel, then starts trading at a price higher than the top of the channel. What do I mean by tight channel? Apple is trading at 300, 305, 300, 305, 300 and then boom jumps to 325. It is breaking out of the “channel” of tight prices.

As Forrest went along experimenting, buying breakouts was working well, so Forrest began trading that way. Some traders take years to find a profitable system, but Forrest had some luck on his side in that he found the right kind of approach—an approach very different from what most others were practicing.

With these kinds of trading rules you can become totally systematic. You can write your rules out and follow them with rigid discipline. Forrest’s first system was very simple: buying weekly breakouts. It was a 12-week breakout system. Enter long or enter short when the market makes a 12-week high or low.

What markets can you trade like this? While the markets were different when Forrest started—all physical commodities—systematic trend following rules allow you to trade almost all markets today. That means stocks, currencies, gold, oil—you name it.

Night Class

While Forrest was doing his own research and trading, he had an interesting experience early on. He took a night class from legendary trader Ed Seykota, during the early 1980s. Seykota reinforced trend trading rules and trading psychology.

Seykota was teaching a four-week channel breakout system with a filter—only to be applied if the market was going up (from the long side). He did not apply the system if the market was decreasing (no short selling).

A filter is set up as a hurdle for taking a trade signal (your breakout). You would only trade from the long side if the most recent six-month breakout was up.

Trend following can be simple, but sticking with it is the hard part.

It was more than just rules though. Because Seykota had been so successful with a systematic approach, it gave Forrest the confidence that he too had a shot at that type of success.

It’s the same reason I want to introduce you to successful trend following traders throughout this book: to give you that same confidence.

Teaching Friends

Jack Forrest and Gary Davis were both doctors working in research at the University of California—San Diego. They were also tennis partners. Forrest desperately wanted someone to bounce trading ideas off of and who could trade his same systematic trend trading way, but he had no luck initially finding a trading comrade.

Forrest had about a five-year start on Davis before they even began discussing trading. Even though they were good friends, Davis had no idea of Forrest’s trading passion.

How did Davis finally learn of Forrest’s passion? It all started with the mention of pork bellies while sitting on the beach after a tennis match. Yes, they were talking pork belly futures contracts—the type traded at the CME. Pork bellies? Just a fancy name for bacon.

While talking about pork bellies on the beach that day, Forrest said that he had “all of these books on trading” and told Davis that if he was interested in learning about the markets he was welcome to borrow them. Davis powered through almost 20 books in a week’s time. It was the beginning of his trend following trading career.

Does this sound like an accident? Does this sound like Davis had no preset plan to be a trader? You would be correct. Davis enjoyed his faculty work, but never thought it was the perfect spot for him. He felt like a misfit among the rest of the faculty.

The First 17 Trades—Losers—or Don’t Ask Around

Davis was just about to turn 34 as he started trading with a trend following program he had learned from author J. Welles Wilder, Jr. He lost on his first 17 trades, but once he made one tweak, which he believed is the only reason he is still trading now, he was back in the game.

What was Davis’s Aha! moment? Dissect people who have been successful in almost any form of trading long-term and who have been trading some form of trend following or momentum trading.

Successful fundamental traders often have great success because they’ve been in the right place at the right time.

After recovering from his first big losing streak, Davis realized that he had no idea what anybody else was doing—beyond his book reading. One thing he did know was that most traders last six months and lose all their money. Worse yet, it seemed successful traders lasted three years and then lost all of their money. He expected that his trading career would follow in a similar fashion.

More apt to be involved in independent study, Davis never did like talking to other traders much. He felt the key to his trend trading strategy was to stick with his plan, not changing rules around after looking at someone else and saying, “He has got this great idea. Oh, I’ll try that.”

As Forrest and Davis were each going down their separate, and growing trading paths, their future partner, Rick Slaughter, had already known for some time that the markets were where he wanted to be. He could remember literally being at his grandfather’s knee learning about stocks.

As a young man, corporate law was Slaughters’ interest, but plans shifted. On his twenty-first birthday he placed his first trade. He was one of the first to program a trading system into a computer in the 1970s. Not long after, Slaughter set up shop and was trading trend following systems for clients.

Friends and Family Plan

Davis came to the conclusion, after a period of rigorous and profitable testing with his own money, that there was significant potential in scaling the size of his trading strategies. He sought the help of friends and family for capital to seed a larger pool of money.

Davis founded and launched what would come to be known as Sunrise Capital Partners (known as Sunrise Commodities at the time of inception) in 1980—with the gentle prodding of Ken Tropin (who then was with Dean Witter brokerage, but who today runs one of the most successful trend following firms in the world).

Davis was not super high tech at the time. He preferred handwritten charts and price quotes from the print version of the Wall Street Journal. That should be an inspiration for those of you who want to make excuses for not having the perfect this or that. Just do it, right?

However, there is an even larger lesson at play here. Today, many are at a disadvantage in testing their trading ideas. It is a computer-generated love affair now with commercials promoting 24/7. However, it takes experience to be able to recognize what’s real and what’s luck coming out of the data. Back in the days before the popularization of computers, testing was done by hand. You saw every trade on paper. Everything was obvious. Back then all you needed was to look at a chart, and the longer you looked at a chart, the more you realized how similar they were.

The latest gizmo or hype is not the key to your trading success.

Davis continued on his trajectory of success with Sunrise, and by the mid-1990s was successfully managing over $200 million and routinely delivering double-digit annual returns for investors. Forrest at this point had met and become partners with Rick Slaughter. The two were enjoying success as a team, albeit at a more modest level of assets under management than Davis. Acting on instinct in early 1995, the three industry pioneers merged to form Sunrise Capital Partners.

Markets Are Not Efficient

Many people think you can’t beat the market. Markets are efficient they say. The academics believe it as religion. The story goes something like this: Even if you see a discrepancy in the markets, by the time you try to take advantage of it, it will be gone. So, instead buy a mutual fund and hold on until you are six feet under. Trend followers don’t accept that jaded worldview.

Rick Slaughter may have been young, and a touch arrogant about some things in life and perhaps in the markets, but he never bought the efficient market hypothesis. When he was exposed to Eugene Fama, the founder of the efficient market hypothesis, he was in graduate school and the theory was just taking hold. Slaughter perceived a hole in it. He cou...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Introduction
• Foreword by Cole Wilcox
• Foreword by Cullen O. Roche
• Chapter One: Stick to Your Knitting
• Chapter Two: Someone’s Gotta Lose for You to Win
• Chapter Three: No Guts, No Glory
• Chapter Four: In a Land Far, Far Away from Wall Street
• Chapter Five: Think Like a Poker Player and Play the Odds
• Chapter Six: Stand Up, Dust Yourself Off, and Keep Going
• Chapter Seven: Throw Away the Fundamentals and Stick to Your Charts
• Chapter Eight: Study Hard and Get an A+
• Chapter Nine: You Can’t Know Everything
• Chapter Ten: Make It Work Across All Markets
• Chapter Eleven: Stay in the Moment of Right Now
• Chapter Twelve: Sing the Whipsaw Song
• Appendix A: Getting Technical
• Appendix B: Fund Performance Data
• Glossary of Key Terms
• Author Disclaimer
• Acknowledgments