Michael Covel – The Little Book of Trading

Today’s post is our first visit to a new book – Michael Covel’s Little Book of Trading.

Michael Covel

The Little Book of Trading is from the same series as a couple of books we’ve already looked at – Behavioural Investing and Stock Profits.

This book is unlike the others in our Required Reading series for two reasons:

1. Although it’s a portmanteau book of interviews and profiles of many traders, the chapters are too short individually to warrant their own article (so I will be grouping together several traders at a time).
2. I view it as a gentle introduction to Covel’s main work Trend Following, which he himself says is not easy for the lay reader.

The sub-title – Trend Following Strategy for Big Winnings – reflects the true focus of the book.

Covel is the king of trend following.

• He started off with a book about the Turtle Traders (which we’ll get around to eventually) and then wrote his own book.
• He also runs the TrendFollowing.com blog.

And he has a podcast, upon which most of the traders featured in this book have appeared.

Foreword – Cullen Roche

Cullen Roche writes at Pragmatic Capitalism, and is well worth keeping up with.

Trend following is not just about identifying great investments.

It’s about using rules and techniques to manage the risks associated with these investments.

Cullen is not a pure trend follower.

• Like me, he uses multiple strategies.

No two markets are the same. What works in one will not necessarily work in the next. Trading requires a great deal of flexibility and an ability to adapt to new environments.

At the core are risk management and a systematic approach.

You don’t have to agree with the technical analysis aspect of trend following to know that the techniques applied by trend followers are vital components of any good investor’s success story.

Trend followers understand the importance of psychology. Superior emotional control is a decisive advantage.

A market is the summation of the decisions of its participants. Markets are inefficient because the participants are inefficient.

Wall Street doesn’t prepare you to sell. Wall Street is always thinking of new ways to get you to buy or hold its products.

While the average U.S. equity investor lost 50% of his money, trend followers crushed the S&P 500 in 2008 because they had risk management structures in their portfolios.

Covel – A Wake-up Call

Investors have been conditioned for decades to believe that they cannot beat the market.

Even if we don’t know who the winners are, there are winners in the market, especially in the middle of a crash.

Leave fundamental analysis at the door. You do not need to know how great the demand will be for the next iPad. The only variable is which way the market is trending.

If the market is going up, you buy. If it goes the other way and you start to lose money, you get out. One major rule is accepting when you are wrong in the market and getting out.

You need to be willing to lose a small amount of money. The key is keeping that loss as small as possible to preserve capital.

Michael explains that the rule for getting out is that you have lost the amount you were prepared to risk.

If it doesn’t go down, you stay along for the ride.

He also points out that through trend following you can make money when markets go down, by being short.

• And that your can use commodity, currency and bond markets, besides stocks.

Michael explains that the top traders – the big money makers – all use trend following.

• The reason that the public hasn’t heard of it is the large marketing budget of the mutual funds (OEICs), who pump out a “buy and hold” message.

Stick to Your Knitting – Sunrise Capital

The first proper chapter is about Gary Davis, Jack Forrest, and Rick Slaughter, who run Sunrise Capital.

Michale says in his introduction:

If you learn anything from this book, let it be the simple lesson: Stick with it.

There will always be distractions. Breaking news and chaotic events are everywhere. Top traders don’t pay attention to that stuff.

Jack Forrest started out as a doctor practicing who saved enough to start trading.

Gary Davis was also a doctor, and a tennis partner of Forrest.

• Forrest loaned Davis 20 books about trading and he started trading (separately from Forrest).

Slaughter initially planned to be a lawyer, but started trading aged 21, in the 1970s.

The three partners didin’t all get together until 1995.

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Forrest tried fundamentals first, then moved on to technical trend trading ideas like 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.

Forrest’s first system was very simple: enter long or short when the market makes a 12-week high or low.

Early on is his trading, Forrest took a night class from Ed Seykota, who we covered here.

Seykota was teaching a long-only four-week channel breakout system, with a filter that the most recent six-month breakout was up.

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

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Back to Michael:

Many people think you can’t beat the market. Markets are efficient they say.

The reality? Markets are often in “tail” situations that can produce sizable profits.

By tail, he means the end of the bell curve – events that as supposed to be rare, but appear to be more common in markets (fat tail / Black Swan).

You need to look at the volatility of the market and determine whether the movement is simply noise. You should scale back the size of your initial trade in a situation where there is high volatility.

Michael’s philosophy is follow all signals, and always use (trailing) stop losses.

• In some markets he also uses profit target stops.

You don’t know which ones are going to be winners or losers, so you have to move on every trade. You never know which move is going to be the mother of all moves.

But you must protect yourself on every trade. At the time a trade is placed, assign a pre-set stop loss so that only a very small amount of capital can be lost.

Rules

Jack Forrest says:

Your trading needs to boil down to rules, money management, and that is it.

Michael comments:

If you’re changing your rules around all of the time, you have no chance.

You can buy rules from someone, make them up yourself, or buy some and make changes so they become your own. But most people aren’t willing to put the time in.

Which is of course our opportunity.

Trend trading is a rollercoaster. Having the wherewithal to stay with it when the rollercoaster is roaring downhill is essential.

Davis says:

You don’t make money by explaining how things happen and you don’t make money by guessing what’s going to happen in the future.

A lot of great trades that should have won don’t end up winning, but just because it was a losing trade doesn’t make it a bad idea, or make it a wrong trade.

You want to try and make assessments of the odds. Are they with me or against me? That’s something that you can’t do very well with fundamental trading.

Back to Michael:

Trend trading success is very analogous to learning an instrument. Most people are not willing to sit down, get a good teacher, and practice.

Someone’s Gotta Lose for You to Win – David Druz

Michael sums up David Druz’ philosophy as:

Life is not fair, and everyone doesn’t win. Somebody has to lose for you to win.

Having watched a friend from college make money in the markets, Druz got a job at the Chicago Board of Trade (in research).

•  In his spare time he worked on trend following computer systems.

He left to go to medical school.

• He was offered a job at a brokerage, but a friend told him:

Don’t take that job. You can be a really good trader, but if you take that job, you’ll never be a great trader.

You don’t want to trade with scared money. Finish medical school, and then you’ll be a great trader.

Druz got $5K together and started to trade. With his account down to $1.5K – and about to quit- he got lucky on a “Good Til Cancelled” order (GTC) that he had forgotten about.

Second chances are telling you something. Heed their advice.

Soon he was trading for the other doctors at his hospital, but he was burned out.

• He decided that he needed a mentor, and phoned Ed Seykota out of the blue.

Ed agreed to look at some of his charts, but the next week he had forgotten who Druz was. He hadn’t looked at the charts, but when he did:

I see what you’re doing here. You trade a lot like I do. But there are a few things you need to work out. Why don’t you come be my apprentice?

Theory

Druz believes that trend traders are trying to capture risk premium from hedgers, who need a position in one market to offset exposure in another.

• Hedgers are the opposite of speculators, who want market risk.

Hdgers should be net losers in futures markets over the long run, trend trading approach is based on capturing this loss (risk premium) as profit.

• Trend followers should win less, but win bigger.

As Michael says:

The futures markets are a zero sum game. For you to win, someone has to lose.

However, if your trading plan stays opposite hedgers, if you employ good money management, and you diversify, you can find a mathematical edge.

Druz says:

There are whole families of trend trading ideas that seem to work forever on any market.

The down side is they are very volatile because they are never curve-fit. But over the long run, they do extract money from the market.

If you have money management wired, you can let volatility go because you know it doesn’t have any correlation with the risk of ruin.

Michael points out that the weightings of various markets don’t need to be uniform – you can put more money into the one that you think is the best.

Druz is one of those trend followers who:

Doesn’t get into markets until they are so scarily high that you might feel it is crazy to still buy.

No Guts, No Glory – Paul Mulvaney

Mulvaney started programming as a teenager in the 1970s. (( So did I, but there the similarity ends ))

• He did his own trend trading research, and once he had a working system, he left to trade on his own account.

Mulvaney uses a standard channel breakout system with stop losses, and never overrides his system.

Mulvaney is profitable on 55% of days, but only 25% of trades.

• Obviously his winners are bigger than his losers.

Interestingly, unlike Druz, Mulvaney sees other speculators as the source of his profits.

Michael describes some “key, big picture principles” that he picked up when he interviewed Mulvaney:

1. Don’t be afraid to trade smaller and more obscure markets.
2. Strive to produce a home run out of every trend.
   • Exit only on stop losses (this sounds like run your winners).
3. Aim to make high absolute returns in rising or falling markets by taking long and / or short positions across a diversified range of markets.
4. Markets don’t move from one state to another in a straight line; there are periods of shock and volatility.
5. You want your trend following method to be very general, so that it will continue to work.
   • Trend following robustness and volatility go hand-in-hand.
   • Systems that seem to make money every month will eventually go bust.
6. Ignore people who don’t believe in trend following.
7. Focus on what is happening rather than on what “should” happen.
   • “Markets can remain irrational longer than you can remain solvent.”
8. There is no perfect trading system, and not everyone will chose the same returns / volatility trade-off.
9. Stick to long-term trends (> 1 year).
10. Don’t override your system.
11. You don’t need to know anything about fundamentals, or even the markets that you trade.
12. Only risk a certain percentage in each market.

Michael points out that the high volatility of trend following can actually reduce your overall risk (volatility) when combined with a typical stock / bond portfolio, since the two volatilities are not well correlated.

• This is exactly how my own interest in trend following developed.

Risk of ruin has to be your foundation. Mulvaney will only stop trading his system if his account value drops to a point where he can’t [safely] trade his strategy.

Conclusions

It’s a strange book, quite unlike the others in the “Little Book Of …” series.

• They are typically distilled textbooks of all you really need to know about an area of investment.

This one is much more like the Trading Wizards series.

• But an edited version where Jack Schwager uses the interviewees to illustrate his own ideas about trading, rather than just letting them speak.

That said, there were some useful ideas today, if not quite enough to allow you to build your own trend-following system.

• Perhaps all will be revealed in the later chapters.

Until next time.