Monday, August 1, 2011

Covel, The Little Book of Trading

The latest addition to the “little book big profits” series, Michael W. Covel’s The Little Book of Trading: Trend Following Strategy for Big Winnings (Wiley, 2011) looks at the financial world through the eyes of successful trend traders. In eleven chapters Covel shares insights and life stories from the principals of Sunrise Capital (Gary Davis, Jack Forrest, and Rick Slaughter), David Druz, Paul Mulvaney, Kevin Bruce, Larry Hite, David Harding, Bernard Drury, Justin Vandergrift, Eric Crittenden and Cole Wilcox, Michael Clarke, and Charles Faulkner. And although Ed Seykota doesn’t get his own chapter (except for the lyrics to “The Whipsaw Song”—if you’re not familiar with it, the YouTube video is available at, he is a frequent presence in the discussions of others.

Covel, author of Trend Following, The Complete TurtleTrader, and the recent Trend Commandments, is an unabashed advocate of systematic long-term trend following trading. He doesn’t get into the nitty-gritty of how to develop a trend following system although he references the breakout system of the original turtles, a system I assume most trend traders these days have moved well beyond, and shares some general principles about devising a robust system. That’s okay because each trader really has to come up with his own system in which he believes wholeheartedly; there is no single template for trend trading.

What Covel stresses throughout the book are the accompanying principles that make trend following viable: stick to your plan and manage your risk through diversification, stop placement, and position sizing. These are important principles for any kind of trading, but for trend following they are critical. After all, trend following has a low win percentage and is subject to long stretches of flat to negative performance. As a result it’s easy for a trader to start doubting his system. And for the same reason it’s lethal for a trader to risk too much on any one trade.

Trend traders have to be contrarians in the sense that they have to cut their losses quickly and let their gains run, which “is in fact going against human biology.” We’re “designed to think that what we lose is going to come back,” whether it be the dog who “disappears in the morning but is outside the kitchen door by evening” or our car keys. A trend trader who believes that his unrealized losses will eventually be transformed into real profits won’t be trading for long. Similarly, a trader who accepts the premise of mean reversion—for instance, a trader who “believes he has found a mispricing in an extended market and expects a return to normal prices (whatever normal is)”—as many hedge funds do, will find that “it never works in the long run. That kind of thinking blows up with regularity.” (p. 115)

Covel also rails against buy-and-hold investing and index funds. In the chapter entitled “Study Hard and Get an A+” he recounts a conversation that Justin Vandergrift had with a doctor who kept talking about index investing in the S&P 500.

“When you went to medical school did you ever want to graduate with a C average?” The doctor said, “No.” Vandergrift replied, “Do you want to send your kids to a C school?” He said, “No.” Vandergrift countered, “Then why are you doing that with your money? The S&P is an average. It’s an average of the 500 largest companies in the United States. … It’s a C index. Why would you want to invest to get average returns?” (p. 129)

Successful trend following traders try to capture the outliers, the really big moves that more than compensate for the many small losses they take. This goal requires traders to have confidence in their systems and confidence in themselves. By introducing the reader to successful trend traders, Covel believes that some of their “magic” just might rub off.

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