The Little Book of Trading

1. Trend Following: A Proven Path to Trading Success

"The trend is your friend . . . until it ends."

What is trend following? It's a systematic trading approach that capitalizes on sustained price movements across various markets. Trend followers aim to capture significant portions of market trends, whether up or down, without predicting their direction or duration.

Key principles:

• Enter trades when prices break out of established ranges
• Use stop-loss orders to limit downside risk
• Let profits run by trailing stops as trends develop
• Apply the same rules consistently across all markets

Trend following has a long history of success, with many traders generating substantial returns over decades. Unlike other strategies that rely on forecasting or fundamental analysis, trend following is based on reacting to actual price movements, making it adaptable to changing market conditions.

2. Fundamentals Don't Matter: Focus on Price Action

"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. You don't know what's going to happen in the future."

Price is king. Trend followers believe that all relevant information is reflected in the price of an asset. Instead of analyzing economic reports, earnings statements, or geopolitical events, they focus solely on price charts and technical indicators.

Benefits of ignoring fundamentals:

• Simplifies decision-making process
• Reduces cognitive biases and emotional attachment to trades
• Allows for trading multiple markets without specialized knowledge
• Keeps traders focused on what's actually happening, not predictions

By disregarding fundamental analysis, trend followers can react quickly to market changes and avoid getting caught up in narratives that may not reflect reality. This approach also enables traders to capitalize on trends that may seem irrational or contradictory to conventional wisdom.

3. Risk Management: The Key to Long-Term Survival

"If you don't bet, you can't win. If you lose all your chips, you can't bet."

Control your risk. Successful trend followers prioritize risk management above all else. They understand that preserving capital is crucial for long-term success and that no single trade should have the potential to ruin their account.

Essential risk management techniques:

• Position sizing based on account equity and market volatility
• Using stop-loss orders to limit potential losses
• Diversifying across uncorrelated markets
• Never risking more than a small percentage (e.g., 1-2%) of total capital on any single trade

By focusing on risk management, trend followers can weather drawdowns and stay in the game long enough to catch the big, profitable trends when they occur. This approach also helps traders maintain emotional stability during inevitable losing streaks.

4. Diversification Across Markets Maximizes Opportunities

"You want your trend following method to be very general. You want it to continue to work, meaning it can't be dependent on any unique set of market characteristics."

Trade all markets. Successful trend followers apply their strategies across a wide range of markets, including stocks, bonds, currencies, and commodities. This diversification increases the chances of catching significant trends and reduces overall portfolio risk.

Benefits of broad market exposure:

• More opportunities to profit from trends
• Reduced dependence on any single market or sector
• Lower correlation with traditional buy-and-hold strategies
• Potential for positive returns in both bull and bear markets

By trading multiple markets, trend followers can take advantage of trends wherever they occur, whether in rising stock markets, falling currencies, or surging commodity prices. This approach also helps smooth out returns over time, as different markets tend to trend at different times.

5. Patience and Discipline: Essential Traits for Trend Followers

"Sticking to your system is much more important than the actual details of the system."

Consistency is crucial. Successful trend following requires unwavering discipline and the patience to stick with a proven system through both winning and losing periods. Traders must resist the urge to deviate from their rules based on short-term results or external influences.

Key aspects of trading discipline:

• Following entry and exit signals without hesitation
• Avoiding the temptation to predict market moves
• Accepting losses as a normal part of the process
• Maintaining faith in the system during drawdowns

Developing patience and discipline often requires significant mental training and experience. Many successful trend followers emphasize the importance of treating trading as a long-term business rather than seeking quick profits.

6. Embrace Volatility and Drawdowns as Part of the Process

"Lumpy returns are good for you. Write that down."

Expect ups and downs. Trend following strategies typically experience periods of significant drawdowns followed by substantial gains. Successful traders understand and accept this volatility as an inherent part of the approach.

Characteristics of trend following returns:

• Extended periods of small losses or flat performance
• Occasional large winning trades that drive overall profitability
• Higher volatility compared to buy-and-hold strategies
• Potential for significant outperformance during market crises

By embracing volatility and drawdowns, trend followers can maintain their composure during difficult periods and avoid abandoning their strategy at inopportune times. This mindset also helps traders resist the temptation to overtrade or take unnecessary risks during quiet market periods.

7. Systematic Approach: Remove Emotion from Trading Decisions

"A trading system takes that emotion out. It takes the wishing and wanting out of the equation."

Rules-based trading. Successful trend followers rely on systematic, rules-based approaches to make trading decisions. This removes emotional biases and allows for consistent execution across multiple markets and time frames.

Components of a systematic approach:

• Clear entry and exit rules based on price action
• Predetermined risk management parameters
• Consistent position sizing methodology
• Regular system testing and optimization

By following a systematic approach, traders can avoid common pitfalls such as holding onto losing positions too long or exiting winning trades too early. This discipline also enables traders to analyze their performance objectively and make data-driven improvements to their strategies over time.

8. Learn from Successful Traders, but Develop Your Own Edge

"You have to take those views to heart, especially during tough times."

Study the masters. While it's valuable to learn from experienced trend followers, successful traders ultimately develop their own unique approaches that fit their personalities and risk tolerances.

Ways to develop your edge:

• Study the principles and experiences of successful traders
• Experiment with different systems and parameters
• Keep detailed records of your trades and analyze your performance
• Continuously educate yourself about markets and trading psychology

By combining lessons from proven traders with your own research and experience, you can create a trend following approach that you can confidently stick with through various market conditions. This personal ownership of the strategy is crucial for maintaining discipline during challenging periods.

9. Compound Returns: The Power of Consistent Profits

"Nothing is more powerful in trading than compound interest."

Long-term perspective. Successful trend followers focus on generating consistent returns over time, allowing the power of compounding to work in their favor. Even relatively modest annual returns can lead to substantial wealth accumulation over decades.

Factors that enhance compounding:

• Reinvesting profits to increase account size
• Avoiding large drawdowns that erode capital
• Maintaining a consistent approach across market cycles
• Focusing on risk-adjusted returns rather than short-term gains

By prioritizing steady compounding over flashy short-term profits, trend followers can build significant wealth while minimizing the risk of catastrophic losses. This approach also aligns well with the inherent volatility of trend following returns, as consistent application of the strategy tends to smooth out results over time.

10. Stay Focused on the Process, Not Short-Term Results

"You don't want to make decisions for the wrong reasons. If you're going to make the wrong decisions for the wrong reasons, then it's not going to be good for increasing your wealth."

Trust the system. Successful trend followers maintain a laser focus on executing their trading process consistently, rather than becoming fixated on day-to-day profits or losses. They understand that short-term results can be misleading and that adherence to a proven system is the key to long-term success.

Ways to maintain process focus:

• Evaluate performance based on proper strategy execution, not just P&L
• Avoid constantly checking account balances or individual trade results
• Set realistic long-term goals and track progress over months and years
• Regularly review and refine your trading process based on data, not emotions

By staying focused on the process, trend followers can maintain emotional stability during both winning and losing periods. This mindset also helps traders avoid common pitfalls such as overtrading during drawdowns or becoming complacent after periods of strong performance.

Last updated: November 19, 2024