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The Little Book of Trading

The Little Book of Trading

Trend Following Strategy for Big Winnings
by Michael W. Covel 2011 256 pages
3.41
100+ ratings
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Key Takeaways

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:

FAQ

What's "The Little Book of Trading" about?

  • Trend Following Strategy: The book focuses on the trend following strategy, which involves identifying and capitalizing on market trends, whether they are moving up or down.
  • Real-Life Examples: It provides insights from successful traders who have applied trend following strategies to achieve significant financial success.
  • Educational Journey: The book aims to educate readers on how to think like a successful trader, emphasizing the importance of discipline, risk management, and systematic trading.
  • Practical Advice: It offers practical advice and strategies that can be applied across various markets, including stocks, commodities, and currencies.

Why should I read "The Little Book of Trading"?

  • Proven Strategies: The book presents strategies that have been proven to work over decades, offering a reliable approach to trading.
  • Inspiration from Success Stories: It includes stories of traders who started with little and achieved great success, providing motivation and practical lessons.
  • Comprehensive Learning: Readers can learn about the psychological and technical aspects of trading, making it suitable for both beginners and experienced traders.
  • Avoid Common Pitfalls: The book helps readers avoid common trading mistakes by learning from the experiences of seasoned traders.

What are the key takeaways of "The Little Book of Trading"?

  • Trend Following Works: Trend following is a robust strategy that can be applied to various markets and has been successful for decades.
  • Risk Management is Crucial: Managing risk and knowing how much you can afford to lose is essential for long-term success.
  • Discipline and Consistency: Sticking to a trading plan and maintaining discipline are critical components of successful trading.
  • Learning from the Best: The book emphasizes the importance of learning from successful traders and applying their insights to your own trading.

What is trend following, as explained in "The Little Book of Trading"?

  • Market Direction Focus: Trend following involves identifying the direction of market trends and making trades that align with those trends.
  • No Predictions Needed: It does not require predicting market movements; instead, it focuses on reacting to actual market data.
  • Universal Application: The strategy can be applied to any market, including stocks, commodities, and currencies.
  • Risk and Reward: Trend following emphasizes managing risk while allowing profits to run, capturing significant market moves.

How does "The Little Book of Trading" suggest managing risk?

  • Pre-Set Stop Losses: The book advises setting pre-determined stop losses to limit potential losses on trades.
  • Diversification: It recommends diversifying across different markets to spread risk and reduce exposure to any single market.
  • Position Sizing: Proper position sizing is crucial to ensure that no single trade can significantly impact the overall portfolio.
  • Focus on Downside: The emphasis is on protecting capital by focusing on the downside risk rather than potential profits.

What are some of the best quotes from "The Little Book of Trading" and what do they mean?

  • "The trend is your friend." This quote emphasizes the importance of aligning trades with the prevailing market trend to increase the likelihood of success.
  • "You don’t trade markets. You trade money." It highlights the focus on managing money and risk rather than getting emotionally attached to specific markets.
  • "Stick to the plan and pull the trigger." This underscores the importance of discipline and following a trading plan without hesitation.
  • "If you don’t bet, you can’t win. If you lose all your chips, you can’t bet." It stresses the balance between taking calculated risks and preserving capital.

How does "The Little Book of Trading" address the psychological aspects of trading?

  • Emotional Control: The book emphasizes the need for emotional control to stick with a trading plan during market ups and downs.
  • Avoiding Herd Mentality: It advises against following the crowd and instead encourages independent thinking and decision-making.
  • Learning from Losses: Traders are encouraged to view losses as learning opportunities rather than failures.
  • Confidence Building: By learning from successful traders, readers can build confidence in their own trading strategies.

What role do mentors play in "The Little Book of Trading"?

  • Guidance and Wisdom: Mentors provide valuable guidance and share their wisdom, helping traders avoid common pitfalls.
  • Inspiration: Successful traders often credit their mentors for inspiring them and shaping their trading philosophies.
  • Shortcut to Success: Learning from mentors can accelerate the learning curve and provide practical insights that are not found in textbooks.
  • Networking Opportunities: Mentors can introduce traders to a network of other successful individuals, expanding their learning opportunities.

How does "The Little Book of Trading" suggest dealing with market volatility?

  • Embrace Volatility: The book suggests embracing market volatility as an opportunity rather than fearing it.
  • Systematic Approach: A systematic trading approach helps manage volatility by sticking to predefined rules and strategies.
  • Long-Term Perspective: Maintaining a long-term perspective can help traders ride out short-term market fluctuations.
  • Adjusting Position Sizes: Adjusting position sizes based on market volatility can help manage risk and protect capital.

What is the significance of diversification in "The Little Book of Trading"?

  • Risk Reduction: Diversification helps reduce risk by spreading investments across different markets and asset classes.
  • Smoother Returns: It can lead to smoother returns by reducing the impact of any single market's performance on the overall portfolio.
  • Capture Opportunities: Diversification allows traders to capture opportunities in various markets, increasing the potential for profit.
  • Avoid Overexposure: It prevents overexposure to any single market, reducing the risk of significant losses.

How does "The Little Book of Trading" differentiate between fundamental and technical analysis?

  • Focus on Price Data: The book emphasizes technical analysis, focusing on price data and market trends rather than fundamental factors.
  • Simplicity and Objectivity: Technical analysis is presented as a simpler and more objective approach compared to the complexity of fundamental analysis.
  • Avoiding Information Overload: By focusing on price data, traders can avoid the information overload often associated with fundamental analysis.
  • Proven Success: The book highlights the long-term success of technical analysis and trend following strategies in various markets.

What are the common traits of successful traders in "The Little Book of Trading"?

  • Discipline and Patience: Successful traders exhibit discipline and patience, sticking to their trading plans and waiting for the right opportunities.
  • Continuous Learning: They are committed to continuous learning and improvement, always seeking to refine their strategies.
  • Emotional Resilience: Successful traders have emotional resilience, allowing them to handle losses and setbacks without losing confidence.
  • Adaptability: They are adaptable, willing to adjust their strategies and approaches based on changing market conditions.

Review Summary

3.41 out of 5
Average of 100+ ratings from Goodreads and Amazon.

The Little Book of Trading receives mixed reviews, with an average rating of 3.41 out of 5. Some readers find it inspirational and a good introduction to trend following, while others criticize its lack of practical information and specific trading strategies. Many reviewers note that the book focuses more on stories of successful traders rather than providing detailed technical advice. Critics argue that it's too general and promotional, while supporters appreciate its insights into trading psychology and mindset.

Your rating:

About the Author

Michael W. Covel is an American author, researcher, and public speaker known for his expertise in trend following trading. He has written several books on the subject, including "Trend Following" and "The Complete TurtleTrader." Covel is recognized for his efforts in popularizing trend following strategies and interviewing successful traders. He hosts a podcast called "Trend Following Radio" and has given speeches worldwide on trading and behavioral finance. Michael W. Covel's work often emphasizes the importance of systematic approaches to trading and the psychological aspects of successful investing. He is considered a controversial figure in the trading community due to his strong advocacy for trend following methods.

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