Extract from

TREND TRADING

A Seven Step Approach For Success

Daryl Guppy © This extract copyright 2004.

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A FLEA ON AN ELEPHANT

Trend trading is not about timing the market. It is about doing at least as well as the general market, and out performing it. The task is not as difficult as the fund managers would have us believe. This book examines some of the tools investors and traders use to ride the rising ride, and lift above it. You have advantages as a small investor and we show you how to use them effectively.

Between March and September 2003 over 400 stocks listed on the Australian Stock Exchange increased in value by more than 30% but only a few traders and investors were able to find and lock in these trend driven returns. Some of those caught a ride with a big opportunity, but lost it, turning a winning trade into a much smaller profit, or even in some cases, into a loss. We examine some easy-to-apply trend trading methods to find these opportunities and to capture these types of profits. You can do this and this book shows you how.

Many people  invest in the market with the assistance of professional fund managers. You see their advertisements in the newspapers proclaiming their expertise. They tell readers it is not possible to time the market. It is possible to participate in a rising trend. Ask a simple question of your fund manager, or superannuation return. Did they match the broad market return in any year? Often the answer is a resounding and disappointing “No.” Think for a moment about this answer. It means their team was unable to float with the rising tide, let along add extra value through professional management.

I have given up trying to understand why people behave as they do in the market. Intelligent, sane, experienced, skilled people make serious errors. Losing money does not seem to be a deterrent and it does not modify their behavior. Such reactions are beyond my understanding. I do not waste even my spare time in trying to understand why people do these things in the market.

I do spend a lot of time trying to understand how people behave in the market. Shift to this focus and a entirely new range of relationships emerge. The study of the market becomes a study of human nature and crowd behavior. The activity is tracked effectively in the patterns of buying and selling, in the structure of the price charts. They tell me little about the company, but speak volumes about the crowd of buyers and sellers. Tighten the focus a little more, and we  discern a set of statistical or probability relationships.

Some are as simple as the propensity of a stock to  continue rising after it has been mentioned in Shares magazine. We look at this strategy in CHAPTER 2. Other relationships allow us to hitch a  ride with a strong trend in the same way that a flea hitches a ride with an elephant. We do not create the trend so we look for  a crowd surging in the same direction we want to travel. They push a bow wave of profit ahead of them and we use their behavior to successfully trade the market.

Working with the crowd, but not being part of the crowd, is a strange experience. There is a danger of being sucked into the whirlpool of emotion only to emerge, like so many others, financially poorer for the experience. Our skill and trading discipline  protects us from disaster and in this book we explore seven steps  to build one particular approach to market success and survival. This is about trend trading. These are trades which may last weeks, or months, or years. The objective is to find a trend and hitch a ride for  a defined period, for a defined return, or until we are aware the trend is no longer moving up. We do not create the trend, and the level of our trade participation alone is not enough to maintain the trend.

For trend continuation  we must rely on the activity of many other traders and investors. Understanding what they are thinking and how they are behaving is the most significant aspect of successful trend trading. Understanding how we are going to manage the trade once we buy the stock is the activity which underpins our trading profitability. Mastering these aspects of trading is the focus of this book. Of the many different approaches, we have selected the approach we find most useful. Use this as a guide, but not as a universal solution. Understand how we bring together various indicators and analysis approaches to establish our trading solution. When it comes time to build, or refine your own approach we hope these ideas will help you create a better solution for your own particular circumstances.

SEVEN SUCCESS STEPS

Most of the material covered in the book is new, including the work on Darvas, the use of trend lines,  the structure of selection processes and tests and the extended applications of the Guppy Multiple Moving Average. Inevitably there is some repeated material and concepts but I trust  it is presented  in a new way that adds to your understanding. Each section examines the tests required to identify, select and manage a trade.

Where do we start and what do we need? The first section, GONE FISHING,  provides a starting point. Common solutions rarely lead to uncommon profits so we spend a little bit of time examining some common ideas to see if they are really useful. This includes several simple methods of finding suitable trading opportunities. The market is complex, but solutions for breaking into it need not be. Simple tools give us access to good profits in the market.

The final chapter in the first section introduces the first of eight on-going tests for readers. One of the most pernicious and incorrect of common misconceptions about market success suggests we need exclusive information, or system , or technique for success. This series of tests at the end of each section provides all readers with exactly the same information, yet every reader  makes a different decision and ends up with a different profit result. The tests are based on similar work we did with newsletter readers so you can compare your results and reactions with theirs.

Sift through any collection of stock charts and some immediately stand out as clear and obvious trading opportunities. We show how this visual test is applied in the second section, HEY GOOD LOOKING. This is not a complicated task and perhaps this is why so many new investors ignore it. Their preference seems to lie with what can only be described as ugly charts when prices fall dramatically from the top left of the chart to the bottom right. These are investment bargains and they come with an invitation to financial disaster. We discuss ways to avoid these attempts to separate you from your investment capital.

The third section, BETTER TREND LINES introduces a different approach to the application and use of trend lines. These are probability tools directly related to the management of the trade. Many traders use trend lines to define price action, often with a sneaking suspicion that they might be able to predict the future. This section considers these classic applications and then moves beyond them to examine the relationship between the trend line and better trade management. This turns the trend line into a powerful management tool.

Not all trends are created equal and section four, TESTING CHARACTER, includes an updated and complete discussion of the way the Guppy Multiple Moving Average (GMMA) indicator is used to assess a trend. The GMMA was introduced in TRADING TACTICS in 1997. Since then the indicator has evolved into more advanced and sophisticated applications. For many traders it has become the core way of understanding trend behaviour and indicating the type of trading opportunity. This section is a detailed discussion of the trading and investment applications of the GMMA.

Before a stock is added to our portfolio we need a PRICE CHECK to more precisely define the trend, our entry point, and to commence the calculations necessary to manage risk. Our preferred tool is the count back line. This was introduced in SHARE TRADING in 1996 and this technique has also evolved with more sophisticated applications. It is used as  a stop loss to protect trading capital when a trade is first opened. We show how this is applied to mid-trend entries. We also show how the count back line is combined with the GMMA as a protect profit tool as the trend develops. This is a powerful trend trading combination.

CALCULATING SIZE in section six covers the key processes in nailing down risk. Risk is the cornerstone of the market, and yet so many people accept the  assertion that high reward equals high risk. They believe they are powerless when confronted with the force of the market. This is simply not true and we examine some of the methods designed to effectively manage risk while leaving reward uncapped. The necessary figures are easy to produce, but implementing an effective stop loss or protect profit strategy is much more difficult. Our reaction to risk changes with experience, and unless we recognise these changes we may stumble on the path to success.

MODERN DARVAS in section seven is an important detour. The approach developed by Nicholas Darvas represents an entirely different way of understanding trend behaviour. Originally developed and successfully applied to markets in the mid 1960’s this approach was overwhelmed by the appeal of complex computer driven analysis of the market and by increasing market volatility. We examine the classic Darvas application. We retain the logic of his understanding of trend behaviour and update the technique for application in modern, volatile markets.

We use six tests to select the best trend trading candidate, and no test is complete without a test result. In PERFORMANCE PLUS we discuss some of the ways our performance is diminished. We start a trade with the best of intentions, and then turn it into a trading wreck.   This is Jekyll and Hyde trading where our best laid plans and intentions are thrown overboard when it comes time to act. There are no easy solutions to resolve this behaviour, but our discussion is designed to help you recognise the problem. We also examine a technique to separate luck form skill when assessing your trading results.

This section also concludes the NO SECRETS trading tests. Readers who resisted the temptation to flip forward to find the test answers can enjoy the opportunity to measure their performance and reactions against those who took the original test in real time. These tests results confirm  trading success rests on what you do with information which is also freely available to all your competitors. Success may appear difficult or impossible when everybody knows exactly the same information, but this is just a mirage. Profits come from the way we use information and we can all be successful. This is the true secret of performance plus in trend trading.

Common thinking does not lead to uncommon results in the market. Many market myths, or commonly accepted practices, often stand between us and market success. We look at some of these from new perspectives to show how you can find an edge that delivers better market returns. Your skill makes the difference to trading well but we must remember that like a flea on an elephant, we are just along for the ride.