The title of this book is The Layman’s Guide to Trading Stocks by Dave Landry (2010).
I like this book for a number of reasons:
- “Contents page” right on the cover, similar to the style of books in the 1920s
- Big size, nice clean layouts, decent sized charts and diagrams, large fonts
- Not too much information (~170 pages)
- Information presented in a clear manner.
The book presents David Landry’s trend following methodology. Essentially there are two types of setups given, entry on pullbacks during a trend, and catching trend transitions by looking for first thrusts after significant highs/lows (this is similar to IBD’s method of looking for follow-through days).
One point made that I find particularly pertinent was that if you are trading successfully while holding a full-time job, switching to trading full-time does not mean that your results would improve, contrary to what you might think. Rather, your results would likely worsen because you would find yourself micro-managing your trades and second-guessing yourself out of positions. That is a piece of terrific advice, and a whole chapter was devoted to talking about the problem of micro-managing trades and how to address this issue.
While there are setups given in the book, Dave Landry trades using a discretionary style, so the setups aren’t so precise/comprehensive that you have everything you need to actually code into a system. The benefit is that you get to add your own style into the mix, but the downside is that without precise rules, it is easier for you to talk yourself into making bad decisions.
All in all, I really like this book. Dave wrote two other books previously: Dave Landry on Swing Trading and Dave Landry’s 10 Best Swing Trading Patterns and Strategies. I believe the other two books present more setups in more detail, while this book is mainly an introductory text on trend following, so I’m definitely interested to read the other two books down the road.
Trend Following Methodology Essence
- Trade with the trend (market + sector + stock)
- Confirm sector’s trend matches what you are seeing in the individual stock. Some sectors can trade contra to the overall market.
- Enter following a pullback after resumption of the trend
Strike a Balance Between Short and Longer-Term Trading
- Short term trading keeps risks relatively small, however big trends take time to develop so the real money is in longer-term moves.
- Stock selection
- Seek out stocks that have the potential for both a shorter and longer term gain.
- Tight risk control + longer-term gains
- Capture a small, quick profit, and keep a portion of the position as long as the market continues to move in your favor.
- If a stock moves in your favor, trail the stop higher and take partial profits when offered.
- On an extended move, trail your stop loosely to participate in a longer-term winner.
- This method turns a short-term trade with tight risk control into a longer-term winner.
How to Read a Bar
- Close vs. Open
- Close > Open: Demand during the day, especially true if stock fails to trade much below the open.
- Close < Open: Supply during the day, especially true if stock fails to trade much above the open.
- Close ~= Open: Buyers and sellers agree on valuation.
- Open vs. Prior Close
- Open > Prior day’s High: Gap up
- Open > Prior day’s Close, but Open < Prior day’s High: Lap up
- Gap ups and lap ups indicate pent up demand coming into the trading day. Conversely lap downs and gap downs indicate pent up supply.
- Close vs. Prior Close
- Close > Prior Close: More demand than supply.
- Close < Prior Close: More supply than demand.
- Close vs. Range
- Close at or near top of range: Strong close. Demand both during and late in the day. Late day buying indicates traders were willing to carry the position overnight.
- Close at or near bottom of range: Weak close. Excess supply both during the late in the day. Traders were not willing to carry positions overnight.
- Range (High – Low)
- Narrow range bar (NRB): Traders agreed on price.
- Wide range bar (WRB): Wider the range the less traders agreed on price.
- Higher highs and higher lows: uptrend
- Lower highs and lower lows: downtrend
- Draw a trendline through as many bars as possible. This measures how persistent is a trend, where persistency refers to the market’s ability to follow through from one day to the next.
- Individual bar patterns
- Signs of demand for uptrends
- Close > Prior Close
- Close at or near top of range
- Gap ups, lap ups
- Wide range bars that do not dip much below its open and close strongly
- Signs of demand for uptrends
- Moving averages (slope)
- Upward sloping MA >> uptrend
- Downward sloping MA >> downtrend
- Flat MA >> no trend
- Moving averages (distance from price)
- For uptrends, a stock has daylight to the upside, i.e. lows > moving average. This pulling away from the moving average suggests that the trend is in place and beginning to accelerate.
- For downtrends, a stock has daylight to the downside, i.e. highs < moving average
- Moving averages (crossover)
- Uptrend: 10 SMA > 20 EMA > 30 EMA
- Downtrend: 10 SMA < 20 EMA < 30 EMA
- Obvious test
- Is the right side obviously higher than the left? Yes >> uptrend
- Is the right side obviously lower than the left? Yes >> downtrend
- Else, no trend
- Another way is to look at where it closed today vs. where it closed a week ago, a month ago, and several months ago.
Pullback Patterns: Trend Knockouts (TKO’s)
- Stock in a strong uptrend, ideally a persistent uptrend.
- Stock trades below at least the two prior lows. Ideally this should be a sharp move lower — a WRB down (beware of extreme moves which can really signal an end of a trend). This can occur just after a new high, creating a one-bar pullback or it can occur within several days of a new high, creating a TKO within a pullback.
- Go long above the high of the knockout bar (the bar that trades below its two prior bars’ lows). No trigger, no trade.
- Place protective stop right below the knockout bar.
- The knockout bar knocks out weak hands who quickly dump at the first sign of a correction. It is better to wait until the weak hands are knocked out of the market before entering yourself. This reduces the probability of these traders dumping their positions and taking you out with them. [My note: If a stock can trigger entry even after all the weak hands dump the stock, it is a sign of strength.]
- The knockout bar will also cause top pickers (in uptrends) and bottom pickers (in downtrends) to enter the market. Should the trend resume, they will be forced to exit at a loss, which would propel the trend further.
- Be very selective as this is a very common pattern. Only trade markets that are in obvious trends with obvious knockout moves.
Pullback Pattern: Persistent Pullback
- Stock moved one month, approximately 20 bars, in one direction. A trend line drawn through the bars should intersect as many bars as possible. During this period, the stock should have had made a significant move.
- Look to enter on a pullback or pullback related pattern (e.g. TKO).
- Ideally also require the sector and the overall market to be in a trend.
- Persistent Pullback pattern keeps you on the right side of the market, and keeps you out of the market during less than ideal conditions.
- In choppy markets, it is virtually impossible to find any stocks set up as persistent pullbacks. In bull markets, it is virtually impossible to find shorts. In bear markets, it is virtually impossible to find longs.
- During difficult times or if you are in a slump, return to trading only this pattern until you regain your confidence.
Pullback Patterns: Kiss MA Goodbye
- Stock should pull away from its 10-day SMA for at least 10 days (i.e. at least 10 days of daylight where lows must be above the MA). Fewer days are okay for strongly trending stocks.
- Wait for the stock to correct and intersect the MA.
- Look to enter above the previous high (or highs).
- This pattern looks to define a stock that is in a trend by using daylight, and then looks to enter that trend when the stock pulls back to the MA.
- Since “they slide faster than they glide”, for getting into shorts, it is better to get in earlier using transitional patterns instead.
Ignore Stocks That Pull Back for Too Long
- The best stocks in strong trends usually do not consolidate for very long if they are to resume their move.
- Generally, ignore stocks after they pull back for more than 8 days.
Pullback Depth Varies With Stock Volatility and Market Condition
- Depth of corrections varies with (i) volatility of the stock, and (ii) conditions of the market and representative sector.
- Volatile stocks can pull back deeply and still be in an uptrend.
- In longer term orderly bull markets, pullbacks are often shallow in nature.
- In bear markets, the pullback from the downtrend can be very sharp and vicious.
Give Some Wiggle Room for Your Entry Point
- In the bull market in 2000, trends resumed quickly, so you had to get in before the train left the station. The entry point should be right above the high of the last bar of the pull back.
- Today (2010), stocks often fake out above the prior day’s high and then sell off hard. Hence place your entry point well above the prior day’s high or above multiple days’ highs, give them some wiggle room.
- The entry should be far enough away to avoid being triggered by noise alone, but not so far that you give up too much of the trend.
Stops and Partial Profits
- Initial stop
- Stops must be placed based on the volatility of the underlying asset, and outside the range of a typical day.
- In a raging bull market, a stop can be placed precisely below the low of the pullback.
- If you keep getting stopped out, it could be your stock picking rather than your stop placement.
- Trailing stop
- Trail your protective stop higher when the stock closes higher. This is to avoid giving up too much of the trend when it reverses.
- Keep the distance between the Close and your protective stop the same as your initial risk.
- After you hit your partial profit target, loosen the trailing stop as the position moves progressively in your favor. This increases the chance of you being able to participate in a longer-term move. E.g. say initial stop is $5, loosen your trailing stop to $6 once you have $7 or $8 in open profits.
- Partial profit
- Exit half position when profit = initial risk, then move your stop to breakeven on the remainder of the position.
- Risk no more than 1% to a maximum of 2% per trade based on stop placement (barring overnight gaps).
Trading Trend Transitions
- Markets in major trend transitions often begin with a sharp thrust in the new direction. This tends to catch participants off guard. Trapped on the wrong side of the market, they find themselves waiting for the market to reverse so they can get off the hook.
- Bottom pickers and top pickers who missed the top or bottom and do not want to pay up are also waiting for some sort of meaningful correction. Unfortunately, the meaningful correction may never come.
- By waiting for the market to have a sharp thrust in the new direction, you avoid the pitfalls associated with picking tops/bottoms. By looking to enter at the first signs of a correction rather than waiting for something more substantial, there is the potential for your position to be helped along by the predicament of the aforementioned traders.
- Ideally the market and sector should also be making a sharp transition in trend. Occasionally though, early leaders can emerge long before the market and sector turns.
Transition Patterns: First Thrusts
- Setup (long)
- Stock must make a major new low, e.g. multi-year lows or ideally all-time lows. This helps to ensure the maximum number of traders are on the wrong side of the market when the trend begins to change.
- The stock must then rally sharply.
- The stock needs to make a lower high and a lower low. The first sign of a correction is a one-bar pullback. If WRBs higher dominated the first thrust it may only make a lower high. This can make for riskier trades since the stock has had very little correction. However in trading, risk often comes with reward. These brief corrections give players very little time to get in. Most are waiting for a more meaningful pullback. Should the thrust resume after this brief pause, these traders must either jump in or risk being left behind.
- Go long above the high of (3).
Transition Patterns: First Kiss After Daylight
- The stock must make a major new low. The lower the better. All-time lows make for the best setups.
- The stock should subsequently begin to rally. During this rally, the lows of at least 5 bars should be above the 10-day SMA. Fewer than 5 bars is acceptable for sharp moves, especially on the short side.
- The stock must pull back to touch the moving average. The low must be equal to or less than the moving average.
- Enter if the trend resumes.
- A moving average is used to gauge the strength of a pullback to assess whether it is a transition or a normal correction.
- The First Kiss After Daylight defines the first thrust in the new direction, by requiring daylight.
Transition Patterns: Bowties
- The MAs should converge and spread out again, shifting from proper downtrend order (10 SMA < 20 EMA < 30 EMA) to proper uptrend order (10 SMA > 20 EMA > 30 EMA). This should happen over a period of 3 to 4 days. This creates the appearance of a Bowtie in the averages.
- The market must make a lower low and a lower high. In other words, at least a one-bar pullback. Stocks that only make a lower high (vs. a lower low and a lower high) may be considered. This is especially true when previous day is a WRB.
- Once qualifications for (2) have been met, go long above the high of (2).
- If you only trade pullbacks for stocks that first trend strongly, you will miss stocks that transition to new trends.
- These stocks would make gradual changes and then would accelerate as the new trend emerged. Looking at multiple MAs, they would often come together and spread out in the opposite direction as the market was making a major transition, giving the appearance of a Bowtie.
- Using a 10-day SMA gives the true average price of the stock for the past 2 weeks. For longer-term MAs, EMAs are preferred since they take into consideration the longer-term trend while giving more credence to more current data.
- Respect risk and trade at a small size.
- Honor your stops.
- View a potential loss as a cost of doing business.
- More volatile stocks, within reason, tend to offer the best opportunities because surprises usually happen in the direction of the trend. Longer term, the big favorable moves should more than compensate for the occasional negative outlier.
- Learn from your losses.
- Know your methodology
- For swing trading, (i) the majority of profits come from minority of positions, and (ii) they often come over short periods of time. Markets often make large gains quickly and then they tend to consolidate.
- You must be present to win
- You never know when the next big trend will come along. Without that trend, your performance will be mediocre at best.
- It means that you must do your homework nightly even in less-than-ideal conditions.
- Beware that the market is the worst teacher
- The market often rewards bad behavior, making you hold your losses, abandon your methodology, take on excessive risk, etc.
- Do nothing unless there is something to do
- Know whether the current market conditions are favorable for your methodology.
- In dull, choppy markets, be more a wait-er than a trade-er.
- Trade the best and leave the rest
- Find and trade only the best opportunities
- Don’t micromanage
- Give things time to work and be willing to take a little heat.
- As long as you have done your homework, stick with your positions, good, bad, or indifferent.
- Good times follow bad
- Time and time again, I see people give up in less than ideal conditions right before the next trend. If you keep flipping methodologies, you will end up perpetually out of phase, quitting right before the plan begins working.
- Bad times follow good
- When conditions are good people assume that their methodology will always work. They gain confidence and begin risking more and more. I have seen people sell puts in bull markets and make huge gains, only to give it all up the first time a bear market comes along. I have seen people do extremely well buying oversold markets and selling overbought markets until the next trend comes along and wipes them out.
- Mentally rehearse taking a loss
- Plan your trade and know exactly where your stop will be. Then, mentally take the loss before you enter. Do not think that you can simply handle this. Close your eyes and imagine the stop is hit and see how it makes you feel. If this causes you anxiety then you are trading at too large a size.
- You can’t think clearly if you keep beating yourself up
- When you find yourself in a drawdown, making a lot of mistakes, and unable to something happen, stop trading. Ask yourself is it me? Or just the markets [being in a bad environment for your trading strategy]?
- Perfectionists and control freaks need not apply
- You will never get it exactly right, and no one can control the markets, at least not for very long.
- Freedom is not free
- Not having anyone to share the blame is very stressful. Heavy is the head that wears the crown.
- Avoid trades around major life events
- Applies for both bad and good events. Good events make you feel invincible and lead to reckless trading.
Trading Full Time Does Not Mean Better Results
- When people have success in trading while juggling a full-time career, they assume that they will automatically be even more successful once they can focus exclusively on trading full time. Unfortunately, many times this is not the case.
- Watching a screen all day for a longer term methodology can be damaging to both your financial and psychological health. Every little tick becomes larger than life. It will look like a new trend is emerging or an old one is ending. You will soon find yourself firing off day trades, micromanaging yourself out of soon-to-become big winners, and taking setups that are mediocre at best. Sitting in front of a screen all day is like sitting in front of a slot machine.
- Busy traders make good traders. They tend to trade only when opportunities present themselves and then they go off to save lives, build buildings, and do other great things.
- If you do have the luxury of being able to watch the markets all day, make sure you have some other interest to keep you busy. Do not depend on the market for entertainment. In dull conditions, do some research or study historical markets, enjoy a hobby, start a new business, or pay some attention to your friends and loved ones.
- Why micromanagement is bad
- Micromanagement can pay over the short term. Longer term, micromanagement does not pay. Sticking with just one longer-term winner will make up for the amount you will save on dozens of micromanaged positions.
- Never forget that the real money is in longer term trends.
- The arguments you use to shake yourself out usually sound good
- Market was up 2% today but the stock was down
- It cannot get through this minor resistance. If it were truly a strong stock, it should blow right past that resistance
- Why traders micromanage
- Market rewards bad behavior
- Need for instant gratification
- Humans are wired to avoid pain
- How to avoid micromanaging
- Let the market make decisions for you (i.e. let your orders and stops do their job)
- Obsess before you enter a trade, not afterwards
- Plan your trade and trade your plan
- Trade at a reasonable size
- When in doubt, tough it out (not get out)
- In a raging bull market, if a stock doesn’t move, getting out is correct.
- However now that stocks chop around more, you need to give positions time to work.
- Do not watch the screen all day (set your stops and turn off your screens)
Don’t Quibble Over Price On Entries
- Don’t trip over the nickels while going for the dollars. Some of the best trades come from the worst fills. If you get a good price, chances are the guy on the other side of the trade was looking to unload his stock for a reason. Conversely, if you have to pay up, it may be because someone is reluctant to let go of the inventory.
Don’t Quibble Over Price on Partial Profits
- Sometimes a stock will rally intraday and come very close to the profit target, but it just cannot seem to get above it. When this occurs, it is a good idea to not split hairs and be willing to take partial profits a little early.
- This is especially true in less than ideal conditions, like choppy markets, or if the overall market and sector appears to be running out of steam.
- Entries and exits
- Use market orders. If you want in, you get in. If you need to get out, then get out.
- Can also use a stop market order to trigger an entry into a position.
- Don’t use limit orders to enter. Good stocks can zoom past your entry and leave you behind, while bad stocks can fill you and stop you out.
- Don’t use stop limit orders to enter. Some of the biggest winners have come from some of the worst fills, when demand is so great that the stock triggers and never looks back.
- Newer traders should use a stop market order for protective stops. More advanced traders who prefer more discretion can use mental stops.
- Don’t use stop limit orders to exit. You might not be able to get out in a fast adverse move.
- Take profit
- Can use a limit order to take partial profits at your initial profit target.
Place Orders After the Open, Do Not Carry Orders / Stops Overnight
- Do not carry orders overnight. Wait for a stock to open and then enter your protective stop, entry stops, and limits for profit targets (if used).
- A bad tick, fast move, or opening gap reversals can often occur and needlessly trigger a bad trade or close your position if you have orders in place before the market opens.
Handling Opening Gaps and Fast Moves When Entering
- Opening gaps can often become the exact high for the day, so it is usually not a good idea to jump in with the rest of the crowd. You are better off waiting a few minutes to see if the stock quickly finds its high and begins to reverse.
- Scenario 1: Stock reverses
- Look to enter if and only if the stock can trade back above its opening range (i.e. above its intraday high).
- Scenario 2: Stock keeps going
- If the stock makes an extreme gap, then you are probably better off letting it go.
- Conversely if a gap is barely above your original planned entry price, then you probably want to consider the trade since you are not buying into extreme euphoria.
- Fast moves occur when a stock has a fairly quiet open, then shoots up quickly. This behavior is very similar to a gap up, and should be treated like a gap up.
Handling Gaps Against Your Position
- There will often be some initial follow through of the opening gap. Wait to see if the stock begins to reverse. You already have a large loss on your hands, taking on additional risk is not going to make a huge difference.
- How much additional risk will be based on the size of the gap, the price of the stock, and the volatility of the stock. As a general rule, you want to give higher priced stocks (e.g. > $30) at least an additional point. On extreme gaps in volatile stocks, you might give as much as two points or more.
- If the stock reverses, you can exit as it rallies higher. If it closes the gap and goes positive, you might keep the trade.
- Surviving just one major reversal will pay for the additional risks on many future damage control situations.
Take Partial Profits on Instant Rewards
- Sometimes you will enter a stock and you are instantly rewarded. The stock has a fast move over a few days and quickly approaches the initial profit target.
- When this occurs, especially when the overall sector and market have also rallied sharply, it is probably a good idea to take the profit a little early. Do not look a gift horse in the mouth since the stock has become overbought very quickly and is likely due to correct.
Using a Intraday Trailing Stop to Take Partial Profits
- When a stock makes a fast move through our initial profit target and keeps on going, you can either
- trail a stop higher intraday to capture much more than the initial profit target, and sell on a significant rally; or
- place a protective stop to take partial profits at or above where you originally intended. If you are not stopped out, exit half of your shares on the close.
- 50-day average volume >= 500,000 shares
- Prefer stocks that trade less than 2,000,000 shares per day.
- Smaller capitalization stocks have the potential to make large moves but you face a liquidity problem.
- It is more difficult for large capitalization stocks to have persistent trends and trade cleanly. The more players in a market, the more the stock tends to chop around.
- Price >= $3
- Higher priced stocks tend to move around more and trade more cleanly.
- 50-day historical volatility >= 40
- Stocks with higher volatility can provide better opportunities. However extreme volatility (> 100) should be avoided.
- The historical volatility of the stocks you trade should be higher than the broader market.
- Prefer stocks that traded cleanly with high volatility
- A stock that trades cleanly does not bounce wildly. It should have many trend qualifiers, and when it trends, it should exhibit persistency. Study the past performance of each stock and pick the one that had the cleanest charts in the past. If you still cannot decide, pick the one with the highest historical volatility.
- Sector and similar stocks should be trending
- Early leaders can emerge within a sector, forming trend transitional patterns long before the sector begins to trend.
Bottom Up Beats Top Down
- Instead of starting at the top and working my way down, I do the opposite. I start by looking at a large number of individual stocks, I then look at hundreds of sectors, and finally I study the major indices.
- This gives me an edge over those who only look at a few select areas. I know what is really going on under the hood. This allows me to see old trends ending and new ones emerging long before most individual traders.
Analysis / Selection Process
- Create tradeable universe
- Price > $3, 50-day average volume >= 500,000 shares
- Sort by 50-day historical volatility
- Take 30 minutes to go through 1,500 – 2,000 stocks, add interesting stocks to watch list.
- Run a pullback scan
- Scan for stocks recently making 20-day highs or 20-day lows.
- Sort by 50-day historical volatility.
- Go through the 500 – 1,000 stocks, add interesting stocks to watch list.
- Look at all new IPOs that have come public over the last 50 days
- 50 days because after 50 days the stock would be covered by the regular scan.
- Analyze the watch list carefully
- Look for trend, trend transition, whether historical trends traded cleanly, overlay the sub-sector chart to compare with the stock, create a detailed watch list for stocks with potential.
- Group the detailed watch list by sector. For sectors that seem to be setting up, study their components.
- Do a sector relative strength analysis
- Sort the 249 Morningstar Industry Groups (available in Telechart) by their relative strength vs. the S&P 500.
- Pick a significant low or high in the S&P and study that period forward using a number of time frames (period lengths).
- You want to see how the relative strength for the sectors change over time to see where things are heating up or cooling down.
- Analyze ETFs
- Sort by 5-day volume, look through the first 150 ETFs.
- Look at major indices
- Look for trends, transitions, chop, support, resistance, technical patterns.
- Several times a week, look at the weekly and monthly index charts to maintain perspective, but trade from the daily chart.
Indices Are More Choppy Than Stocks
- Trading the indices is often choppy when compared to individual stocks. They are an average of the representative stocks and the playing field contains many trading derivative issues. Therefore, you have to be a little more lenient with the technical patterns.