Trader and author Steve Burns tells MoneyShow.com about his trend-trading methodology, and discusses his use of moving averages to determine entry and exit points. He also mentions a couple of his current watch-list names.
Kate Stalter: Today my guest is Steve Burns, author of a number of books that share his investment philosophy. New Trader, Rich Trader is one of those.
Steve, I know you've got a new book about options trading. I wanted to just start with the idea that you identify yourself as a trend trader who can capitalize on various instruments, not just equities, as well as markets trending either higher or lower. I noticed a conversation on your Facebook page recently about the distinction between trend following, which is a term that Michael Covel has popularized, and what you call trend trading. Is there a distinction, or is it just semantics?
Steve Burns: Well, the main trend-following camp believes in mechanical trend following. They believe in no discretion. They have back-tested computer models, where they time their entries and exits and then they back that on computers to make sure it's a robust, profitable system. And then they trade it with their signals regardless of what's going on in the market.
While trend trading, to me, back in the school of Nicolas Darvas, is where we're simply trying to profit on a trend and we do have discretion and we do look for monster stocks to choose, while the mechanical trend follower may use indexes, commodities, currencies, and they may use a basket of stocks.
You know, in trend trading we actually have discretion on our watch list. I am very mechanical once I get into a trade, but I believe that I have the ability to make better decisions than just a mechanical model does, and I think I have proven that historically.
Kate Stalter: That's a good explanation. Talk a little bit about the new options book, and why you've decided to move into options. Historically, you've been more of an equities trader.
Steve Burns: Yeah. Historically, I have traded equities for 13 years, but I have been studying options for many years and I have understood now that I can have a limited downside and an unlimited upside through options, because they have a built-in stop loss.
Many believe options are just gambling, but they don't understand exactly how they can be used. You can actually get an edge in options by using them in place of stocks. I had very nice returns in the first quarter on Apple (AAPL) and I never traded a single share of Apple. I strictly used in-the-money call options.
Kate Stalter: And you're right. A lot of people do get fearful about options. It seems to me that there's a bit of misinformation out there about how risky they might be.
Steve Burns: Oh absolutely, and I thought the same thing for years. Because, you know, it's always the out-of-the-money options and it has to hit your strike, and it has to go so far into the option for the premium. And they're very efficiently priced-using the at-the-money is priced perfectly for how much it's going to move-so it's difficult to get an advantage, but I found a way.
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My advantage is actually using the call options in place of stocks. So if I'm going to go long Apple at a breakout, instead of buying-you know, tying up $60,000 in 100 shares-I can buy an option for a couple of thousand dollars, and then somebody has sold me the upside of Apple in the first quarter for a small fee, and I still have the rest of my capital to use in other ways.
Kate Stalter: A related topic that I really wanted to discuss with you today. As I mentioned, you're very transparent about your results and about your methodologies. But really, some of the underlying principals here are pertaining to the mindset of a successful trader. I know that's maybe a little bit more qualitative than some traders like to focus on, but more and more I am hearing successful traders discussing the psychological element. What kind of mindset do you believe a successful trader needs?
Steve Burns: The hard thing about trading, and people do not understand, is even the best traders in the world are only right 50% of the time. The very best ones, maybe 55%, 60% of the time.
We spend a lot of our time being stopped out of half of our positions, but good traders are the ones that can lose the best. They're the ones that can admit they're wrong quickly, stop out of their trade, and wait for a better entry. They can let their winners run and not get nervous about a winner and take the profits too soon.
The real key to winning and trading is to execute a system that has an edge and to let your losers be small and your winners be big. To lose small, win big; that's the real key to it, and you have to be able to sit through your losses.
Any trader is going to have ten losses in a row, and you have to manage your risk properly, so when you have those ten losses you're only down a small percentage of your account. You're not just blowing up and risking too much. You know, that comes from not trading with your ego. You have to trade with your plan.
Kate Stalter: Right, and that seems like something that is very difficult for a lot of people to develop. I imagine that a lot of people just quit trading altogether because they have those ten losses in a row and figure, "I can't do this."
Steve Burns: Exactly. You're exactly right, Kate. That's the thing: Being able to lose well. Being able to have those ten losses and have no less faith in yourself or confidence in yourself.
I think the confidence in the trader comes from knowing that you've done your homework, knowing that your system works in the long-term when you've looked at charts and studied tests, like William O'Neil has done about the greatest winners of all time. When you've looked at the charts of the best winners in history, you know what that looks like, and you have confidence to buy the breakout, while the other people are terrified, because they've already lost ten times in a row.
Kate Stalter: Right, so some of it's a bit counterintuitive: Buying stocks that are showing technical strength, rather than technical weakness.
Steve Burns: Yeah, I try to make the money from the trend, where somebody sold me an Apple call at an all-time high for a very cheap price, because they don't believe that it's going to go any higher.
And then I benefit from the trend or they sell me a put on a stock that's collapsing like a Groupon(GRPN) or a Netflix (NFLX) or a Research In Motion (RIMM) and they believe that it can't possibly go lower, and it does. All the historical testing has proven 52-week lows and 52-week highs tend to get higher and lower.
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Kate Stalter: Given the trends-such as they are in the market these days-what is on your watch list? What are you looking at these days?
Steve Burns: Right now, I'm on the sidelines this week. I'm just letting the range-bound S&P play out, and I am going to sit through whatever happens through Greece for Monday morning. I'm just going to sit this out. But when I go back in, I'm looking at Apple being another great run, if it breaks the 50-day moving average.
I think Coinstar (CSTR) is a very safe place to put some money. It's building a sloppy base, but it is building a base, and Coinstar is just booming with their little Redbox video rental locations and their Coinstar change machines and their gumball machines. I mean, they're just booming right now.
And Monster (MNST) energy drink. I'm shocked that they haven't been acquired by Coke (KO), orPepsi (PEP), or anybody yet. I think eventually it could very well double out of its base, and the investors are going to be richly rewarded. It's very hard to get in the beverage sector, and they have both feet in.
Kate Stalter: There was a rumor a few weeks ago, and that particular stock spiked on that. But would you ever buy a stock, Steve, based on speculation that it could be an acquisition target?
Steve Burns: I trade the charts when I trade. I traded the chart in Monster. You know, that chart spike really showed me there's so much interest in it, and it is a target, and I think it could double out of its base. I think everything is there where it could run to $100 this year.
Kate Stalter: But nonetheless, you're going to look at what the chart is telling you, and not at what people out there are saying as a rumor.
Steve Burns: Yeah. My watch list is discretionary. I look for the monster stocks like Nicolas Darvas or William O'Neil discussed, so I have a discretionary watch list, and I have ideas. But the chart has to validate my beliefs. And then once I am in, I will trade the chart 100%. My opinions are meaningless once I am into a trade.
Kate Stalter: Once you're into a trade on the long side, what kind of signals are you looking for to exit that position?
Steve Burns: Oh, I will look at the long-term chart for the past six months to a year, and look at which moving average had the most effect on it. The short-term, the five-day exponential and the ten-day simple moving average, are two that are used a lot by the professionals.
It's amazing, some charts-even Apple right now. The ten-day simple moving average is support, really strong support. It might lose a little bit during the day but it always recovers, so I will use a ten-day SMA or a five-day EMA to trail my winners.
Kate Stalter: And how about the 50-day? I know that's a very popular trend line that people do tend to use, and it does seem that a lot of stocks do kind of gravitate right around that line before making a big price move.
Steve Burns: That is one of my entries. I like to buy at a breakout above a 50-day. That will be one of my entries initially. That's where I got into Apple in the first quarter.
But once we get away from the 50-day and we start having the trend, then I will trail it with the five- or the ten-day. I want to get out; I don't want it to go all the way back to the 50-day. So that's how I exit after I get in at the 50.
- Also read: Use Moving Averages to Spot Trend Changes