This issue of using phonics versus the whole-word approach to teach reading came up on another thread, and I thought it deserved its own. It's a huge debate in the education community about which method for teaching reading is best. It seems silly, because that probably depends on the child, anyway. And for us homeschoolers, it doesn't matter as much, since we'll be trying various things and sticking with what works.
For some background on the "great debate" look here: http://www.child-reading-tips.com/greatdebate.html
For what it's worth, I can tell what I observed about the way my son taught himself to read. I guess he used the whole-word approach -- I doubt there are many self-taught readers who used phonics!
What I noticed first, was that he became interested in having me label things. We'd be drawing chalk figures of our family on the sidewalk, for example, and he'd get me to label them "Mommy" "Daddy" and so on. Draw a house, a flower, a tree, label them all. Soon it was apparent that he could recognize those labels without a picture. It just seemed like educated guessing. If I wrote down "Daddy" and he said "Daddy" I thought to myself, "well, of course, it's pretty much the only word he knows that starts with a D." Also, I noticed that if I wrote a word he didn't know, such as "Moon" he'd guess a word he did already know that started with the same letter, such as "Mommy". As months progressed, his guesses got progressively better because he'd look at both the first and last letters before guessing. Later still he'd take into account the middle letters, in kind of a jumble, when guessing the word. At no point did I ever hear him sounding out the letters.
Somewhere in there, he also became very interested -- shall we say obsessed -- for a few months in my pointing to each word as I read it in a book. That was an extremely tedious time for me. I started realizing he could read pretty well (he wouldn't demonstrate on request), because eventually he'd stop me and have me read and point over again at any weird word (like "fizzle" or "whee") that he'd never heard/read before. Did that mean he already "knew" the other ones?
Anyway, NOW a long time later, I notice he does sound out words syllable by syllable, so I guess he sort of figured out the phonics on his own. I think it has occasionally come up naturally that I've told him rules like "tion" is pronounced "shun" and so on. I'm not sure how much of that he retains, but of course he's still very young.
I think one of the things that the advocates of whole-word reading suggest is going around your house and putting labels on things. We never did that, but in hindsight, I bet Eric would have loved it.
I'd welcome any stories pro/con you have about teaching reading with various methods. My sister used "Teach Your Child to Read in 100 Easy Lessons" for several of her kids and loves it.