Chapter 9
Following Market Indicators and Tried-and-True Day Trading Strategies
IN THIS CHAPTER
Studying the psychology and moods of the market
Following the flow of funds
Knowing what to look for during the trading day
Avoiding dangerous situations
Looking at strategies that many day traders use
Day traders put their research to work through a range of different strategies. All strategies have two things in common: They’re designed to make money, and they’re designed to work in a single day. And the best ones help traders cut through the psychology of the market.
In this day and age, most trading takes place via computers. Of course, human beings often direct the trading, but the machines are doing the work. Short-term profit potentials can be very small. As much as they want to be dispassionate, human traders get sucked into hope, fear, and greed — the three emotions that ruin people every day. To complicate matters, many markets, such as options and futures, are zero-sum markets, meaning that for every win, someone has to lose. Some markets, such as the stock market, have a positive bias, meaning that winners outnumber losers in the long run, but that doesn’t mean that’ll be the case today.
With thin profit potential and so much emotional upheaval, making money in the long run as a day trader can be tough. This chapter may help. In it, I cover some common day trading strategies, and I discuss some of the cold analysis that goes into figuring out the psychology of the markets.
Psyching Out the Markets
For every buyer, there’s a seller. (There has to be, or no transaction will take place.) The price changes to reach the point where the buyer is willing to buy the security and the seller is willing to part with it. This interaction is basic supply and demand. The financial markets are more efficient at matching supply and demand than almost any other market in existence. There are no racks of unsold sweaters at the end of the season, no hot new cars that can’t be purchased at any price, no long lines to get a table. The prices change to match the demand, and those who want to pay the price or receive the price are going to make a trade.
Despite the ruthless capitalistic efficiency underlying trading, the markets are also dominated by human emotion and psychology. All the buyers and all the sellers look at the same information, but they reach different conclusions. There’s a seller out there for every buyer, so the trader looking to buy needs to know why the seller is willing to make a deal.
Why would someone be on the other side of your trade?
- The other trader may have a different time horizon. For example, long-term investors may sell on bad news that changes a security’s outlook. A short-term trader may not care about the long-term outlook if the selling in the morning is overdone, creating an opportunity to buy now and sell at a higher price in the afternoon.
- The other trader may have a different risk profile. A conservative investor may not want to own shares in a company that’s being acquired by a high-flying technology company. That investor will sell, and someone with more interest in growth will buy. A trading algorithm may place a trade to manage the risk on another trade.
- The other trader may be engaging in wishful thinking, acting out of fear, or trading from sheer greed. He or she may not be thinking rationally about what is happening, creating an opportunity for you.
- You may be engaging in wishful thinking, acting out of fear, or trading from sheer greed. You may be the irrational trader, making mistakes that cost you. Hey, it happens to the best of us sometimes, but the more aware you are of your emotional tendencies, the better you can trade past them.
Don’t try to psych out the trader on the other side. You won’t face the same traders each time you trade, and more likely than not, the trader you’re facing is a machine. Worry about yourself instead.
Betting on the buy side
Every market participant has his or her own set of reasons and rationales for placing an order today. In general, though, although many reasons to sell exist — to pay taxes, generate cash for college tuition, or meet a pension obligation, among many others — there’s only one reason to buy: You think the security is going up in price.
For that reason alone, traders often pay more attention to what is happening to buy orders than to sell orders. To get a sense of who is projecting a profit, traders look at the number of buy orders coming in, how large they are, and at what price. I cover volume and price indicators in more detail later in the chapter.
Because there are so many good reasons to sell but only one good reason to buy, the market can take a long time to recognize bearish (pessimistic) sentiment indicators. Even if you see that prices should start to go down in the near future, you have to consider that the market today can be very different from what you see coming up. And as a day trader, you only have today.
Avoiding the projection trap
If you took a peek at some of the technical analysis charts in Chapter 8, you may have noticed that you can see what you want to see in some price charts. And if you thought a little about fundamental analysis, you may have seen that interpreting information the way you want to is just as easy. Instead of looking objectively at what the market is telling them, some traders see what they want to see. That’s one reason why knowing your system and using your limits are so important.
The best traders are able to figure out the psychology of the market almost by instinct. They can’t necessarily explain what they do — which makes it hard for those trying to learn from them. But they can tell you this much: If you can rationally determine why the person on the other side of the trade is trading, you can be in a better position to make money and avoid the big mistakes brought on by hope, fear, and greed.
Taking the Temperature of the Market
For decades, most traders were rooted on the floors of the exchanges. They had a good sense of the mood of the market because they could pick up the mood of the people in the pits with them. They often knew their fellow traders well enough to know how good they were or the needs of the people they were working for. It made for a clubby atmosphere, despite all the shouting and arm waving. It wasn’t the most efficient way to trade big volume, but it allowed traders to read the minds of those around them.
Now, almost all trading is electronic, without the paper and the jackets and the excitement. Professional traders, who work for brokerage firms or fund companies, trade electronically, but along long tables (known as trading desks) where they sit next to colleagues trading similar securities. Even though everyone is trading off a screen, they share a mood and thus a sense of what’s happening out there. Some day traders can replicate this camaraderie by working for a proprietary trading firm, but most traders work alone at home, with nothing but the information on their screens to tell them what’s happening in the market.
Fortunately, ways do exist to figure out what’s happening, even when you’re just looking at the screen. They include paying attention to price, volume, and volatility indicators, and you’re in the right place to find out more about them.
Some traders rely on Internet chat rooms to help them measure market sentiment. Doing so can be risky. Some chat rooms have smart people who are willing to share their perspectives on the market, but many are dominated by novice traders who have no good information to share or by people who are trying to manipulate the market in their favor. Check out a chat room carefully before participating.
Pinpointing with price indicators
In an efficient market, all information about a security is included in its price. If the price is high and going up, then the fundamentals are doing well. If the price is low and going lower, then something’s not good. And everything in between means something else.
The change in a security’s price gives you a first cut of information. Price changes can be analyzed in other ways to help you know when to buy or when to sell.
Measuring a rate of change: Momentum
Momentum, which I discuss in Chapter 8 in greater detail, is the rate at which a security’s price is increasing (or decreasing). If momentum is strong and positive, then the security shows both higher highs and higher lows. People want to buy the security for whatever reason, and the price reflects that. Likewise, momentum can be strong and negative. Negative momentum is marked with lower highs and lower lows. No one seems interested in buying, and that keeps dragging the price down.
The exact amount of momentum that a security has can be measured with indicators known as momentum oscillators. A classic momentum oscillator starts with the moving average, which is the average of the closing prices for a past time period, say the last ten trading days. Then the change in each day’s moving average is plotted below the price line. When the oscillator is positive, traders say that the security is overbought; when it’s negative, they say that the security is oversold. Figure 9-1 shows a momentum oscillator plotted below a price line.
© John Wiley & Sons, Inc.
FIGURE 9-1: A momentum oscillator indicates (no surprise here) momentum.
If a momentum oscillator shows that a security is overbought (the line is above the center line), too many people own it relative to the remaining demand in the market, and some of them will start selling. Remember, some of these people have perfectly good reasons for selling that may have nothing to do with the underlying fundamentals of the security, but they are going to sell anyway, and that brings the price down. Traders who see that a security is overbought want to sell in advance of those people.
If a momentum oscillator shows that a security is oversold (the line is below the center line), the security is probably too cheap. Everyone who wanted to get out has gotten out, and now it may be a bargain. When the buyers who see the profit opportunity jump in, the price goes up.
The trend is your friend … until the end. Although great reasons exist to follow price trends, remember that they all end, so you still need to pay attention to your money management and your stops, no matter how strong a trend seems to be.
Given that most trends end — or at least zig and zag along the way — some traders look for securities that fit what they call the 1-2-3-4 criterion. If a security goes up in price for three consecutive days, then it’s likely to go down on the fourth day. Likewise, if a security has fallen in price for three days in a row, it’s likely to be up on day four. Be sure to run some simulations (see Chapter 13) to see whether this strategy works for a market that interests you.
Trading on the tick
A tick is an upward or downward price change. For some securities, such as futures contracts, the tick size is defined as part of the contract. For others, such as stocks, a tick can be anywhere from a penny to infinity (at least in theory).
You can also calculate the tick indicator for the market as a whole. (In fact, most quotation systems calculate the market tick for you.) The tick for the market is the total number of securities in that market that traded up on the last trade minus the number that traded down on the last trade. If the tick is a positive number, that’s good: The market as a whole has a lot of buying interest. Although any given security may not do as well, a positive tick shows that most people in the market have a positive perspective right now.
By contrast, a negative tick shows that most people in the market are watching prices fall. Sure, some prices are going up, but unhappy people outnumber happy ones (assuming that most people are trading on the long side, meaning that they make money when prices go up, not down). This shows that the sentiment is negative in the market right now.
Tracking the trin
Trin is short for trading indicator, and it’s another measure of market sentiment based on how many prices have gone up relative to how many have gone down. Most quotation systems pull up the trin for a given market, but you can also calculate it on your own. The math looks like this:
The numerator is based on the tick: the number of securities that went up divided by (not less) the number that went down. The denominator includes the volume: the number of shares or contracts that traded for those securities that went up divided by the number of securities traded for those that went down in price. This solution tells you just how strongly buyers supported the securities that were going up and just how much selling pressure faced those securities that went down.
A trin of less than 1.00 usually means that a lot of buyers are taking securities up in price, and that’s positive. A trin above 1.00 indicates that the sellers are acting more strongly, which means a lot of negative sentiment is in the market.
Volume
The trin indicator looks at price in conjunction with volume. Volume tells you how much trading is taking place in the market. How excited are people about the current price? Do they see this as a great opportunity to buy or to sell? Are they selling fast, to get out now, or are they taking a more leisurely approach to the market these days? This information is carried in the volume of the trading, and it’s an important adjunct to the information you see in the prices. Volume tells you whether enough support exists to maintain price trends or whether price trends are likely to change soon.
Force index
The force index gives you a sense of the strength of a trend. It starts with information from prices, namely that if the closing price today is higher than the closing price yesterday, that’s positive for the security. Conversely, if today’s closing price is lower than yesterday’s, then the force is generally negative. Then that price information is combined with volume information. The more volume that goes with that price change, the stronger that positive or negative force.
Although many quotation systems calculate force for you, you can do it yourself, too. For each trading day, run this calculation:
Force index = volume × (today’s moving average – yesterday’s moving average)
In other words, the force index simply scales the moving average momentum oscillator (discussed in the earlier section “Pinpointing with price indicators”) for the amount of volume that accompanies that price change. That way, the trader has a sense of just how overbought or oversold the security is on any particular day.
On-balance volume
The on-balance volume is a running total of the amount of trading in a security. To calculate the on-balance volume, first look at today’s closing price relative to yesterday’s and then do one of the following:
- If today’s close is higher than yesterday’s: Add today’s volume to yesterday’s on-balance volume.
- If today’s closing price is less than yesterday’s: Subtract today’s volume from yesterday’s total.
- If today’s close is the same as yesterday’s: Don’t do anything! Today’s balance is the same as yesterday’s.
Many traders track on-balance volume over time, and here’s why: A change in volume signals a change in demand. The change in demand may not show up in price right away if enough buyers exist to absorb volume from sellers. But if still more buyers are out there, then the price is going to go up. Hence, the volume from even small day-to-day increases in price need to be added up over time. If the volume keeps going up, then at some point, prices are going to have to go up to meet the demand.
On the downside, the volume from small price declines add up over time, too. Over time, this volume may show that very little pent-up interest exists, indicating that prices could languish for some time.
Many traders look to on-balance volume to gauge the behavior of so-called smart money, such as pension funds, hedge funds, and mutual fund companies. Unlike individual investors, these big institutional accounts tend to trade on fundamentals rather than emotion. They generally start buying a security at the point where the dumb money is tired of owning it, so their early buying may show big volume with little price change. But as the institutions keep buying, the price has to go up to get the smarter individuals and the early institutions to part with their shares.
Open interest
Open interest has a different meaning in the stock market than in the options and futures markets, but in both cases, it gives traders useful information about demand:
- In the stock market, open interest is the number of buy orders submitted before the market opens. When the open interest is high, people are ready to add shares to their positions or initiate new positions, which means that the stock is likely to go up in price on the demand.
- In the options and futures markets, open interest is the number of contracts at the end of every day that have not been exercised, closed out, or allowed to expire.
Day traders don’t have open interest, because by definition, day traders close out at the end of every day. But some traders keep open interest, either because they think that their position has the ability to increase in profitability or because they’re hedging another transaction and need to keep that options or futures position in place. If open interest in a contract is increasing, new money is coming into the market, and prices are likely to continue to go up. This is especially true if volume is increasing at about the same rate as open interest. On the other hand, if open interest is falling, people are closing out their positions because they no longer see a profit potential, and prices are likely to fall.
Volatility, crisis, and opportunity
The volatility of a security is a measure of how much that security tends to go up or down in a given time period. The more volatile the security, the more the price fluctuates. Most day traders prefer volatile securities, because they create more opportunities to make a profit in a short amount of time. But volatility can make gauging market sentiment tougher. If a security is volatile, the mood can change quickly. What looked like a profit opportunity at the market open may be gone by lunchtime — and back again before the close.
Average true range
The average true range is a measure of volatility that’s commonly used in commodity markets, but some stock traders use it, too. It’s a measure of how much volatility occurred each day. When averaged over time, this measure shows how much volatility takes place during the period in question. The higher the average true range is, the more volatile a security is.
Many quotation systems calculate the average true range automatically, but if you want to do it yourself, start with finding each day’s true range, which is the greatest of
- The current high less the current low
- The absolute value of the current high less the previous close
- The absolute value of the current low less the previous close
Calculate those three numbers and then average the highest of them with the true range for the past 14 days.
Each day’s true range number shows you just how much the security swung between the high and the low or how much the high or the low that day varied from the previous day’s close.
Beta
Beta is the covariance (that is, the statistical measure of how much two variables move together) of a stock relative to the rest of the market. The number comes from the capital assets pricing model, which is an equation used in academic circles to model the performance of securities. Traders don’t use the capital assets pricing model, but they often talk about beta to evaluate the volatility of stocks and options.
What does beta mean?
- A beta of 1.00 means that the security is moving at a faster rate than the market. You would buy high betas if you think the market is going up but not if the market is going down.
- A beta of less than 1.00 means that the security is moving more slowly than the market — a good thing if you want less risk than the market.
- A beta of exactly 1.00 means that the security is moving at the same rate as the market.
- A negative beta means that the security is moving in the opposite direction of the market. The easiest way to get a negative beta security is to short (borrow and then sell) a positive beta security.
The VIX
VIX is short for the Chicago Board Options Exchange Volatility Index. Calculating VIX is complex enough to border on being proprietary, but it’s available on many quotation systems and on the exchange’s website, www.cboe.com/products/vix-index-volatility.
The VIX is based on the implied volatility of options on stocks included in the S&P 500 Index. The greater the volatility, the more uncertainty investors have; the more options that show great volatility, the more widespread is the concern about prospects for the financial markets. In fact, the VIX is often called the fear index and is used to gauge the amount of negative sentiment investors have. The greater the VIX, the more bearish the outlook for the market in general. The more bearish the outlook, the more likely the market is to be volatile. And volatility is the day trader’s best friend.
Traders can use the VIX to help them value options on the market indexes. (For that matter, traders who want to take a position on market volatility can use options and futures contracts on the VIX, including a mini-sized future, offered by the Chicago Board Options Exchange.) The VIX can also be used to help confirm bullish or bearish sentiment that shows up in other market signals, such as the tick or the on-balance volume measures described earlier. The CBOE also calculates a VIX number on a handful of common stocks, if you are trading those issues or the options on them.
In addition to the VIX, the exchange also tracks the VXN (volatility on the Nasdaq 100 Index) and the VXD (volatility on the Dow Jones Industrial Average).
Volatility ratio
The volatility ratio tells traders what the implied volatility of a security is relative to the recent historical volatility. This ratio shows whether the security is expected to be more or less volatile right now than it has been in the past, and it’s widely used in option markets. The first calculation required is the implied volatility, which is backed out using the Black-Scholes model, an academic model for valuing options. When you plug in to the model certain variables — time until expiration, interest rates, dividends, stock price, and strike price — the implied volatility is the volatility number that then generates the current option price. (You don’t have to perform these calculations yourself because most quotation systems generate implied volatility for you.)
After you have the implied volatility, you can compare it to the historical volatility of the option, which tells you just how much the price changed over the last 20 or 90 days. If the implied volatility is greater than the statistical volatility, the market may be overestimating the uncertainty in the prices, and the options may be overvalued. If the implied volatility is much less than the statistical volatility, the market may be underestimating uncertainty, so the options may be undervalued.
Measuring Money Flows
Money flows tell you how much money is going into or out of a market. They are another set of indicators telling you where the market sentiment is right now and where it may be going soon. Money-flow indicators combine features of price and volume indicators to help traders gauge the market. Although amounts spent to buy and sell have to match — otherwise, the market wouldn’t exist — the enthusiasm of the buyers and the anxiousness of the sellers show up in the volume traded and the direction of the price change. Just how hard was it for the buyers to get the sellers to part with their positions? And how hard will it be to get them to part with their positions tomorrow? That’s the information contained in money-flow indicators.
The most basic money-flow indicator is the change in closing price multiplied by the number of shares traded. If the closing price was higher than the closing price yesterday, then the number is positive; if the closing price today was lower than the price yesterday, then the number is negative. Other indicators out there use midpoint values and don’t go negative; instead, the numbers range from higher to lower. Whether positive or negative, a high money flow indicates strong buying activity, and that indicates that a positive price trend is likely to continue.
Accumulation/distribution index
In trading terms, accumulation is controlled buying, and distribution is controlled selling. This kind of buying and selling doesn’t lead to big changes in securities prices, usually because the action was planned. No one accumulates or distributes a security in a state of panic.
But even if the buying and selling activity isn’t driven by madcap rushes in and out of positions, it’s still important to know whether, on balance, the buyers or the sellers have the slight predominance in the market, because that may affect the direction of prices in the near future. For example, if a security has been in an upward trend but more and more down days occur with increasing volume, the sellers are starting to dominate the trading, and the price trend is likely to go down.
To determine the accumulation/distribution index, you use this equation:
Some traders look at accumulation/distribution from day to day, whereas others prefer to look at it for a week or even a month’s worth of trading. One way isn’t inherently better than the other; it depends on what you trade and how you trade it.
Money-flow ratio and money-flow index
Money flow is closing price multiplied by the number of shares traded. That basic statistic can be manipulated in strange and wonderful ways to generate new statistics carrying even more information about whether the markets are likely to have more buying pressure or more selling pressure in the future.
The first is the money-flow ratio, which is simply the total money flow for those days where prices were up from the prior day (days with positive money flow) divided by the total money flow for those days where prices were down from the prior day (which are the days with negative money flow). Day traders tend to calculate money-flow ratios for short time periods, such as a week or ten days, whereas swing traders and investors tend to care about longer time periods, like a month or even four months of trading.
The money-flow ratio is sometimes converted into the money-flow index, which can be used as a single indicator or tracked relative to prices for a given period of time. The equation used to figure out the money-flow index looks like this:
If the money-flow index is more than 80, the security is usually considered to be overbought — meaning that the buyers are done buying, and the sellers will put downward pressure on prices. If the money-flow index is less than 20, the security is usually considered to be oversold, and the buyers will soon take over and drive prices up. In between, the money-flow index can help clarify information from other market indicators.
Short interest ratios
Short selling is a way to make money if a security falls in price. In the options and futures markets, one simply agrees to sell a contract to someone else. In the stock and bond markets, short selling is a little more complicated. The short seller borrows stock or bonds through the brokerage firm and then sells them. Ideally, the price falls, and then the trader can buy back the stock or bonds at the lower price to repay the loan. The trader keeps the difference between the security’s selling price and its repurchasing price. (The process is described in more detail in Chapter 5.)
People take the short side of a position for only one reason: They think that prices are going to go down. They may want to hedge against this, or they may want to make a big profit if it happens. In the stock market in particular, monitoring the rate of short selling can give clues to investor expectations and future market direction.
The New York Stock Exchange and Nasdaq report the short interest in stocks listed with them. The data are updated monthly, as it can take a while for brokerage firms to sort out exactly how many shares have been shorted and then report that data to the exchanges. The resulting number, the short interest ratio, tells the number of shares that have been shorted, the percentage change from the month before, the average daily trading volume in the same month, and the number of days of trading at the average volume that covering the short positions would take.
The loans that enable short selling have to be repaid. If the lender asks for the securities back or if prices go up so that the position starts to lose money, the trader is going to have to buy shares to make repayment. The harder it is to get the right number of shares in the market, the more desperate the trader will become, and the higher prices will go.
An increase in short interest shows that investors are becoming nervous about a stock. However, given that short interest is not calculated frequently, the number would probably not give a trader a lot of information about the prospects for the company itself. This doesn’t mean short interest doesn’t carry a lot of useful information for traders. It does. If the short interest is high, then the security price is likely to go up when all the people who are short need to buy back stock. Likewise, if short interest is low, there will be little buying pressure in the near future.
High short interest, along with other bullish indicators, is a sign that prices are more likely to go up than down in the near future.
Considering Information That Crops Up during the Trading Day
Technical analysis (see Chapter 8) and all the indicators discussed in this chapter offer useful information about what’s happening in the markets, but there’s one problem: Because so many of those indicators are based on closing prices and closing volume, they aren’t much use during the trading day. In fact, many traders read through the information in the morning before the open to sort out what is likely to happen and what the mood of the market is likely to be, but then they have to recalibrate their gauge of the market as information comes to them during the trading day. That information doesn’t show up on charts or in neat numerical indicators until the day ends. Fortunately, several sources of information that are updated while the market is open can give a trader a sense of what’s happening at any given time.
Price, time, and sales
The most important information for a trader is the current price of the security, how often and in what volume it has been trading, and how much the price has moved from the last trade. This information is the most basic real-time info out there, and it’s readily available through a brokerage firm’s quotation screens.
Chapter 15 discusses the different quotation services that traders can obtain from their brokerage firms. Although your broker may charge you more to get more detailed quotes, doing so is worth it for most trading strategies. Knowing how the price is moving can give you a sense of whether the general mood of the market is being confirmed or contradicted — information that can help you place more profitable trades.
Order book
High-level price-quote data, such as that available through Nasdaq Level 2 or Nasdaq TotalView-ITCH, include information on who is placing orders and just how large those orders are. (Flip to Chapter 15 to see what such high-level price-quote data looks like.) The order book gives you key data because it gives you a sense of how smart the other buyers and sellers are. Are they day traders just trying not to be killed? Or are they institutions that have done a lot of research and are under a lot of performance pressure? Sure, day traders are often very right and institutions are often very wrong, but the information you see in the order book can help you sense whether people are trading on information or on emotion.
An additional piece of information from the order book can help you figure out what’s happening in the market now — namely, the presence of an order imbalance. An order imbalance means that the number of buyers and sellers doesn’t match. This situation often occurs during the open because some traders prefer to place orders before the market opens, whereas others prefer to wait until after the open. These imbalances tend to be small and clear up quickly. However, if a major news event takes place or a great deal of fear exists in the market, large imbalances can occur during the trading day. These imbalances can be disruptive, and in some cases, the exchange stops trading until news is disseminated and enough new orders are placed to balance out the orders.
The order book doesn’t show all the orders. Most brokerage firms maintain dark pools (also known as dark books or dark liquidity) for large clients or for their trading desks. Dark pools are collections of orders above or below market prices that aren’t advertised except in the pool or on electronic communication networks (also known as ECNs). Traders use this technique to help buy or sell securities without affecting the price and to reduce trading costs. The order is executed only if someone matches it inadvertently rather than the market price changing to meet the changing supply and demand. The bad news for a day trader is that these trades can contribute to market volatility without giving any advance warning.
Quote stuffing
Quote stuffing is the practice of placing a really large number of orders for a security, often at a price significantly above or below the current market price. Almost as soon as the orders are placed, they’re cancelled. The transaction is completely handled by computerized trading systems, not people. The people behind the placement of these orders are sometimes referred to as quote-rate pirates.
The official idea seems to be to hide customer orders in order to reduce their effect on the market, especially to keep them hidden from other computer trading systems, but in practice, these quotes seem to be a way to lead the market up or down by placing an unusually high or low order out there. Hence, quote stuffing may be outright market manipulation. In some cases, it may simply be that the algorithms in the computer programs place wacky orders for reasons that make sense only to other computer programs. Either way, these orders contribute to market volatility. That may be just the way it goes, unless the orders are placed for nefarious purposes.
Regulators aren’t happy with quote stuffing, and it is prohibited — if it’s caught.
News flows
Although much of the discussion in this chapter is about the information contained in price, volume, and other trade data, the actual information that comes from news releases is at least as important.
Much of the news is regularly scheduled and much predicted: corporate earnings, Federal Reserve discount rates, unemployment rates, housing starts, and the like. When this information comes in, traders want to know how the actual results compare with what was expected and how this info fits with the overall bullish or bearish sentiment of the market.
The second type of news is the unscheduled breaking event, such as corporate takeovers, horrible storms, political assassinations, or other happenings that were not expected and that take more time for the market to digest. That’s in part because these events have the ability to change trends rather than play out against them. In some cases, the markets will halt trading to allow this information to disseminate; in others, traders have to react quickly based on what they know now and what they suspect will happen in the near future.
Many day traders track Twitter and other social-media feeds for information during the trading day, and some brokers include these feeds as part of the services that they offer to their customers. Social media is a permitted way for companies to disseminate information to the market, but it can also be spoofed in such a way as to cause headaches. Even if the tweet is legitimate, it can be used in ways that create havoc. In August of 2018, the CEO of Tesla, Inc. sent out a tweet that he was thinking of taking the company private before the board of directors or other senior executives knew. The story created turmoil in the market — as well as in the company.
What’s the difference between risk and uncertainty? Risk is something that happens often enough that people can quantify the damage. Uncertainty is something that may happen, but no one can figure out the likelihood. A fire that knocks out power to Midtown Manhattan sometime in the next ten years is a risk; the invasion of the planet by aliens from outer space is uncertainty.
News can happen at any time. It can change a trend and throw all your careful analysis into disarray. For this reason, careful analysis is no substitute for risk management. Watch your position sizes and have stops in place so that you exit when you need to.
Identifying Anomalies and Traps
Traders can be superstitious, and that superstition shows up in different anomalies and traps that affect the mood of the market even when there is no logical reason for their existence. You want to be aware of them, because they can affect trading.
An anomaly is a market condition that occurs regularly but for no good reason. It can be related to the month of the year, the day of the week, or the size of the company involved. A trap is a situation where the market doesn’t perform the way you expect it to given the indicators that you are looking at. You have a choice: Go with what the market is telling you or go with what your indicators are telling you.
To a long-term investor, perception is perception. When perception is different from reality, an opportunity exists to make money. To a short-term trader, perception is reality because it affects what happens before everyone figures out what’s real.
Bear traps and bull traps
Traders talk about getting caught in traps, which neatly fits the language of bulls and bears. When they stumble into a trap, they’re stuck moving against the market, which causes them big trouble. After all, day trading is about identifying trends and moving with them. You only have a few hours to work before the time comes to close out. In this section, I list a few common traps to help you identify and, I hope, avoid them.
The best antidote for a trap is to take your loss and move on to the next trade.
Chart traps
Look at some of the sample charts in Chapter 8. If you look at actual price charts created in the market every day, you may notice that sometimes it’s difficult to determine whether a breakout is false or real and whether a trend is changing or just playing out with a smaller subtrend. A ton of subjectivity goes into reading charts, and some days you read them wrong. You think you’re ahead of the market when you’re actually just trading against it. Ouch!
Some traders try to work around these types of chart traps by automating their trading. Several different software packages are available that can scan the market and identify potential trading opportunities (see Chapter 15 for more information). But even the best software misreads the market on some occasions, which is why you need to monitor your positions and make sure you stick to your loss limits.
Contrarian traps
In Chapter 1 I note that about 80 percent of day traders lose money. So maybe you’re thinking that the way to make money is to just do the opposite of what everyone else is doing. But the reason that day traders lose money isn’t so much that they’re wrong about the trend; it’s because they’re sloppy in their trading and don’t limit their losses. (That’s why so much of this book is about the business of trading rather than the actual mechanics of placing buy and sell orders.)
In a contrarian trap, the trader has made the decision to trade against the market, and that’s exactly what happens: He or she loses money because the market is moving in the opposite direction. Taking a contrary position doesn’t work too well in day trading. In most cases, you have to go with the flow, not against it, to make money in a single day’s session. The market is always right in the short term.
A lot of people make money with a contrarian strategy, but they need to pay attention to avoid the traps.
Calendar effects
Many trading anomalies follow time periods — which is not completely unexpected — because many economic and business trends follow the calendar. Companies report their results quarterly. Most close their books for tax purposes at the end of the year. Investors are also evaluated quarterly. Retail sales follow holiday seasons, demand for commodities follows the growing season, and fuel demand varies with the weather. Whatever you decide to trade, you need to do enough fundamental research (the study of the business and economic factors that affect the security, described in Chapter 7) so that you know how your chosen securities move over time.
But some of the calendar effects — the January effect, the Monday effect, and the October effect — make little logical sense, yet they still influence trading.
The January effect
Many years ago, the stock market would go up in the early part of January. Why? No one was entirely sure, but the guess is that people tended to sell at the end of December for tax reasons and then buy back those securities in January. It may also be that in the new year everyone is flush with excitement and ready to see the market go up, so they put money to work and start buying.
If stocks go up in January, then you can get a jump on the market by buying in December, right? And that would make prices go up in December. To get a jump on the December rally, you could buy in November. And that’s exactly what people started to do, and the once-pronounced January effect is now weak to nonexistent. (People still talk about it, though, sometimes calling it the December effect.) In an efficient market, people eventually figure out these unexplained phenomena and then trade on them until they disappear. Use these anomalies as a way to gauge psychology, not as hard and fast trading rules.
The Monday effect
The market seems to do more poorly on Monday than on the other days of the week. And no matter what the evidence shows (the research is ambiguous, and the findings vary greatly based on the time period and the markets examined), many traders believe this to be true, so it has an effect. Why? There are two thoughts. The first is that people are in a bad mood on Monday because they have to go back to work after the weekend. The second is that people spend all weekend analyzing any bad news from the end of the prior week and then sell as soon as they get back to the office.
The 2008 stock market crash happened on a Monday. Over the previous weekend, the different regulatory agencies decided to allow the old-line brokerage firm of Lehman Brothers to fail. The firm failed to open on Monday, September 15, and the rest of the market went into a tailspin.
The October effect
The stock market has had two grand crashes and one smaller but profound one in October:
- October 29, 1929: On this day, known as Black Tuesday, the Dow Jones Industrial Average declined 12 percent in one day as market speculators caught up with the less rosy reality of the economy. This crash kicked off a general decline that contributed to the Great Depression of the 1930s.
- October 19, 1987: This day, known as Black Monday, saw the Dow Jones Industrial Average decline 23 percent. No one is really sure why this crash happened, but it did.
- October 13, 1989: On this day, the Dow Jones declined 7 percent in the last hour of trading when a leveraged buyout for United Airlines fell through.
Because of these crashes, many traders believe that bad things happen in October, and they act accordingly. Of course, bad things happen in other months. The crash in the Nasdaq market that marked the end of the 1990s tech bubble took place in March 2000, but no one talks about a March effect. The 2008 crash took place in September; maybe, like the January effect, the October effect is starting to roll earlier into the year.