Chapter 7
IN THIS CHAPTER
Organizing your business
Planning trades to start your day
Making short-term and long-term choices
This chapter may be one of the most important chapters in this book. Day trading isn’t a mad frenzy of order entry, nor it is a software package that you can buy, set, and forget. If you want to be successful, you have to put some time and attention into your trading. Before you trade, you need to think through what you want to do and how to do it. Afterward, you want to evaluate what you did and whether to do the same thing next time.
The best traders have plans for their trades. They know in advance how they want to trade and what they expect to do when they face the market. They may, at times, find themselves deviating from their plans, due to luck or circumstance or changing markets, but in those cases, they understand why they’re trying something else. Even experienced day traders make notes about their trades. In fact, the planning is what allows a novice day trader to stay in the game long enough to become experienced.
Trading comes in many flavors, and many of those who call themselves day traders are actually doing other things with their money. More than a few are actually gambling. If you know in advance what you want to do, not only will you be less likely to panic or follow fads, but you’ll also be in a better position to take advantage of opportunities in a way that suits your personality, trading skills, and goals. You’ll be more likely to make money because you’ll see when the market is moving your favor. And that’s why this entire chapter is devoted to planning.
A good trader has a plan. She knows what she wants to trade and how to trade it. She knows what her limits are before she places the order. She’s not afraid to take a loss now in order to prevent a bigger loss in the future, and she’s willing to sit out the market if nothing is happening that day. Her plan gives her the discipline to protect her capital so that she has money in her account when the opportunities present themselves.
In this section, I cover the components of trade planning. When you start trading, you’ll probably write notes each day to form a trading plan that covers what you expect for the day, what trades you hope to make, and what your profit goals and loss limit are. As you develop experience, trade planning may become innate. You develop the discipline to trade according to plan without needing to write it all down — although you may find it useful to tape a list of the day’s expected announcements to your monitor.
The first step in your trading plan should also be addressed in your business plan: What do you want to trade? Many traders work in more than one market, and each market is a little different. Some trade different products simultaneously, whereas others choose one for the day and work only on that.
Chapters 3 and 4 cover the different assets that day traders can work with in great detail. You can refer to them if you’re just starting out. What assets fit your style, your expertise, and your risk levels? For example, many farmers trade commodities futures both to manage their own risk and to apply their knowledge of agriculture to short-term profits. If your expertise is technology, commodities may not be as good a fit for you. Everything flows from your asset choices.
You need to figure out which markets give you the best chance of getting a profit that day, and this changes regularly. Some days, no trades will be good for you in one market, and you’ll be better off sitting out. If you’re too antsy to sit out, then find another market to keep you busy so that you don’t trade just to stay awake. (Of course, many traders report that the big money opportunities are in the slower, less glamorous markets.)
You want to find assets that are trading when you are. That sounds obvious, right? Well, it’s so obvious that it should be in your plan.
Although global markets seem to be operating 24 hours a day these days, they really don’t. Breaks in trading sessions occur, and market holidays in different countries close markets. Even assets that trade well in overnight markets trade differently in them because the participants in them are different. For instance, the interests of currency traders in Asia are somewhat different from those of currency traders in Europe if only because their profit accounting will take place in different currencies, which means that currency trading will be different during the Asian business day than during the European business day.
Hence, you need to consider what is happening when you’ll be trading. It’s particularly important if you don’t trade at the same time every day or if you trade something like currency where one region’s business day may be ending and another day beginning while you’re trading.
And so, determine if this asset is one you want to trade today, and if you want to work with it all day or for only part of the day.
Figuring out how to trade an asset involves a lot of considerations: What is your mood today? What will other traders be reacting to today? How much risk do you want to take? How much money do you want to commit? These considerations represent the nitty-gritty stage of trade planning that can help you manage your market day better.
Before you start trading, take some time to determine where your head is relative to the market. Is today a day that you can concentrate? Are things happening in your life that may distract you, are you coming down with the flu, or were you out too late last night? Or are you raring to go, ready to take on whatever the day brings?
Your mindset will influence how aggressively you want to trade and how much risk you want to take. Acknowledge it up front or live in denial until the losses come in.
You have to pay attention to do well in the markets, but you also have to know when to hang back during the day’s activities. For example, many traders find that their strategies work best at certain times of the day, such as at the open or before major news announcements.
After you determine your own mindset, think about what people will be reacting to that day. Check the newswires to gather information. Then figure out the answers to these questions:
After you have a sense of how you’re going to tackle the day, determine how much you’re going to trade. Following are the key considerations:
Do you want to borrow money? If so, how much? Borrowing — also known as margin or leverage — increases your potential return as well as your risk. (I discuss margin, leverage, and short selling in Chapter 5.)
Some contracts, such as futures, have built-in leverage. As soon as you decide to trade them, you’re borrowing money.
With these items detailed, you’re in good shape to get started for the day.
After you get insight into what the day may be like and how much money you want to allocate to the markets, your next step is to figure out when you’ll buy and when you’ll sell. Ah, but if deciding when to buy and sell were easy, do you think I’d be revising a book on day trading? No. I’d be too busy taking private surfing lessons in front of my beachfront mansion on Maui.
Many traders rely on technical analysis, which involves looking at patterns in charts of the price and volume changes (I discuss technical analysis in Chapter 8). Other traders look at news and price information as the market changes rather than looking at price patterns (you can find a discussion of this in Chapter 9). Still others care only about very short-term price discrepancies (covered in Chapter 10). But the most important thing, no matter what approach you prefer, is that you backtest and simulate your trading before you commit real dollars. That way, you have a better sense of how you’ll react in real market conditions. You can find information about Backtesting in Chapter 13.
When you trade, you want to have a realistic idea how much money you can make. What’s a fair profit? Do you want to ride a winning position until the end of the day, or do you want to get out quickly after you make enough money to compensate for your risk? This question has no one single answer because so much depends on market conditions and your trading style. In this section are some guidelines that can help you determine what’s best for you.
Your profit goals can be sliced and diced a few different ways. The first is the gain per trade on both a percentage basis and an absolute basis. The second is the gain per day on both a percentage basis and an absolute basis. What do you have to do to reach these goals? How many successful trades will you have to make? Do you have the capital to do that? And what is right for the trade you are making right now, regardless of what your longer-term goals are?
Setting a loss limit along with a profit goal is a good idea. For example, many futures traders have a rule to risk two ticks in pursuit of three ticks. That means that they’ll sell a position as soon as it loses two ticks in value and as soon as it gains three ticks in value. And for anything in between? Well, they close out their positions at the end of the days the result is profit even smaller than three ticks or a loss smaller than two. It’s a boring strategy that usually has small profits, but a small profit is better than a negative one.
Even traders who don’t have a rule as specific as losing two ticks in pursuit of three often set a limit on how much they’ll lose per trade. They know that there is no shame in a loss, only in wishing and hoping that it would magically reverse. Other traders use computer programs to guide their buys and their sells, so they sell their positions automatically. Brokers make setting limits easy by giving customers the choice of a stop order or a limit order to protect their positions.
A stop order is an order to buy or sell a security as soon as a security moves beyond the current market price. A stop buy order is set above the current market price, and it is used to manage a short position. A stop sell order is set at a price below where the market is now, and it is used to protect a profit or limit a loss on a security that you already own. If you want to make sure you sell a block of stock when it falls below $30 per share, for example, you can enter a stop order at $30 (telling your broker “Sell Stop 30”). As soon as the stock hits or goes below $30, the broker sells it, even if the price goes to $29 or $31 before all the stock is sold. This is often known as a stop loss order.
A version of a stop, known as a trailing stop, is used to help protect a profit. You can enter a trailing stop order at the current market with a stop loss price below the current market price. It would be set to trail, or automatically increase, as the stock price does. If you bought a block of stock at $30 with a trailing stop of $5, for example, the stop would kick in at $25. But if your trade was a good one and the stock went from $30 to $35, the stop would trail with it and rise to $30, a price $5 below the current market value.
A limit order is an order to buy or sell a security at a specific price or better: lower than the current price for the buy order (because you want to buy low, naturally), higher than the specific price for a sell order (because you want to sell high).
If you want to make sure you sell a block of stock when it’s at $30 per share, for example, you can enter a limit order at $30 (telling your broker, “Sell Limit 30”). As soon as the stock hits $30, the broker sells it, continuing to place the order as long as the price stays at $30 or higher. If the price goes even a penny below $30, the limit is no longer enforced, and the broker stops selling your position. After all, no buyers are going to want to pay an above-market price just so you can get your order completed!
A stop-limit order is a combination of a stop order and a limit order. It tells the broker to buy or sell at a specific price or better but only after the price passes a given stop price. If, for example, you want to make sure you sell a block of stock when it falls below $30 per share but you also want to make sure you sell it only when you’d have a loss, you can enter a stop order at $30 with a limit of $29 (telling your broker, “Sell 30 Limit 29”). As soon as the stock hits $30, the broker sells it as long as the price stays above $29. If it goes below $29, the broker stops selling.
Stop-limit orders help you get out without maximizing your losses; the danger, of course, is that the stock goes to $6 and you could have gotten out at $28 without the stop-limit order.
Are you confused? Well, the differences may be confusing, but understanding them is important to helping you manage your risks. That’s why Table 7-1 gives you a handy breakout of the different types of orders.
TABLE 7-1 Different Types of Orders
Buy Orders |
|||
Stop Order |
Limit Order |
Stop-Limit Order |
|
Order instructions |
Buy Stop 30 |
Buy Limit 30 |
Buy Stop 30 Limit 31 |
Market Price ($) |
Action after the stock hits $30 |
||
28.50 |
Nothing |
Buy |
Nothing |
29.00 |
Nothing |
Buy |
Nothing |
29.50 |
Nothing |
Buy |
Nothing |
30.00 |
Buy |
Buy |
Buy |
30.50 |
Buy |
Nothing |
Buy |
31.00 |
Buy |
Nothing |
Nothing |
31.50 |
Buy |
Nothing |
Nothing |
Sell Orders |
|||
Stop Order |
Limit Order |
Stop-Limit Order |
|
Order Instructions |
Sell Stop 30 |
Sell Limit 30 |
Sell Stop 30 Limit 29 |
Market Price ($) |
Action after the stock hits $30 |
||
28.50 |
Sell |
Nothing |
Nothing |
29.00 |
Sell |
Nothing |
Sell |
29.50 |
Sell |
Nothing |
Sell |
30.00 |
Sell |
Sell |
Sell |
30.50 |
Nothing |
Sell |
Nothing |
31.00 |
Nothing |
Sell |
Nothing |
31.50 |
Nothing |
Sell |
Nothing |
Also known as one cancels other or OCO, an order cancels other order is used with a limit and a stop-loss to set a trading bracket in a volatile market. The limit sets an automatic exit point when your position hits your price target, and the stop-loss kicks in if your trade moves against you in order to limit your losses. The broker will execute only the relevant order, cancelling the other order when that happens. If not, the other half of the order will be hanging out, waiting to be executed, causing you headaches.
Depending on whom you talk to, OSO stands for order sends order, order sends other, or one sends other. They all mean the same thing: When one order is executed, another order is automatically entered into the system — and not a moment before. You use an OSO to enter a limit order or a stop-loss order as soon as your order to open a long or short position is executed.
No matter how in tune you feel with the market, no matter how good your track record, and no matter how disciplined you are with setting stops, stuff is going to happen. Just as you can make more money than you plan to, you can also lose a lot more. If you day trade, you have to accept that you’re going to have some really bad days.
So what do you do? You suck it up, take the loss, and get on with your life. Yes, the market may have blown past your stops. That happens sometimes, and it’s hard to watch real dollars disappear into someone else’s account, someone you will never know. Still, close your position and just remember that tomorrow is another day with another chance to do better.
By definition, day traders only hold their investment positions for a single day. Closing out at the end of the day is important for a few reasons:
But like all rules, the single-day rule can be broken and probably should be broken sometimes. In this section, I cover a few longer-term trading strategies that you may want to add to your trading business on occasion.
Swing trading involves holding a position for several days. Some swing traders hold overnight, while others hold for days or even months. The longer time period gives more time for a position to work out, which is especially important if the position is based on news events or if it requires taking a position contrary to the current market sentiment. Although swing trading gives traders more options for making a profit, it carries some risks because the position can turn against you while you are away from the markets.
Swing trading requires paying attention to some basic fundamentals and news flow. (Fundamental research is discussed in Chapter 8.) It’s also a good choice for people who have the discipline to go to bed at night instead of waiting up and watching their position in hopes that nothing goes wrong.
A position trader holds a stake in a stock or a commodity for several weeks and possibly even for months. This person is attracted to the short-term price opportunities, but he also believes that he can make more money holding the stake for a long enough period of time to see business fundamentals play out. Position trading increases the risk and the potential return because a lot more can happen over months than minutes.
An investor is not a trader. Investors do careful research and buy a stake in an asset in the hopes of building a profit over the long term. It’s not unusual for investors to hold assets for decades, although good ones sell quickly if they realize that they’ve made a mistake or if the story changes. (They want to cut their losses early, just as any good trader should.)
Investors are concerned about the prospects of the underlying business. Will it make money? Will it pay off its debts? Will it hold its value? They view short-term price fluctuations as noise rather than as profit opportunities.
Many traders pull out some of their profits to invest for the long term (or to give to someone else, such as a mutual-fund manager or hedge fund, to invest). Doing so is a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account.
In this chapter, I cover a few of the many maxims traders use to think about their trading, such as
A lot more are out there.
Clichés are useful shorthand for important rules that can help you plan your trading. But they can also mislead you because some are really obvious — too obvious to act on effectively. Yes, everyone knows that you make money by buying low and selling high, but how do you tell what low is and high is? Here’s a run-through of some clichés that you’ll come across in your trading career, along with my take on what they mean.
Trading is pure capitalism, and people do it for one primary reason: to make money. Sure, a ton of economic benefits come from having well-functioning capital markets, such as better price prediction, risk management, and capital formation. But a day trader just wants to make money.
Get too greedy, however, and you’re likely to get stupid. You start taking too much risk, deviating too much from your strategy, and getting careless about dealing with your losses. Good traders know when it’s time to take a profit and move on to the next trade.
This maxim is one of those obvious but tough-to-follow ones. After all, when do you cross the line from being a happy little piggy to a big fat greedy hog that’s about to be turned into a pork belly? Just know that if you’re deviating from your trading plan because things are going so great, you may be headed for some trouble.
Here’s a cliché that’s related to “Pigs get fat, hogs get slaughtered”: “Bears get fat, bulls get fat, and hogs get slaughtered.” In other words, a savvy trader can make money whether the market is up or down, but a greedy trader runs into trouble.
A bull market is one that charges ahead; a bear market is one that does poorly. Many people erroneously think of themselves as trading geniuses because they make money when the entire market is going up. Making money by day trading was easy with Internet stocks in 1999, but it wasn’t so easy in 2000 when the bubble burst. And when the markets turn negative, those people who really understand trading and who know how to manage risk are able to stay in until things get better, possibly even making nice profits along the way.
The corollary cliché for “In a bear market, the money returns to its rightful owners,” is “Don’t confuse brains with a bull market.” When things are going well, watch out for overconfidence. It may be time to update your business and trading plans, but it’s not to time cast them aside.
When you day trade, you need to make money fast. You do not have the luxury of waiting for your unique, contrary theory to play out. An investor may be buying a stock in the hopes of holding it for decades, but a trader needs things to work now.
There are two problems with the maxim “The trend is your friend.” The first is that by the time you identify a trend, it may be over. Second, sometimes, going against the herd makes sense because you can collect when everyone else realizes their mistake. In such a situation, the psychology of trading comes into play. Are you a good enough judge of human behavior to know when the trend is right and when it’s not?
Markets react to information. That’s ultimately what drives supply and demand. Although the market tends to react quickly to information, it can overreact, too. Lots of gossip gets traded in the markets as everyone looks to get the information they need to gain an advantage. And despite such things as confidentiality agreements and insider-trading laws, many rumors turn out to be true.
These rumors are often attached to such news events as corporate earnings. For whatever reason — good news, analyst research, a popular product — traders may believe, for example, that the company will report good quarterly earnings per share. That’s the rumor. If you buy on the rumor, you can take advantage of the price appreciation as the story gets more play. When the earnings are actually announced, one of two things will happen:
Of course, if the rumor is bad, you want to do the opposite: sell on the rumor and buy on the news. For more information on short selling — selling securities in hopes that they fall in price — turn to Chapter 9.
The problem with “Buy the rumor, sell the news” is that rumors are often wrong, and there may be more opportunities to buy on bad news when other traders are panicking, thus driving prices down for a few minutes before sanity sets in. But this rule is one of those that everyone talks about, whether or not they actually follow it.
I mention earlier in this chapter that you need to cut your losses before they drag you down. No matter how much it hurts and no matter how much you believe that you’re right, you need to close out a losing position and move on.
But the opposite — that you should ride your winners — is not necessarily true. Although good traders tend to be disciplined about selling winning positions, they don’t use stops and limits as rigorously on the upside as they may on the downside. They’re likely to stick with a profit and see how high it goes before closing out a position.
Note that this conflicts a little with the “Pigs get fat, hogs get slaughtered” maxim. (Trading maxims can be so contradictory!) To prevent overconfidence and sloppiness from greed, ride your winners within reason. If your general discipline is to risk three ticks on a futures contract to make five, and a contract goes up six ticks before you can close it out, you may want to stick with it. But if you also close out at the end of every day, don’t give in to the temptation of keeping that position open just because it’s still going up. Keep to your overall discipline.
The markets churn on every day with little regard for why everyone trading right now is there. Prices go up and down to match the supply and the demand at any given moment, which may have nothing to do with the actual long-term worth of an item being traded. And it certainly has nothing to do with how much you really, really want the trade to work out.
One of the biggest enemies of good traders is overconfidence. Especially after a nice run of winning trades, a trader can get caught up in the euphoria and believe that he finally has the secret to successful trading under control. While he’s checking the real estate listings for that beachfront estate in Maui, BAM! The next trade is a disaster. Does that mean that the trader is a disaster, too? No, it just means that the markets won this time around.
The best traders know their limits. They know what gets them excited, what gets them angry, and what they need to watch out for. They haven’t necessarily figured it out in front of a screen, either. Instead, they’ve looked back on their lives and realized how to apply their strengths and weaknesses to trading.
If you are new to trading, consider your own capabilities when designing a trading plan and think carefully about the things that are likely to trip you up. By thinking about those things, you can pay attention and act accordingly.
Trading has a huge survival bias, meaning that the most experienced traders are also the best traders because the worst traders got washed out early on. The sure-fire route to losing your trading capital is to make a few big bets. The older traders know that they have to watch what they do. They have to plan for the risks they want to take and understand when to close out their risks. After all, if you want excitement, go to Vegas,
If you want to make the ranks of the old traders, plan your traders and trade your plan.