Chapter 2
IN THIS CHAPTER
Understanding the magic and mechanics of the market
Opening an account and placing a trade
Grasping how day trading fits into the markets
Comprehending the fundamental powers of risk and return
Distinguishing trading from investing and gambling
Identifying the special risks of day trading
The market is the aggregation of all the traders you’ll face in a given day. They’re placing orders to buy and sell for every possible rational or irrational reason you can imagine. The financial markets are more or less instantaneous these days. They are global, and they operate almost continuously.
Over centuries — yes, centuries — institutions and regulations have been established to keep the markets from disintegrating into chaos. Markets operate more or less around the globe, around the clock, so that money moves and trades clear even if one part is knocked out by a terrorist attack or political crisis. Not a lot of regulations exist, but enough do to ensure that anonymous participants in far-flung locations honor contracts.
As the world’s financial markets become more automated and intertwined, day traders have fewer opportunities to do their thing. That’s a fact. But, the more you understand about the markets, the more opportunities you’ll find and the fewer expensive mistakes you’ll be likely to make.
This chapter gives you a high-level overview of supply and demand, exchanges, and zero-sum games. It discusses the basics of commissions and fees while giving you the underlying knowledge you need to get started.
In 1776, a leading thinker wrote a treatise that changed the way people thought about the world.
Thomas Jefferson and the Declaration of Independence? Oh, heck no. Although that work was certainly important, I’m referring to Adam Smith and The Wealth of Nations. In his book, Smith set forth the basic principles of markets. He said that the markets work like an “invisible hand” that brought together the efforts of countless people to meet the needs of countless others at a price that made both parties satisfied.
This basic explanation of how the market works has held up for more than 200 years. No one has improved it. Smith’s explanation for how markets work is still genius.
The following sections explain in plain English some important concepts in Smith’s book and how they apply today to day trading.
Note: Wealth of Nations isn’t the easiest book to read, but if you’re interested, check it out online at www.adamsmith.org/the-wealth-of-nations/
. Alternatively, you can find good explanation in a 1980 public television series featuring economist Milton Friedman called “Free to Choose,” available online at www.freetochoose.tv/broadcasts/ftc80.php
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In a free market, supply and demand meet at a price where the buyer receives good value for the price paid and the seller makes enough of a profit to stay in business. The supply for a given price is the number of goods that sellers are willing to sell at a given price, and the demand is the price that buyers are willing to pay for a given number of goods. If demand increases, then sellers are able to raise prices. If demand falls, sellers lower prices. Likewise, if the supply increases, sellers will cut prices to move inventory. If the supply falls, sellers will raise prices.
Consider what happens if supply and demand are out of whack. Say you want a pair of new shoes and have a budget of $50. You go shopping and find that the shoes you want cost $75, so you walk out empty handed. It’s possible someone else would find the $75 price fair, but you don’t. And in this example, not enough people do, so the shoe store runs a huge sale on its unsold inventory. Everything is two-thirds off! The shoes that were two expensive at $75? They are now $25 a pair, so you leave with two of them.
But at $25 a pair, the shoe store can’t make any money and goes out of business. You’re better off, but the seller is worse off — nothing’s magical about that.
In this example, if the people running the shoe store had been paying more attention, they would have figured out that at $50, they could sell shoes and still make money. In the real world, business owners talk to customers and track what competitors are doing so that they can figure out where to price their products. They also pay close attention to their costs to make sure that they are able to keep customers happy and stay in business.
And this is what happens in the financial markets. Every day, people go shopping for what they want to buy, whether it be shares of stock, an ETF (exchange-traded fund), commodity option, or foreign currency. Some of these buyers have to make a purchase to cover a loan. Others have done research to figure out how much something seems to be worth. And still others are placing their orders based on hunches. The buyers are determining the amount of demand in the market.
At the same time, people are looking to sell the same set of assets. Some of these sellers have mundane interests. Maybe the assets belonged to someone who died, and so they have to be sold so that the cash can be divided among the heirs. Maybe they’re looking to hedge a risk but no longer need to do it. Maybe they’ve done research to show that the item in question is overpriced, or maybe they’re acting on pure emotion. These sellers determine the amount of supply in the market.
And, of course, if the price gets high enough, a lot more people will be interested in selling than in buying, and if it gets low enough, traders will be looking to scoop up bargains. Sometimes traders quip that a stock is up in price because there are more buyers than sellers. That’s not quite true — someone has to be on each side of the trade — but motivated buyers will have to raise the price they’re willing to pay in order to entice the sellers to part with their shares, bitcoins, or futures contracts.
The people who actually place your order to buy or sell securities are known as brokers. Brokers are members or shareholders of the exchanges. The exchanges, in turn, are organizations designed to bring together groups of brokers representing a number of buyers and sellers. Having a central place to meet, whether in real life or virtually, increases the number of trades taking place and increases the likelihood that the transaction price will match the true value of the asset in question.
Once upon a time, brokers met physically on the floor of the exchange building. Nowadays, of course, most trading happens electronically, and the exchange buildings are often giant server farms. You won’t see that when you watch the opening bell on TV, because the servers are hidden in high-security, temperature-controlled rooms.
Some financial assets trade over the counter rather than on the exchange. Instead, they trade through networks of brokers or banks. Years ago, these items traded at special desks at banks and brokerage firms or on the street outside the exchange buildings. That’s why sometimes market pundits refer to these markets as the curb.
For most traders, there is no real difference in the execution of an order placed in an exchange market or an over-the-counter market. Both are now executed on electronic networks. Some markets, like currency, take place almost entirely over the counter. You still need an account with a broker to access over the counter listings.
After all, the broker’s reason for being is to guarantee that customers have the items that they want to sell or the cash to pay for the things they want to buy, which ensures that the market works as intended.
The broker’s service isn’t free. After all, brokerage firms are run by capitalists subject to their own sets of supply and demand forces. The prices you pay come in three forms: commissions, fees, and spreads.
The commission is the charge for placing a trade. Some firms charge a flat rate, like $15 per trade; others charge a price per share or per contract. In any event, the lowest commission isn’t always the best deal, because it’s only one of several fees a broker charges.
Also, most brokers offer more services than simple trade execution, which makes a difference. Chapter 15 has more information about choosing brokerage firms.
The exchanges charge fees (a cost added to the trade bill) for their services, too. They aren’t high but are tacked on to your trade commission (the quoted price to execute your trade. You can’t get out of these fees if you’re trading an asset listed on an exchange.
The spread is the difference between the price that the broker pays to buy an asset and the price it sells it to a customer. It’s the broker’s profit on the trade and is often more significant than the commission. Some brokers do a better job working with day traders than others, and the difference tends to show up in the spread.
The first thing to know about game theory is that, despite the name, it isn’t about why people have fun. The second thing to know is that it classifies different activities based on how much total value is added or created for the people involved. Game theory is often used to describe financial markets, so the three main categories matter:
Day trading is a zero-sum game. Your gain is someone else’s loss, and vice-versa. To make this work, you have to determine who is willing to lose money.
This isn’t as horrible as it may seem. Remember that each of the people in the market has a different reason for being in it. Many people use options to manage risk, for example (as I explain in Chapter 4). They’re all right with paying a little bit of money now in order to prevent a big loss in the future.
Likewise, in currency markets, some people are trading because they need one particular currency in order to make a transaction. Sure, they may get a better rate if they could wait a little bit, but they can’t wait. That’s the point.
This section is super basic, but that may be what you need. It goes through the process of opening an account and placing a trade, and sometimes, it’s these mechanics that prove to be the highest hurdle to trading. If you already have a brokerage account, you can skip it.
After you find a broker (see Chapter 15 for ideas), you go to its website, fill out a bunch of forms, and then set up a transfer from your bank account to your new brokerage account. This transfer will be your initial trading capital.
There are no shortcuts here, by the way. The broker is required by a range of international laws to verify who you are and where your money comes from. A compliance officer isn’t willing to go to prison because you don’t want to share your personal information in exquisite detail.
To place an order, log in to your account and fill out the form to place an order. It’s almost like online shopping! You tell the broker what you want and how much of it, and then you enter the other details such as whether the trade is long (that is, you’re buying) or short (if you’re selling) (see Chapter 3). You can pay for it either with the money in your account or by borrowing money from the broker, known as a trade on margin. Press enter, and away it goes for the broker to handle.
If your initial order was a buy, now you need to sell your position. And, once again, it’s almost like online shopping. This time, you’re doing a return. You log in and place the order, again specifying what and how much. When the broker completes the transaction, the money will be used to pay off any margin and then go into your account.
If your brokerage account grows beyond the amount you want to risk, transfer some money back into your bank account. It’s simple and easy – and is the way you take your trading profits and apply them to everything else in your life.
Although you can day trade almost every asset with wild abandon, doing so probably isn’t a good idea. Some traders spend their entire careers working with just one or two types of securities. This section covers the basics of success: working with just a few assets in one market, managing positions carefully, and concentrating on the work at hand.
Most day traders pick one or two markets and concentrate on those to the exclusion of all others. That way they can figure out how the markets trade, how news affects prices, and how the other participants react to new information. Also, concentrating on just one or two markets helps them maintain focus.
And what do day traders trade? Chapters 3 and 4 have information on all of the different markets and how they work. Here’s a quick recap, in no particular order, of the most popular assets with day traders right now if you’re overeager:
Day traders can, and sometimes do, trade bonds and commodities. Usually, they do so through financial futures or exchange-traded funds.
A key to successful trading is knowing how much you’re going to trade and when you’re going to get out of your position. Sure, day traders are always going to close out at the end of the day — or they wouldn’t be day traders — but they also need to cut their losses and take their profits as they occur during the day. Specifically, they need to determine the size of the trade and the maximum profit or loss:
Day traders are often undone by stress and emotion. Keeping a steady eye on what’s happening in the market is hard when you’re looking at screens all day and working alone. But as a trader, you have to be able to concentrate on the market and stick to your trading system, staying as calm and rational as possible.
Day traders who do well have support systems in place. They’re able to close their positions and spend the rest of the day on other activities. They do something to get rid of their excess energy and clear their minds, such as running or yoga or meditation. They understand that their ability to maintain a clear mind when the market is open is crucial.
Traders sometimes think of the market itself, or everyone else who is trading, as the enemy. The real enemies are emotions: doubt, fear, greed, and hope. Those four feelings keep traders from concentrating on the market and sticking to their systems.
Investors, traders, and gamblers have this in common: They put their money at risk, and they expect to get a return. Ideally, that return comes in the form of cold, hard cash, but if they’re not careful, they could get nothing — or worse, end up owing money. Traders should risk no more than they can afford to lose. There is no shortcut to this: Strategies that offer high returns carry more risk with them and don’t trust anyone who tells you otherwise.
Risk can’t be eliminated in trading, but it can be managed.
If you don’t want any risk, then your return will be really low. The interest rate on a federally insured bank certificate of deposit is an example of a return without risk, and if that’s what you wanted, you wouldn’t have even picked up this book. Because earning a return requires taking risk, understanding what risk is and how to manage it is a key to day trading success.
Risk is the measurable likelihood of loss. The riskier something is, the more frequently a loss will occur, and the larger that loss is likely to be. Playing in traffic is riskier than driving in traffic, and skydiving is riskier than gardening. This doesn’t mean that you can’t have losses in a low-risk activity or big gains in a high-risk one. It just means that with the low-risk game, losses are less likely to happen, and when they do, they’re likely to be small.
The ability to measure risk makes modern business possible. Until mathematicians were able to use statistics to quantify human activities, people assumed that bad things were simply the result of bad luck or the wrath of the gods. But when people understand probability, they can apply and use that to assess the likelihood of an event happening and determine the commensurate compensation for taking the risk. If a sailor agreed to join a voyage of exploration, what was the probability that he would return home alive? And what would be fair compensation to him for that risk? What was the probability of a silo of grain going up in flames? And how much should the farmer charge the grain buyers for the risk that he was taking, and how much should someone else charge to insure the farmer against that fire?
Whenever you take risk, you take on the probability of loss. If you know what that probability is, you can determine whether the terms you’re being offered are fair and whether you have a reasonable expectation for the size of the loss.
Say that you’re presented with this opportunity: You put up $10. You have an 80 percent chance of getting back $11 and a 20 percent chance of losing everything. Should you take it? To find out, you multiply the expected return by the likelihood and add them together: (80% × $11) + (20% × $0) = $8.80. Your expected return of $8.80 is less than the $10 cost of this contract, so you should pass on it.
Now suppose you’re offered this opportunity: You put up $10. You have a 90 percent chance of getting back $11 and a 10 percent chance of getting back $6. Your expected return is (90% × $11) + (10% × $6) = $10.50. This contract would be in your favor, so you should take it.
Here’s a third proposition: You put up $10. You have a 90 percent chance of getting back $13.89 and a 10 percent chance of losing $20 — even more than you put up. Your expected return is (90% × 13.89) + (10% × –$20) = $10.50. You end up with the same expected return as the preceding proposition, but do you like it as much? Many people would not like that deal because they are looking at the dollar value of the loss rather than the risk. People who overreact to the risk of loss without considering the facts on hand are probably not going to be good traders.
Securities markets rely on the concept of limited liability. That is, you cannot lose any more money than you invested in the first place. If you buy a stock, that stock can go down to zero, but it can’t go any lower. If the company goes bankrupt, no one can come to you and ask you to cover the bills. On the other hand, the stock price can go up infinitely, so the possible return for your risk is huge. (At least as I write this, Apple and Amazon shares seem to have increased by something mighty close to infinity. Can they go up more? Who knows.)
Many day trading strategies are zero-sum games, meaning that for every winner on a trade, there is a loser. It’s especially true in options markets. Of course, the person on the other side of the trade may not mind being a loser; she may have entered into a trade to hedge (protect against a decline in) another investment and is happy to have a small loss instead of a much larger one.
The problem for you as a day trader is that a zero-sum game has little wiggle room. Every trade you make is going to win or lose, and your losses may exactly offset your winners. Beating the odds is even tougher when so many traders are using computer algorithms. Backtesting and tracking (see Chapter 15) are important for assessing your changing risk.
In addition to absolute measures of risk and liability, you also need to consider volatility. That’s how much a security’s price may go up or down in a given time period.
The math for measuring volatility is based on standard deviation. A standard deviation calculation starts with the average return over a given time period. That average is the expected return — the return that, on average, you’ll get if you stick with your trading strategy. But any given week, month, or year, the return may be very different from what you expect. The more likely you are to get what you expect, the less risk you take in the form of volatility.
Standard deviation is used to calculate another statistic: beta. Beta tells you how risky a security is relative to the risk of the market itself. If you buy a stock with a beta of more than 1, that stock is expected to go up in price by a larger percentage than the market when the market is up, and it’s expected to go down by a larger percentage than the market when the market is down.
When you take risk, you expect to get a return. That’s fair enough, right? That return comes in a few different forms related to the risk taken. Although you may not really care how you get your return as long as you get it, thinking about the breakdown of returns can help you think about your trading strategy and how it works for you.
The opportunity cost of your money is the return you could get doing something else. Is your choice day trading or staying at your current job? Your opportunity cost is your current salary and benefits. You’d give up that money if you quit to day trade. Is the opportunity cost low enough that it’s worth your while? It may be. Just because taking advantage of an opportunity carries a cost doesn’t mean that the opportunity isn’t worth it.
Here’s another way to think about opportunity cost. When you make one trade, you give up the opportunity to use that money for another trade. That means you only want to trade if you know that the trade is going to work out, more likely than not. That’s why you need to plan your trades (see Chapter 7) and backtest (run a simulation using your strategy and historic securities prices) and evaluate your performance (see Chapter 13). By doing these things, you know that you are trading for the right reasons and not just out of boredom.
The value of money changes over time. In most cases, this change is the result of inflation, which is the general increase in price levels in an economy. But the value of money also changes because you give up the use of money for some period of time. That’s why any investment or trading opportunity should include compensation for the time value of your money.
In day trading, your returns from the time value of money are small, because you only hold positions for a short period of time and close them out overnight. Still, there’s some time component to the money you make. That smallest return is known as the risk-free rate of return. That’s what you demand for giving up the use of your money, even if you know with certainty that you’ll get your money back. In practice, investors think of the risk-free rate of return as the rate on U.S. government treasury bills, which are bonds that mature in less than one year. This rate is widely quoted in The Wall Street Journal and electronic price-quote systems.
Economists say that there’s no such thing as a free lunch. Whatever return you get, you get because you took some risk and gave up another opportunity for your time and money. In that sense, there’s no secret to making money. It’s all about work and risk.
This concept is known as the risk-reward tradeoff. The greater the potential reward, the greater the amount of risk you’re expected to take and thus the greater potential you have for loss. But if you understand the risks you’re taking, you may well find that they’re worth it. That’s why you have to think about the risks and rewards up front.
The reason a balance exists between risk and reward is that markets are reasonably efficient. This efficiency means that prices reflect all known information about the companies and the economy and that all participants understand the relative tradeoffs available to them. Otherwise, you’d have opportunities to make a riskless profit, and that just won’t do, according to the average economist. “You can’t pluck nickels out of thin air,” they like to say. In an efficient market, if an opportunity exists to make money without risk, someone would have taken advantage of it already.
Here’s how market efficiency works: You have information that says that Company A is going to announce good earnings tomorrow, so you buy the stock. Your increased demand causes the price to go up, and pretty soon, the stock price is where it should be, given that the company is doing well. The information advantage is rapidly eliminated. In most cases, everyone gets the news — or hears the rumor — of the good earnings at the same time, so the price adjustment happens quickly.
The markets may be more or less efficient, but that doesn’t mean they work by magic. Price changes happen because people act on news, and the people who act the fastest are day traders. In the example, notice that it was the activity of traders that caused the price of Company A stock to go up to reflect the expected good earnings report.
In economic terms, arbitrage is a riskless profit. A hard-core believer in academic theory would say that arbitrage opportunities don’t exist. In practice, though, they do. Here’s how arbitrage works: Although Company A is expected to have a good earnings announcement tomorrow, you notice that the stock price has gone up faster than the price of a call option on Company A, even though premium should reflect the stock price. So you sell Company A (borrowing shares and selling it short if you have to) and then use the proceeds to buy the option. When the option price goes up to reflect the stock price, you can sell the option (that is, close out your short position) and lock in a riskless profit — at least, before your trading costs are considered. Chapter 10 discusses arbitrage in more detail.
Market efficiency isn’t perfect. It can take a while for people to make a logical decision about what an asset is worth, and until that happens, trading can be irrational and inefficient. Whether it’s Japanese stocks, Internet stocks, condominiums in Florida, or gold, the markets have pockets of craziness that defy rhyme and reason. In the short term, a wave of panic or euphoria can overtake the market during a single trading day, pushing prices into inefficient territory. On days like that, your ability to keep calm and steer into the trend, rather than getting swept up into an uncontrollable craze, will help you have more winning trades.
Day trading is a cousin to both investing and gambling, but it isn’t the same as either. Day trading involves quick reactions to the markets, not a long-term consideration of all the factors that can drive an investment. It works with odds in your favor, or at least that are even, rather than with odds that are against you.
Still, the three activities overlap. Many day traders also invest, and some came to trading after years of watching the markets as an investor. In addition, more than one day trader claims that good poker skills are useful for understanding market psychology, and many day traders can point to a winning trade that was made for no particular reason at all. To help you keep straight the differences between day trading, investing, and gambling, this section explains which is which so that you can better understand what you’re doing when you day trade. After all, you can increase your chances of success if you stick to the business at hand.
Investing is the process of putting money at risk in order to get a return. It’s the raw material of capitalism. It’s the way that businesses get started, roads get built, and explorations get financed. It’s how our economy matches people who have more money than they need, at least during part of their lives, with people who need it in order to grow society’s capabilities.
Investing is heady stuff. And it’s very much focused on the long term. Good investors do a lot of research before committing their money because they know that it will take a long time to see a payoff. That’s okay with them. Investors often invest in things that are out of favor, because they know that, with time, others will recognize the value and respond in kind. In the long run, investing is a positive-sum game; on average, investors will make money, the only question is how much.
What’s the difference between investing and saving? When you save, you take no risk. Your compensation is low; it’s just enough to cover the time value of money. Generally, the return on savings equals inflation and no more. In fact, a lot of banks pay a lot less than the inflation rate on a federally insured savings account, meaning that you’re paying the bank to use your money.
In contrast to investing, day trading moves fast. Day traders react only to what’s on the screen. There’s no time to do research, and the market is always right when you’re day trading. You don’t have two months or two years to wait for the fundamentals to work out and the rest of Wall Street to see how smart you were. You have today. And if you can’t live with that, you shouldn’t be day trading.
Trading is the act of buying and selling securities. All investors trade, because they need to buy and sell their investments. But to investors, trading is a rare transaction, and they get more value from finding a good opportunity, buying it cheap, and selling it at a much higher price sometime in the future. But traders are not investors.
Traders look to take advantage of short-term price discrepancies in the market. In general, they don’t take a lot of risk on each trade, so they don’t get a lot of return on each trade, either. Traders act quickly. They look at what the market is telling them and then respond. They know that many of their trades won’t work out, but as long as they measure proper risk versus reward, they’ll be okay. They don’t do a lot of in-depth research on the securities they trade, but they know the normal price and volume patterns well enough that they can recognize potential profit opportunities.
Trading keeps markets efficient because it creates the short-term supply and demand that eliminates small price discrepancies. It also creates a lot of stress for traders, who must react in the here and now. Traders give up the luxury of time in exchange for a quick profit.
A gambler puts up money in the hopes of a payoff if a random event occurs. The odds are always against the gambler and in favor of the house, but people like to gamble because they like to hope that, if they hit it lucky, their return will be as large as their loss is likely. It’s a zero-sum game with one big winner – the house – and a whole bunch of losers.
Some gamblers believe that the odds can be beaten, but they are wrong. (Certain card games are more games of skill than gambling, assuming you can find a casino that plays under standard rules. Yeah, you can count cards when playing blackjack with your friends, but doing so is a lot harder in a professionally run casino.) They get excited about the potential for a big win and get caught up in the glamour of the casino, and soon the odds go to work and drain away their stakes.
There is some evidence that day traders are gamblers. For example, in 2016, some researchers at the University of Adelaide published the paper “Day Traders in South Australia: Similarities and Differences with Traditional Gamblers.” They found that almost 91% of the day traders in their survey were also gamblers, and that 7.6% of those also had a problem with gambling, significantly higher than among people who were not day traders. The authors concluded that many day traders are actually gamblers who have added the financial markets to the games that they play.
When you know more about the risks, returns, and related activities of day trading, you can think more about how you’re going to run your day trading business. Before you flip through the book to find out how to get started, consider two more kinds of risk that you need to think about:
You need to understand and manage both in order to better manage the risks of the trading day.
Business risk is the uncertainty of the timing of your cash flow. Not every month of trading is going to be great, but your bills will come due no matter what. You’ll have to pay for subscriptions while keeping the lights turned on and the computer connected to the Internet. Taxes come due four times a year, and keyboards hold a mysterious attraction for carbonated beverages, causing them to short out at the most inopportune times.
Keep track of your business expenses and keep them as low as is reasonable. You should invest in your business, obviously, but only to the extent that you can pay your bills even if you have an off month in the market.
The personal risk of trading is that it becomes an obsession that crowds out everything else in your life. Trading is a stressful business, and the difference between those who succeed and those who fail is often psychological. You need to be on when you are trading and then, at the end of the trading day, close out the emotions the same way that you close out your positions. It’s not easy, so you need to have ways to manage your mood. Figure those out before you start trading, and you’ll be ahead of the game.
In fact, the personal risk is so great that I devote an entire chapter to managing it — Chapter 14. Go there if anything you have read in this chapter alarms you.