Chapter 2
IN THIS CHAPTER
Organizing your business
Planning trades to start your day
Making short-term and long-term choices
Raining clichés like cats and dogs
Taking a peek into the life of a day trader
Day trading is sometimes presented as a profitable hobby. Anyone who buys a day trading course via infomercial can make money easily in just a few hours a week, right? Well, no. Day trading is a job. It can be a full-time job or a part-time job, but it requires the same commitment to working regular hours and the same dedication to learning a craft and honing skills as any other job.
The best traders have plans for their business and 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 find themselves deviating from their plans at times, due to luck or circumstance or changing markets, but in those cases at least they understand why they are trying something else.
Here’s another reason for planning: Trading comes in many flavours, and many of those who call themselves day traders are actually doing other things with their money. If you know in advance what you want to do, you’ll be less likely to panic or follow fads. You’ll be in a better position to take advantage of opportunities in a way that suits your personality, trading skills, and goals. And that’s why this entire chapter is devoted to planning.
The day trader is an entrepreneur who has started a small business that trades in securities in hopes of making a return. You’ll get your business off to a good start if you have a plan for what you want to do and how you’re going to do it. That way, you know what your goals are and what you need to do to achieve them.
You can find a lot of sample business plans in books and on the Internet, but most of them are not appropriate for a trader. A typical business plan is designed not only to guide the business, but also to attract outside financing. Unless you’re going to take in partners or borrow money from an outside source, your day trading business plan is for you only. No executive summary and no pages of projections needed.
So what do you need instead? How about a list of your goals and a plan for what you will trade, what your hours will be, what equipment you’ll need, and how much to invest in the business?
The first thing you need in your plan is a list of your goals, both short term and long term. Here is a sample list to get you started:
Be as specific as possible when you think about what you want to do with your trading business, and don’t worry if your business goals overlap with your personal goals. When you’re in business for yourself, the two often mix.
There are so many different securities and derivatives that you can day trade! Sure, you want to trade anything that makes money for you, but what on earth is that? Each market has its own nuances, so if you flit from futures to forex (foreign exchange), you might be courting disaster. That’s another reason why you need a plan. If you know what markets you want to trade, you’ll have a better sense of what research services you’ll need, what ongoing training you might want to consider, and how to evaluate your performance.
Chapter 3 in Book 5 covers different asset classes and how day traders might use them in great detail. For now, Table 2-1 gives a little cheat sheet that covers those that are most popular with day traders. Think about your chosen markets in the same way: What do you want to trade, where will you trade it, what is the risk and return, and what are some of the characteristics that make this market attractive to you?
TABLE 2-1 Popular Things for Day Traders to Trade
Item |
Main Exchange |
Risk/Reward |
Characteristics |
---|---|---|---|
Stock index futures |
MX, CME |
Zero sum/leverage |
Benefits from movements of broad markets |
Treasury bond futures |
CBOT |
Zero sum/leverage |
Best way for day traders to play the bond market |
Foreign exchange |
OTC |
Zero sum/leverage |
Markets open all day, every day, except Sunday |
Commodities |
CBOT, CME |
Zero sum/leverage |
An agricultural market liquid enough for day traders |
Large-cap stocks |
TSX, NYSE |
Upward bias |
Good stocks for day trading, large and volatile |
Key: TSX = Toronto Stock Exchange, MX = Montreal Exchange, CME = Chicago Mercantile Exchange, CBOT = Chicago Board of Trade, OTC = Over the counter, NYSE = New York Stock Exchange
And what do zero sum, leverage, and upward bias mean?
The characteristics of the different markets and assets will affect both your business plan and your trading plan. The business plan should include information on what you will trade and why, as well as on what you hope to learn to trade in the future. The trading plan looks at what you want to trade each day and why, so that you can channel your efforts.
The markets are open more or less continuously. Although many exchanges have set trading hours, there are traders working after hours who are willing to sell if you want to buy. Some markets, such as foreign exchange, take only the briefest of breaks over the course of a week. This gives day traders incredible flexibility — no matter what hours and what days are best for you to trade, you can find something that works for you. If you are sharpest in the evenings, you might be better off trading Asian currencies, because those markets are active when you are. Of course, this can be a disadvantage, because no one is setting limits for you. Few markets are great places to trade every hour of every day.
If you want to, you can trade almost all the time. But you probably don’t want to. To keep your sanity, maintain your perspective, and have a life outside of your trading, you should set regular hours and stick to them. In your business plan, determine when you’re going to trade, how often you’re going to take a vacation, how many sick days you’ll give yourself, and how you’ll know to take a day off. One of the joys of self-employment is that you can take time off when you need to, so give yourself that little perk in your business plan.
Part of your business plan should cover where you work and what equipment you need. What can you afford now, and what is on your wish list? Do you have enough computing equipment, the right Internet connection, and a working filing system? This is part of your plan for getting your business underway, so put some thought into your infrastructure.
And yes, this is important. You don’t want to lose a day of trading because your computer has crashed, nor do you want to be stuck with an open position because your Internet service provider has a temporary outage. And you certainly don’t want to lose your concentration because you’re trying to work in the family room while other members of your household are playing video games.
You won’t have the time and money to do everything you want to do in your trading business, so part of your business plan should include a list of things that you want to add over time. A key part of that is continuous improvement: No matter how good a trader you are now, you can always be better. Furthermore, the markets are always changing. New products come to market, new trading regulations are passed, and new technologies appear. You will always need to absorb new things, and part of your business plan should consider that.
Ask yourself the following questions:
One component of your business plan should be a plan for revising it. Things are going to change. You may be more or less successful than you hope, market conditions may change on you, and you may simply find out more about how you trade best. That’s why you should set a plan for updating your business plan to reflect where you are and where you want to be as you go along. At least once a year, and more often if you feel the need for a change, go through your business plan and revise it to reflect where you are now. What are your new goals? What are your new investment plans? What are you doing right, and what needs to change?
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 to profit when the opportunities present themselves.
This section covers the components of trade planning. When you start trading, you’ll probably write notes to set up a trading plan for each day 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 might 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 is it that 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. (See the earlier section “Picking the markets.”)
You need to figure out which markets give you the best chance of getting a profit that day. It’s going to be different. Some days, no trades will be good for you in one market. If you’re too antsy for that, 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.)
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? This is 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 there things happening in your life that might 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 should influence how aggressively you want to trade and how much risk you want to take. 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.
Think about what people will be reacting to. Go through the newspapers and check the online 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, you want to determine how much you’re going to trade. The key considerations are the following:
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.
Some contracts, such as futures, have built-in leverage. As soon as you decide to trade them, you are borrowing money.
After you have those items detailed, you’re in good shape to get started for the day.
After you get insight into what the day might be like and how much money you want to allocate to the markets, your next step is to figure out when you will buy and when you will sell. Ah, but if that were easy, do you think we’d be writing a book on day trading? No.
Many traders rely on technical analysis, which involves looking at patterns in charts of the price and volume changes. Other traders look at news and price information as the market changes, rather than looking at price patterns. Still others care only about very short-term price discrepancies. 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.
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 when you’ve made enough money to compensate for your risk? No one answer to this question exists, because so much depends on market conditions and your trading style. In this section you get some guidelines that can help you determine what’s best for you, and you find definitions for all the different terms for profits you might come across.
Profits are discussed differently in different markets, and you may as well have the right lingo when you write your plan:
Pips: A pip is the smallest unit of currency that can be traded. In foreign exchange markets (forex), a pip is generally equal to one one-hundredth of a cent. If the value of the euro moves from $1.2934 to $1.2935, it has moved a pip.
Do not confuse a pip in the forex market with an investment scheme known as PIP, sometimes called People in Profit or Pure Investor. (The fraud also operates as HYIP, for High Yield Investment Program.) PIP has been promoted as a trading system with a guaranteed daily return, but it’s really a pyramid scheme that takes money from participants and returns little or nothing. You can get more information from the U.S. Securities and Exchange Commission’s website, www.sec.gov/divisions/enforce/primebank.shtml
.
Your profit goals can be sliced and diced a few different ways:
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’re making right now, regardless of what your longer-term goals are?
It’s a good idea to set a loss limit along with a profit goal.
Even traders who do not have a rule like that often set a limit on how much they will lose per trade. Other traders use computer programs to guide their buys and their sells, so they need to sell their positions automatically. Brokers make this easy by giving customers the choice of a stop order or a limit order to protect their positions.
A stop order, also known as a stop loss order, is an order to sell a security at the market price as soon as it hits a predetermined level. If you want to make sure you sell a block of stock when it falls below $30 per share, for example, you could enter a stop order at $30 (telling your broker “Sell Stop 30”). As soon as the stock hits $30 the broker sells it, even if the price goes to $29 or $31 before all the stock is sold.
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, higher than the specific price for a sell order. If you want to make sure you sell a block of stock when it reaches $30 per share, for example, you could enter a limit order at $30 (telling your broker “Sell Limit 30”). As soon as the stock hits $30, the broker sells it, 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. After all, no buyers are going to want to pay an above-market price just so you can get your order filled all the way!
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 reaches a given stop price. If you want to make sure you sell a block of stock when it falls below $30 per share, but you do not want to sell it if it starts to go back up, for example, you could enter a stop order at $29 — the price is usually set lower than your stop price — with a limit of $31 (telling your broker “Sell 29 Limit 31”). As soon as the stock hits $29, the broker sells it as long as the price stays under $31. If the price goes above $31, the order is no longer enforced. The price range where this order will be executed is very small. Stop limit orders aren’t typically used as a trading strategy, but it can come in handy if there’s a sudden drop in the market like we saw with the “flash crash” on May 6, 2010. On that day the market fell, for reasons not fully understood, by 600 points and then minutes later shot back up. A stop limit order would have prevented your stocks from selling.
Are you confused? Well, the differences may be confusing, but understanding them is important to helping you manage your risks. That’s why Table 2-2 and Table 2-3 are a handy breakout of the different types of orders.
TABLE 2-2 Different Types of Orders for Buying
Buy Orders |
Stop Order |
Limit Order |
Stop Limit Order |
---|---|---|---|
Order instructions |
Buy Stop 30 |
Buy Limit 30 |
Buy Stop 30 Limit 31 |
Market Price ($) |
Action after the stock hits $30 | ||
28.50 |
Buy |
Buy |
Buy |
29.00 |
Buy |
Buy |
Buy |
29.50 |
Buy |
Buy |
Buy |
30.00 |
Buy |
Buy |
Buy |
30.50 |
Buy |
Nothing |
Buy |
31.00 |
Buy |
Nothing |
Nothing |
31.50 |
Buy |
Nothing |
Nothing |
TABLE 2-3 Different Types of Orders for Selling
Sell Orders |
Stop Order |
Limit Order |
Stop Limit Order |
---|---|---|---|
Order Instructions |
Sell Stop 30 |
Sell Limit 30 |
Sell Stop 30 Limit 29 |
Market Price ($) |
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 |
Sell |
Sell |
Sell |
31.00 |
Sell |
Sell |
Sell |
31.50 |
Sell |
Sell |
Sell |
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’re going to day trade, you have to accept that you’ll 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.
But like all rules, the single-day rule can be broken and probably should be broken sometimes. This section covers a few longer-term trading strategies 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, whereas 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 it 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 could turn against you while you’re away from the markets.
Swing trading requires paying attention to some basic fundamentals and news flow. 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. This 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 have made a mistake. (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). It’s a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account. (Flip to Book 2 for more about stock investing and Book 3 for more about mutual fund investing.)
This section covers 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 you’ll come across in your trading career, along with our 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.
However, get too greedy 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 is also a good example of an obvious but tough-to-follow maxim. When are you crossing 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 might be headed for some trouble.
A bull market is one that charges ahead; a bear market is one that does poorly. Many people think they’re trading geniuses because they make money when the entire market is going up. It was easy to make money day trading just about any stock in 2009, when the market recovered from near economic collapse, but it wasn’t so easy the year before when the frighteningly out-of-control financial crisis began. It’s when the markets turn negative that those people who really understand trading and who know how to manage risk will be able to stay in until things get better, possibly even making nice profits along the way.
The corollary cliché for this is “Don’t confuse brains with a bull market.” When things are going well, watch out for overconfidence. It might be time to update your business and trading plans, but it’s not to time to cast them aside.
When you day trade, you need to make money fast. You don’t 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.
Given the short-term nature of the market, the short-term sentiment is going to trump long-term fundamentals. People trading today may be wrong about the direction of foreign exchange, interest rates, or share prices, but if you’re closing out your positions tonight, you need to work with the information in the market today.
Two problems exist with The trend is your friend. The first is that by the time you identify a trend, it may be over. Second, there are times when it makes sense to go against the herd, because you can collect when everyone else realizes their mistakes. This is where the psychology of trading comes into play. Are you a good enough judge of human behaviour 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 in order to gain an advantage in the markets. And despite such things as confidentiality agreements and insider-trading laws, many rumours turn out to be true.
These rumours are often attached to such news events as corporate earnings. For whatever reason — good news, analyst research, a popular product — traders might believe that the company will report good quarterly earnings per share. That’s the rumour. If you buy on the rumour, 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 rumour is bad, you want to do the opposite: sell on the rumour, and buy on the news.
The problem with Buy the rumour, sell the news is that rumours 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 it’s one of those rules that everyone talks about, whether or not they actually follow it.
A reminder: You need to cut your losses before they drag you down. No matter how much it hurts and no matter how much you believe you’re right, you need to close out a losing position and move on.
But the opposite 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 might on the downside. They’re likely to stick with a profit and see how high it goes before closing out a position.
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.