This chapters covers:
Why different personalities require different trading styles
The benefits of a flexible, active trading style
Different active trading approaches:
Day trading
Trend trading
Fading the gap
Trading based on technical analysis
Options trading
How to learn trading skills
Why trading must differ from gambling
How to develop a winning attitude
How to make trading fun
Every trader has his or her own style. How could it be otherwise?
Everyone’s personality is different, and everyone has a unique combination of strengths and limitations. Even people who excel at the same things don’t excel in the same way. Look at top athletes. Even within the same sport, some excel through superior strength, others through strategic thinking, and still others through sheer physical grace. They use their greatest talents to make up for other areas where they aren’t quite as strong.
Likewise, some of us are slow, others fast; some have a high tolerance for risk, while others want to feel secure. None of these traits is better than another; they just give us some limits to work within. And let’s face it—if we could do everything, we’d become so confused by our limitless choices that we’d never really be able to accomplish anything.
For example, when I was a kid, I loved to watch horses run. What if I had developed a life’s ambition to become a jockey? What if I’d decided that riding the winner to the finish was the only career for me?
That career choice would have created a big problem, because I was not a small kid. In fact, I was the opposite of small. By junior high, I was so tall that it would have been crystal clear that I had a snowball’s chance in hell of becoming a jockey. I kept growing and growing, eventually ending up at six-foot-five.
It would have taken me a while to accept the fact that I had a limitation that prevented me from doing something I wanted to do. But gradually I’d have learned to work with what I’d been given. As it was, I took up baseball, became a good pitcher, and have found lots of advantages in being a big guy.
Some people are cut out to be hypercaffeinated day-trading dynamos who make hundred of trades a day to capture tiny price movements. This isn’t my style, and I personally don’t think it’s the best or most profitable one—the commissions alone can kill you. Most people have no desire to make hundreds of trades a day, and most wouldn’t be any good at it anyway.
The point here is that we all have different personal styles—it’s just a matter of finding out what works for you.
How do you find your own trading style?
The way I found mine was the same way I’ve learned everything about trading: through trial and error. I don’t think there’s any other way to do it. You can read a hundred books (not a bad idea, anyway), but until you put what you’ve learned into practice, you won’t be able to see what makes you money and what doesn’t. As you read about the different trading styles below, don’t overanalyze them and try to predict what will work for you. It’s pretty hard to know until you’ve taken them for a few test drives.
Some traders stick to pretty much one single style, and others use two or more or really mix it up with many approaches. My style is an active one that’s mostly based on trends, but it’s flexible because I’m also willing to use any other available trading tool that makes me money. There’s no one approach that works all the time, and different things work at different times if you know how to use them.
These are some of the active trading styles and techniques I have in my toolbox and use often:
Day trading
Trend trading
Fading the gap up or gap down at market open
Technical analysis
Options trading
The more you understand all the trading techniques available for you to use, the more you’ll have to choose from, and the more flexible and intelligent a trader you’ll become.
What’s involved in each of these trading techniques, and what does each require of traders? First I’ll explain what they all have in common, and then I’ll describe their differences.
TRADER TALK Momentum (“momo”) is the strength (due to volume) of the buying or selling that’s causing a stock’s price to move. When a price movement has momentum behind it, the movement is more likely to continue in the same direction, at least in the short term.
TRADER TALK A stock’s volatility is the degree to which its price moves up and down. A highly volatile stock experiences large price fluctuations, while a more stable stock does not. A particular stock’s volatility can vary over time according to market and stock-specific conditions.
Trading is not about the fundamental value of the company, and it has little to do with the company’s true future prospects. In other words, it’s got almost nothing in common with investing. Instead, trading is about capitalizing on price movements that can be dramatic—the crowd goes wild!—but don’t much matter in the long term. All trading is about momentum—the big momo.
When a stock has momentum, it’s like a ball that’s been given a push: It’s going to roll for a while before it stops. How fast and how far the ball rolls, though, depends on many other things, like the surface it’s on (rough or smooth, inclined or flat), opposing forces (such as wind), and what kind of ball it is (fully inflated, soft, irregularly shaped, and so forth). When a stock is showing some momentum because lots of people are starting to buy it, you have to figure out the state of the market it’s moving in, whether there are opposing forces (upcoming resistance levels or flocks of short sellers ready to pounce because of the company’s bad long-term prospects), and what kind of stock it is (what sector, how strong a company, size of float).
TRADER TALK A stock’s float is the number of issued shares available for public trading. Because momentum depends on supply and demand, the size of a stock’s float can affect its potential for volatility. Stocks with relatively few outstanding shares can fairly easily encounter situations where demand far exceeds supply, thus creating a lot of momentum. For example, when a stock with only 8 million shares outstanding suddenly becomes popular, it can zoom up in price much faster than a stock with 800 million shares outstanding.
What creates momentum in a stock? Let’s think about upward momentum—rapidly increasing price with increased volume—and its basis in market psychology and basic economics. When lots more people want to buy the stock than want to sell it, the increased demand will be greater than the available supply. When demand overtakes supply, the price goes up because sellers realize they can ask for much more and get it as buyers compete with each other for shares. It’s a seller’s market. The price rises higher and higher until something happens to make it stop—the price reaches a level where no more buyers are willing to pay the price, sellers think it’s not going to get any better and they’d better clean up while they have the chance, or new information appears about the stock that makes its value decrease.
The same concept holds for downward momentum—rapidly decreasing price, also with increased volume—but in this case more people want to sell the stock than buy it. It’s like rats leaving a sinking ship—except that the leaving is what’s making the ship sink. There’s way too big a supply, nobody wants to buy, and sellers start lowering the price to get rid of shares. It’s like an overstock sale—it’s a buyer’s market. The price falls until the price reaches a level that’s so low no more sellers are willing to sell out, buyers think it’s a bargain that’s not going to get any better and is too good to pass up, or new information becomes available that increases the stock’s perceived value.
Increased demand to buy or sell also usually means increased volume: When there are more shares changing hands because of increased buying or selling, the volume (total number of shares traded) increases. And these two things—changing price and increased volume—have another effect, as well: They draw attention to the stock. When something is moving more than it usually does, people want to know why. They’ll take a look at it and try to figure out the reason. If they can find a reason, they may decide it’s a reason for them to buy or sell, too. If they can’t find a reason, they may decide it’s only a matter of time until the reason becomes obvious, and that once that happens, the price may move even more; in this case, they buy or sell because they want to be in or out of the stock at a good price when the news finally comes out.
TRADER TALK Volume (trading volume) means the number of shares of stock traded in a particular period of time. Volumes are tracked for individual stocks and also for entire stock exchanges.
Momentum can build and continue over minutes, hours, days, or weeks. The time frame of the momo a trader looks for determines that trader’s style. Let’s look at some examples.
TRADER TALK Although the term’s been used loosely to describe a lot of active trading styles, true day trading is hyperactive stock trading in which a trader can make hundreds of trades each day, attempting with each trade to capture extremely small price movements such as 0.1 to 0.3 dollars per share on stocks that are making momentum moves. A day trader often holds positions between a few minutes and a few hours. Most day traders routinely end the day “flat”—holding no stock positions, only cash.
TRADER TALK A scalp is a quick trade, lasting a few minutes, for a small profit.
True day traders live and die by intraday volatility. They look for little spurts of momo and try to jump in and out of stocks as they rise (or fall, if they’re shorting) to catch a little slice of the action—to get a scalp. And they do this many, many times a day—even hundreds of times. Day traders usually trade with a very large amount of capital—they have to, to make trading for such small percentage returns worthwhile. They figure that if they can capture little price movements enough times, at the end of the day all their scalps will add up to a worthwhile profit.
This can be a useful tool at times, and sometimes a trade that you thought would be longer-term turns into a scalp when you’ve got a small profit and realize you want out because the situation has changed. That’s fine. As a primary strategy, though, I don’t believe that pure day trading is a good way to make money over the long term. Few people succeed at it. The problem is that intraday volatility is so short-lived and changes direction so fast that you end up losing almost as much money as you make, and your trading commissions add up to be staggering. Also, each trade involves risking a huge amount of capital for an extremely small percentage return—a typical scalp could be worth as little as 0.1 percent and usually won’t be higher than 2 percent. This is a very high risk-to-benefit ratio. On top of everything else, pure day trading is really stressful. You need to have hair-trigger reflexes, and you have to be glued to the computer screen every minute you’re trading. To me, that’s not fun, and trading should be fun.
That’s just me, though. The pure day-trading style is perfectly suited to some people’s abilities and personalities, and I sincerely wish them the best. I also hope they stay at it, since by constantly buying and selling huge lots, they create volatility that I can trade on in other ways!
TRADER TALK Trend trading is a style of trading in which a trader identifies market trends, or patterns, that occur again and again. By knowing when a stock is likely to exhibit trend behavior, the trader can anticipate price movements and capitalize on them.
TRADER TALK Swing trading is a strategy that involves holding positions for fairly short periods of time, such as a day to a week, to profit from short-term price movements. Swing trading is really a subtype of trend trading that deals mainly with short-term trends but is much slower-paced than day trading.
My style is based primarily on trend trading.
Where a day trader tries to scalp fractions of dollars on ultrashort trades, usually for percentage returns ranging from 0.1 percent to 2 percent, the idea of trend trading is to net much bigger profits—5 percent to as much as 50 percent, or even more during a strong bull market—by holding the stock from hours to days or weeks.
Trend trading is a much more laid-back style than day trading (but then, what isn’t?). What trend trading requires is a lot of thought, planning, and attention to trends—recurring patterns—in the market. A trend is a pattern that’s repeated again and again in the market and can be relied on to reasonably anticipate the price movements of stocks in similar situations.
TRADER TALK A trend is a pattern that is repeated by different stocks and can be relied on to reasonably anticipate the price movements of similar stocks.
There are hundreds of different trends in the market. For example, one of the strongest trends is the earnings trend: Quarter after quarter, stocks with upcoming earnings announcements that are expected to be favorable begin, about two weeks prior to the scheduled announcement, to gradually rise in price. Other examples of recurring medium- to long-term trends are price runups before stock splits, price decreases after stock splits, runups before earnings announcements, runups before IPO spinoffs, price decreases immediately after IPO spinoffs, runups in stocks that are about to be added to major stock indexes, price decreases before IPO lockup expirations, and runups due to “window dressing.” (See Chapter 6 for a full discussion of different types of trends and how to look for them.)
I find trends in the market that occur over and over again, then use them to anticipate price movements in specific stocks and take positions in those stocks before the movements happen. Trends occur in both bear and bull markets. They won’t always be the same trends, because trends only last for a certain amount of time before they become well-known and lose strength (in this way they’re like fads: Once enough people have their Razor scooters, the mystique wears off, it’s not cool anymore, and the fad fades away), and because different trends are seen in bull markets and bear markets. Still, the stock market can never go for long without developing new habits and patterns that start to recur, and trading on a new trend will be just as profitable as trading on the old ones. That’s why trends are your friends!
Most of my money has been made playing trends.
RULES OF THE GAME Trends are your friends.
TRADER TALK A gap up is an opening stock price that is significantly higher than the previous day’s closing price. For the entire market, a gap up is when the market opens higher than it closed the previous day.
TRADER TALK A gap down is an opening stock price that is significantly lower than the previous day’s closing price. For the entire market, a gap down is when the market opens lower than it closed the previous day.
NASDAQ stocks often open at prices significantly higher or lower than their prices at market close the day before. A higher open is a gap up, and a lower open is a gap down. The open is followed by a period of volatility that lasts for around half an hour. During this volatility, the price usually moves a bit more in the same direction as the gap (upward after a gap up, downward after a gap down) and then reverses to close the gap—to return to near the previous day’s closing price. (It’s very rare, though not impossible, for a stock to gap up and then just keep on going up, or for it to gap down and continue to go down without a bounce.) On a gap-up day, the reversal downward to close the gap often ends in what will turn out to be the low of the day, and on a gap-down day, the reversal upward often ends in what will turn out to be the low of the day. The morning gap is a trend, but it’s a particularly predictable and resilient one. To some extent, it’s the result of a structural phenomenon, something built into the way the NASDAQ works.
What makes NASDAQ stocks gap up and down in the morning?
There are two facts responsible for the pattern of gaps followed by volatility. The first fact is premarket trading between 8:00 A.M. Eastern and the market’s open at 9:30 A.M. (during the premarket, only institutions and traders with premarket access can trade, and their activity can make the price of a stock rise or fall considerably). The second fact is that anyone with an online trading account can place overnight orders between the time the market closes (at 4:00 P.M. Eastern) and its reopening the next day. They can, and many do.
These overnight orders aren’t executed during the premarket. They all wait in a big pile for the market to open at nine-thirty. The market makers, whose job it is to fill them, can see whether there are more buy or sell orders. And a lot of the people who place overnight orders—the naive and foolish ones—place market orders instead of limit orders. (Never, ever place an overnight market order! This is one of the most brain-dead things you can do!) So when the regular market finally opens, that big, helpless pile of orders is lined up to be executed first thing. And the traders who placed them should be executed, too, and put out of their misery!
Never, ever, ever place an overnight market order! It’s the same as saying, Steal my money! Placing overnight market orders is one of the most foolish things a trader can do.
The whole situation plays out pretty predictably. Let’s say there are a lot more buy orders than sell orders. The market makers have every incentive to drive up the price in the premarket, so the stock opens with a gap up to begin with. Then the rush of pent-up demand drives the price up even more, and it’s driven up all the faster because of all those market orders just screaming to the sellers and market makers, Take advantage of me! Charge as much as you want, because there’s no limit to what I’ll pay for this stock! Besides the backed-up overnight orders, some clueless traders and investors inevitably see the price rising after the market opens and decide they need to jump in, too, driving the price up even further.
In the same way, if there are a lot more sell than buy orders, there’s a gap down and pent-up selling pressure drives the price down further, again all the faster because of the overnight market orders and by people who panic and sell when they see the price going down after market open.
Back to the gap up example: As market makers fill all those defenseless market buy orders, the price of the stock runs up until there aren’t any more orders left to fill; then, as soon as the buyers dry up, the price drops back down to some level either near the opening price or even below it, closing the gap, and everyone who bought on the way up sees their stock lose value immediately.
This happens almost every day.
So, how does the smart trader play the gaps up and down?
What works most days there’s a gap is to buy the gap down or sell or sell short (or sell and then sell short) the gap up. This technique is known as fading the gap because, by trading against it, traders make the price gap close or fade. Fading the gap means buying near the lowest point in the volatility after a gap down, with the expectation that the stock price will bounce right back up after all the sellers have been shaken out. Likewise, when there’s a gap up, you’ll sell short (or sell a stock you’ve been holding overnight) near the highest point in the volatility after the gap up, anticipating that the price will zing down again after all the backed-up buy orders have been filled.
Lots of traders do this every morning there’s a tradable gap, and it’s all some traders do. West Coasters can do it every day before they go to work. I fade the gap just about every day there is one, including gaps on stocks I’m holding long for other trend plays, which I sell on the gap up and later rebuy using the 10 A.M. rule to reestablish my positions. (The 10 A.M. rule is explained in Chapter 8.) If I’m short, I buy to cover on a gap up and reshort later.
Fading the gap has made me tons of extra money, and it’s good trading to take a profit that’s offered to you on a gap. In fact, I’d say it’s bad trading not to. This technique is quite fast-paced, though, so if you don’t have a direct-access broker and Level II quotes, it may not work well for you. Web-based brokers’ sites can be very slow during the first half hour or so of the trading day, especially during periods of high trading volume.
TRADER TALK Trading based on technical analysis (TA) relies on the study of price and volume charts and other market data to discover trends and significant price levels (technical indicators) that reveal probable future stock-price movements.
Just about any trading style relies to some degree on technical analysis, or TA, and every trader should know at least the TA basics. Technical analysis is a big part of research: By looking at historical price charts, you can see where a stock’s been, for how long, how it got there, and where it seems to be headed. Without this knowledge, you’d be flying blind.
Technical analysis is mainly about charts. There are also market indicators such as the Trading Index (TRIN) that tend to indicate whether the market is bullish or bearish. There’s a lot to learn about charting: how to find support and resistance (see Chapter 9); how to use trend lines and momentum indicators; how to tell if the market is overbought or oversold; candlesticks; and lots of patterns and configurations. Why isn’t analysis of charts just a lot of hocus-pocus, like reading tea leaves? It’s because lots of other people, including professional traders working for five-hundred-pound-gorilla enterprises like banks, mutual funds, and other institutional investors, are looking at the same charts, seeing the same patterns, and acting on them. The fact that a price of 27.0 is a resistance point for ARFF doesn’t mean that 27 is the most a share in the company can possibly be worth, based on a true and absolute valuation of the company performed by the magic of the market; it just means that that’s a price the stock couldn’t overcome before, so now everyone will have their eyes on 27 to see if ARFF can break through the level this time. For that reason, everyone will become cautious in their buying of ARFF as the price approaches 27.
In other words, there’s a lot of self-fulfilling prophecy in TA, but that’s the way the market works. It’s not about the real value of the company—no one really knows what that is. Instead, it’s all about how the game is played.
As I see it, there are two possible ways to handle TA. The first is to read books on the subject, such as Technical Analysis of Stock Trends by Robert D. Edwards and John F. McGee and Beyond Candlesticks by Steve Nison, and become a competent or even an expert chartist. It will definitely help your trading. (It would be a mistake to think TA is the be-all and end-all, though, because lots of other factors, such as news and nontechnical trends, come into stock and market behavior.) The other is to use teamwork: to find a trading buddy who is very good at TA and have that person handle the sophisticated chart analysis while you keep on top of news and nontechnical trends or perform some other useful service. I found a trading buddy, Tiny (don’t let the name fool you!), who’s a very talented technical analyst, and working together has turned out extremely well for both of us.
Except for the explanations of chart-based information you’ll find in later chapters, a full discussion of technical analysis would require an entire book of its own. Make learning the basics of technical analysis part of your trading education. It will really open your eyes.
TRADER TALK An option is a contract that gives the owner the right to buy or sell a specified amount of a stock or other security (for a stock, generally 100 shares) at a specified price until a specific expiration date. A call is an option to buy, and a put is an option to sell. On its expiration date, an option becomes worthless unless it’s been exercised.
TRADER TALK A naked call is a call position in which the person writing the call doesn’t own the number of shares of the underlying stock the call would require if exercised, or hasn’t deposited the amount of cash equal to the call’s exercise value.
A naked put is a put position in which the person writing the put doesn’t have a short position in the underlying stock of the size the put would require if exercised, and hasn’t deposited the amount of cash equal to the put’s exercise value.
WAXIE’S STREET SMARTS
Options are tradable securities. You don’t have to own shares in a stock to buy its options; instead of writing options contracts, just trade them. You can buy and sell them at a profit before the expiration date without having to exercise them.
Although options trading is a somewhat complicated topic all its own and can’t be covered in a book like this, it’s another extremely useful tool that I use all the time. One of its most important uses is to hedge risk. For example, if you hold a stock position that’s somewhat on the risky side, you may want to take an opposing position with options. Let’s say you’re holding Dream Big Software (RUNT) long for earnings. RUNT is expected to have good earnings, but the market has been sour and unsteady and could do a major tank job if there’s any bad economic news. You decide to hedge your risk by buying some puts on RUNT, which will make money if RUNT’s price goes down. This way, if RUNT goes up, you can sell the stock for a profit, and if RUNT goes down, you can sell the puts for a profit.
Don’t try trading options until you’ve educated yourself about how they’re priced and how they work. There are some important complexities to options. For example, if you don’t sell your options by their expiration date, they can expire worthless and you can lose all the money you put into them. Also, you have to be able to figure out the risk-to-reward ratio on your whole hedging strategy and to have a plan to exit both the stock and the options positions so that they don’t cancel each other out.
You can also buy options instead of stock, or in addition to stock, when you see a great trend-trading opportunity. While options are riskier than stocks, their potential reward is huge relative to that of stocks. A successful options play can bring in 50 percent, 100 percent or even more. Basically, the risk and potential reward on options are both much greater than on stocks. The best approach is to become a competent stock trader and then learn to trade options as a next step.
Some traders’ style is to trade only options. This is, uh, an option, but you’ll probably prefer to trade a lot of stocks, if possible, because stocks generally have more liquidity and are easier to trade, and also because some stocks don’t have options available. I think options are best used as a supplement to stock trading.
Learn about options. They won’t always be the answer, since they can be risky, but they can be enormously profitable when you need a hedge or see a solid trend-based opportunity.
These five trading styles are only a few of the choices you have to draw on. There are lots of others. For example, some traders trade many stocks, while others trade only one or two stocks, getting to know them so well that they can make good money by trading the same stock every day. I knew a trader who traded Exxon Mobil Corp. every day for years and made a living doing it. Some traders concentrate on large, high-volume stocks, while others focus on stocks of any size in whatever is the week’s hottest sector. Think of all these styles and ideas as useful tools, try them out, and see which ones work best for you. To help you think about some of the issues that may affect your style, take a look at Exercise I at the end of this chapter.
If you are new to online trading, the first steps you take in finding your style and learning to trade must be safe ones.
Before you start to trade with real money, you need to spend some time following stocks and learning to understand patterns, trends, and the quirks of individual stocks. The best way to do this is by trading on paper or in a simulated account on the Internet. This will help you gain experience and develop your trading style—and make beginners’ mistakes—without losing your capital.
Paper trading basically involves writing down in detail all the trades you would make, including the number of shares, entry price, and entry time. Be scrupulously honest about what you do and when—it does you no good to pretend that you really would have bought the stock five minutes earlier at a better price when in reality you wouldn’t have, or to leave a bad trade out when you calculate your account performance.
Even more realistic than paper trading is managing a simulated online account. For example, at www.trendfund.com, you can place virtual online stock trades and keep track of your performance almost like you would with a real online account. A site called www.investorfactory.com also offers a good online simulation game. Simulated accounts are great because they give you the opportunity to make exactly the same mistakes you’d make trading a real account online, and there’s no way you can fudge your performance to make yourself feel better. If you do well with your simulated account and start to feel bad that you weren’t using real money and making real profits during that time, stop feeling bad. If you’re really doing what you should, you’ll continue to do well when you start to trade with real money. The market isn’t going to go away. There will always be other stocks to trade. And it was just as likely that you would have made a horrendous blunder and lost half the money in your account—if this had happened, think of how glad you’d have been to lose only cybermoney!
Some basic resources to use as you start to learn about the markets are as follows:
www.trendfund.com: free real-time Level I quotes, trader education, current company and economic news, market updates and summaries—and, of course, Waxie!
www.freerealtime.com: free real-time Level I quotes and portfolio tracker
www.yahoo.com (Yahoo! Finance): detailed company and stock information, such as float and short interest
www.ragingbull.com: free real-time Level I quotes
www.quote.com: free real-time Level I quotes and streaming realtime daily charts
www.cbsmarketwatch.com: search engine to find news by stock ticker symbol
Exercise II at the end of this chapter will help you start to recognize market trends by monitoring and analyzing two stocks’ behavior over a week’s time.
While every successful trader’s style is unique, there is one style you won’t see in any of them: a gambling mentality.
Some people honestly think that trading, especially day trading, is gambling, and that for traders, the market is just a glorified online casino. Whoa there, cowboy! For successful traders, this could not be further from the truth.
Any business or financial venture involves fluctuation and risk. Everything from investing to something as down-home as buying the local ice-cream parlor involves financial risk—any time you put money into a venture, you could end up losing some or all of it. This has been true since the dawn of capitalism. The whole idea behind any legitimate business venture is to manage risk responsibly. More often than not, good money management is what separates winning from losing traders. (See Chapter 11 for a full discussion of money management.)
Gambling is not a legitimate business venture. If you have the money to lose, it’s recreation, and if you don’t, it’s either desperation or addiction. There’s no risk management involved; you just throw in your money and wait to see what happens, and what happens doesn’t depend on anything you do. It’s random chance.
Any trading approach that’s essentially gambling or is based on a gambling mentality can’t succeed. Honestly, a lot of people who call themselves investors are really involved in long-term gambling—as little as they know about the companies they invest in, and as unlikely as a ridiculously overpriced market is to keep going up for another five years, what else can you call it? If you believe that trading or investing is gambling, or if you’re simply planning to throw money at stocks without a well-thought-out strategy based on market behavior, you might as well just give your money to charity right now, because that way at least you’ll be giving it to someone who needs it. Trading involves planning, study, strategy, and limiting risk so that your risk-to-reward ratio is favorable on every trade. When the ratio isn’t good enough, you don’t make the trade.
I’ve heard people say that you have to expect to lose money while you’re learning to trade. Not! You should never, ever expect to lose money. Expecting to lose is a loser’s attitude. It makes it seem like it’s okay to lose. Instead, you should realize that trading is a percentage undertaking—not every trade will be a winner, but when a trade doesn’t work out, you should never lose big because you’ve limited your risk and taken the right steps to kept your capital safe (see Chapter 11 on money management). If you make more on your good trades than you lose on your bad trades, you’ll come out a winner.
It’s important to develop a winning attitude right from your first trade. Part of getting off to a good start is to be realistic, because if you have unrealistic expectations, you’ll feel like you’re losing even if you’re doing fine, and you’ll wind up taking unnecessary risks in an attempt to do the impossible—and, if you do extremely well on one trade, you’ll think all your trades have to be as good.
There are three Rules of the Game you always need to keep in mind to remain a winner. These three rules apply to any trading style or combination of styles:
1. It’s a marathon, not a sprint. Trading is not a get-rich-overnight scheme. It’s a way to make money by working at trading over a long period of time. You don’t want to burn up your capital in your first weeks by trying to make a million the first month. Think about marathon runners: They know they have to run for 26.2 miles, so they’d be idiots to start out at breakneck speed. If they did, they’d be burned out after the first five miles. Instead, they find a steady pace they know they can keep up for several hours, and in this way they make the distance. The same is true of trading. Your outlook has to be long-term. Otherwise, you’re going to make bad mistakes. If you feel like you have to double your money by next week, you probably shouldn’t be trading.
RULES OF THE GAME It’s a marathon, not a sprint.
2. No one makes money every day. No real trader in the history of the markets has made money every day. If anyone tells you they do, they’re lying! It’s just not the way trading works, and there’s no reason it has to. Thinking you have to make money every day is like thinking you have to win on every trade—it’s insane, and it will make you do desperate, foolish things to try to meet unrealistic expectations. You don’t need to make money every day. If you trade well, you’ll make lots of solid trades and occasional monster profits—and over time, your account will grow into a beautiful thing.
RULES OF THE GAME No one makes money every day.
3. Swing for singles, not home runs. The key to good trading is to plan solid trades that have a good probability of doing well—a good risk-to-reward ratio. If they work well enough to keep you profitable, you’re doing exactly what you should be doing. If they sometimes exceed your expectations, that’s a bonus. Professional baseball players don’t try to hit home runs every time they’re at bat. They know that most of the time it’s much smarter to go for a safe hit that will get them to first base and advance other runners, rather than try for a homer and risk hitting a fly ball that will be caught and put them out. That’s exactly what it’s like in trading. Always aim for a solid but modest return, and gratefully take more when it comes to you. Just because you aim for singles doesn’t mean you have to limit yourself to small gains if the stock goes wild; it’s just a matter of controlling your expectations. If you hold on to a trade too long, trying to force it to return more than it’s safe to expect, you’ll take on too much risk and end up worse off than if you’d just cashed out with a modest profit. Anyway, four modest profits of, say, 5 percent, 3 percent, 4 percent, and 8 percent will add up to the same return as one trade returning 20 percent—even more if you’re allowing your account to compound—and are probably much safer plays.
RULES OF THE GAME Swing for singles, not the fences—and often you’ll hit home runs anyway.
Whatever your trading style turns out to be, there’s one thing that’s got to be part of it, and that’s having a good time. Trading can mean sitting by yourself with a computer for many hours a day, so you need to be creative and not let yourself stay too serious all the time.
Amuse yourself. Talk back to the market and to CNBC, and tell them what’s what. Do a happy dance when a trade goes well. Do an ecstatic dance when it’s fantastic. Chat online with other traders, joke around, and spread the knowledge and the love.
My morning ritual helps me keep it fun. When I trade, I go into battle as a lean, mean street-fighting ninja. First I put on my black socks and black underwear. Black is the color of the ninja. Then I swallow my green juice, a concoction of thirty-nine greens mixed with water. It’s got a mean smell and a wicked taste, and it gives me strength for the day’s battle. Two large glasses of carrot-beet juice stand at the ready. It may be magenta, but it’s the fuel the ninja needs. Now I’m ready for battle. Bring it on!
RULES OF THE GAME Make trading fun.
I. Comfort level with quick entries and exits and short holding periods
Think about the following questions:
a. Can you make snap decisions comfortably?
b. When you make snap decisions, are they good ones?
c. Can you change your mind quickly if a decision starts to look like a bad one, or do you get stubborn about being right?
d. When you change your mind, can you act on your new strategy quickly?
e. Do you have a fast Internet connection?
f. Do you have a trading account with a high-quality direct-access broker?
g. Does the idea of holding stocks for only a few minutes and doing this fifty to over a hundred times a day seem fun and challenging, or would it drive you crazy?
h. Do you enjoy video games?
i. Does the idea of holding stocks for only a day, a few days, or a week seem appealing, or would it make you feel insane?
j. Does the idea of holding stocks for a few days to a few weeks, and occasionally longer, seem enticing, or would it drive you mad?
II. Stock monitoring for newbies
An important part of trading is getting to know the market and stocks intimately. The approach that works best is to get to know one area very well instead of trying to learn everything about every type of market. For example, you may wish to concentrate only on NASDAQ stocks, and only on those in sectors related to computer technology and biotechnology. These stocks have been volatile in recent years, and volatility generally makes for good trading. If you’re aware of other hot sectors, they may be worth getting to know.
To become more familiar with the market, do the following exercise. Choose two NASDAQ stocks in different sectors. (Computer technology and Internet sectors include semiconductor manufacturers, wireless-technology companies, broadband-delivery companies, Internet service providers, Internet portals, fiber-optic networking companies, software manufacturers, and Internet incubators; biotechnology sectors include genetic-engineering companies, genetic-information providers, and stem-cell technology companies.) Make sure that one has a large float (over 500 million) and the other has a small float (under 20 million). Find out what the two companies are in the business of doing, in ten words or less. Identify the other stocks in their sectors.
Look at historical data on both stocks to see their all-time high and low prices, and look at their one-month, three-month, and oneyear charts. Where have they been, and where do they seem to be going? Has their volume recently become heavier or lighter, or has it stayed the same? Is the volume pattern in keeping with volume trends in the NASDAQ as a whole?
Now, every day for a week, track both stocks carefully and see how they behave from day to day. If you have Level II, find the “ax” (see Chapter 4) and watch what it’s up to. Look at real-time one-minute charts each day, and look at five-day charts to see how the stock’s behavior today compares with its behavior during the past few days. Check for company news. How does each stock react to company news? To news about other companies in its sector? To general economic news or Federal Reserve actions? How closely does it follow the general direction of the NASDAQ? How does it behave compared with other stocks in its sector? Keep detailed notes on the stock’s behavior. What is the stock’s typical daily volume? Is it five thousand, five hundred thousand, or five million? If there’s a big surge in price or volume, can you find the cause?
At the end of the week, you should start to develop a feel for two things: how a single stock behaves and how one stock’s behavior differs from another’s. When you start to trade, you’ll want to be closely attuned to the behavior of stocks so that you can decide when a change is significant and when it’s just a hiccup that doesn’t mean anything important.