eBook
Available on Compatible NOOK devices, the free NOOK App and in My Digital Library.
Related collections and offers
Overview
Product Details
| ISBN-13: | 9780470475553 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 12/16/2008 |
| Series: | Wiley Trading , #436 |
| Sold by: | JOHN WILEY & SONS |
| Format: | eBook |
| Pages: | 208 |
| File size: | 801 KB |
About the Author
MARK R. SOBOL is the founding principal of Leadership Strategies International, Inc. and is part of A4SL Coaching and Consulting.
PHIL HARKINS is president, CEO, and chairman of the board of directors of Linkage, Inc., the company that he founded in 1988.
TERENCE CONLEY is executive vice president of human resources and corporate services for Cendant Corporation.
LINKAGE, INC. is a global organizational development company that specializes in leadership development. Linkage provides clients around the world with customized leadership development and strategic change solutions that include and integrate consulting, training, assessment, coaching, and benchmark research. Linkage also offers a full range of conferences, institutes, summits, public workshops, and distance learning programs on leading-edge topics in leadership, management, HR, and OD.
Read an Excerpt
Chapter One
The Baptism by Fire
Preparing the Uninitiated
for Their First Trade
Do you want to get your head handed to you on a platter? Do you want to get your eyes ripped right out of your skull? Unfortunately, that is the inevitable fate of too many first time traders. Why? Because they make the classic mistake of thinking day trading is that easy. It is not. The market is like a wild beast. Sometimes the beast is asleep, and sometimes it is awake. Regardless, you must have a respect for its power, because the beast doesn't care about you, your money, or your livelihood. Yet the only way to make a living buying and selling stocks is to fight this beast, head to head, nose to nose. If you want to be a day trader, that is what you must do. But everything you have ever learned about investing won't help you now. The short term is an entirely different world, on a different planet, with different rules. The people who excel here are a rare breed, and the way they make their money may surprise you. Second to second, minute to minute, this is a battle. And when there is a battle, there are casualties. Who will prevail? The one who is best prepared; the one who knows the risks; the one who knows when to fight and when to run.
It is often said that the market will humble those who do not respect its power. There are many day traders who enter the financial arena for the first time without having any respect for or real understanding of the system or of the risks that are involved. These people will only last so longbefore the market inevitably crushes them. Before you risk even a single penny of your trading capital, you must understand what you are getting yourself into. Good day traders can make literally tens of thousands of dollars in a single day. But any time you can make that kind of money, there is also the chance, however slight, that you can lose that kind of money as well. Most likely, this will not happen, but if you let your guard down, beware! You have to proceed cautiously. With that in mind, I will do everything possible in this book to make sure you are properly prepared before you make your first trade. And when you do finally "pull the trigger" for the first time, it is my hope that this book will have given you everything you need to successfully compete in the world of stock trading.
Figure 1.1 is a picture of my computer screen on a typical trading day. What do you see here? What can you make of this chaos? To the uninitiated, this is like an alien world, where the inhabitants speak a different language. But to the day trader, this screen is a bird's-eye view of a battlefield—of a war. And it is a war filled with opportunities, filled with emotion, filled with danger. Fear and greed. Risk and reward. What are they fighting over? Over gold, over wealth. But who is fighting whom? You can't see the players; you don't know who they are. All you see are numbers. But you know a struggle is going on. Fortunes are won and lost every single second of every single day, throughout Wall Street and throughout the world, on battlefields just like this one. And, to the well-trained day trader, this battlefield has within it extraordinary opportunities for profit if you know what to look for. When you are finished with this book, you will know exactly what I'm talking about. You will also know precisely how to take this information and profit from it.
What is the key to making a living as a day trader? To answer this question, you have to look to Wall Street for answers. Wall Street is better at the business of making money than any other industry in the world. Look at the large brokerage firms, banks, and trading firms. How do they make their money? What is it they do to generate billions of dollars per year in profits by trading stocks? Where is the money coming from? I will devote a good portion of the next few chapters to answering these questions. Why is this important? Because as a day trader, you are doing the exact same thing with your money as Wall Street does with its money. Understanding how the system works is the first step in seeing how to exploit it for profit. And exploiting the system is the only way it is possible to make a living as a day trader.
Once you get a little insight into how Wall Street works, we will then formulate a specific strategy on understanding how stocks actually trade. The emphasis in the beginning is on the inherent disadvantages that face the day trader who trades over the Internet. We will spend a good deal of time on the mechanics of the market maker systern, the specialist, and the bid-ask spread. This will lay the groundwork for formulating the differences between trading New York Stock Exchange (NYSE) stocks and National Association of Securities Dealers Automated Quotation (NASDAQ) stocks.
Finally, we will get down to the task at hand: day trading. I will use a conservative approach, starting with low-volatility stocks like utilities and closed-end funds, before venturing into the volatile, high-risk, high-reward domain of the Dow stocks, technology stocks, and other momentum plays. This way, you will become acquainted with the principles of day trading in areas that are safer, instead of jumping headfirst into the volatile sectors of the market.
When you finish with the book, you will see that day trading is far different than you first thought it was. It really doesn't have anything to do with the kind of investing you see, hear, and read about in the media. Surprisingly, you really don't need to know the markets that well, and you certainly don't have to spend hours doing research and studying charts. But that is what makes day trading so interesting. To be honest, I find the economics of the market to be a blt dry. The mechanics of trading, however, are far from dry. Day trading is a dynamic and vibrant phenomenon. That is what makes me look forward to getting up every morning.
Chapter Two
The Golden Age of
Internet Day Trading
The markets were going haywire that day. With the click of a mouse, I sold. The fill report came back. I breathed a sigh of relief. I was out. Five thousand shares sold at 8. A $4,000 profit in only 18 minutes. This was my best trade ever: I had never made this much money this quickly in my life. Finally, l had hit a home run. And there was no need to press my luck. I didn't want to trade for the rest of the day I turned off my computer and got out my golf clubs. My workday was over. It was 9:48 A.M.
We live in a very special time. The Internet has changed the way we work, live, and interact. The flow of information is faster today than at any time in the history of the world. And nowhere is it faster than in the financial markets. The stock market of today is a far different place than the stock market of five years ago. We are witness to a revolution in the world of finance that began only a short time ago. The general public is fascinated with the stock market. As a society, we can't seem to get enough: The sheer numbers of financial Web sites, online trading firms, and news shows devoted to the markets stand as testament to this. Over the last few years, the bull market in stocks has made investing a dinnertime topic in many middle-class households for the first time. The investing obsession is now forever ingrained in mainstream America. And the Internet has played a huge role. The result is that the individual investor is much more educated today than ever before. The necessity of depending on stockbrokers for advice and information is fast becoming a thing of the past. More and more each day, people are taking financial matters into their own hands. And, while the old paradigm is fading into the background, a new breed of speculator has emerged: the online day trader.
This is the backdrop for the explosion in online trading that has occurred in the last two years. There are now over 80 online brokerage firms competing for the 5 million individual accounts that now trade actively over the Internet. By the year 2000, it is estimated that that figure will have grown to over 10 million online accounts.
In many regards, this is a golden age for Internet day trading. In today's world, conditions are ideal for the day trader. Low commissions, a fair regulatory environment, and technology that allows someone in Alaska to have the same split-second financial information as a trader on the floor of the New York Stock Exchange are but a few of the reasons. Thanks to the Internet, information travels so quickly and efficiently that the day trader can witness and react to tiny, second-to-second price fluctuations in stocks that in the old days would go unnoticed. This enables day traders to make quick 1/16-, 1/8-, and 1/4-point profits in less time than it takes to make a phone call, allowing them to capitalize on opportunities created by markets that can change drastically in just a few seconds.
It has not always been this way. For decades, the world of stock trading was dominated by a select few on Wall Street. The best and most profitable traders all held seats on the New York Stock Exchange. In the past, this was a necessity. These insiders had a virtual monopoly on financial information. Markets moved too fast for those who did not have the same access to quick trades and timely information that the floor traders had. If you were not on the floor of the exchange, you were on the outside, plain and simple. To make matters worse, only a privileged few could afford the high price of owning a seat. Day trading required a tremendous amount of money and resources just to compete. And the playing field was not level. The individual investor did not stand a chance in this environment. That is why, back then, the idea of the individual day trader competing on the same field with the Wall Street giants was unheard of.
In those days, the high commissions alone prevented most individuals from doing any stock trading. There was no such thing as discount brokers: Full-service brokerage firms were the only means for the individual to invest. If you bought 1,000 shares of a stock, you might pay a few dollars per share for the order. Imagine buying 1,000 shares of IBM and paying a $2,000 commission! The stock would have to move several points just to break even. And that doesn't count the commission you'd pay on the way out as well. There was simply no way to trade under these circumstances. If you were in the market, you had to have a long-term perspective. That was the only way.
But times have changed. Thanks to online trading, day trading is now feasible for those with limited resources and a small amount of trading capital. The individual trading from home now has access to the same profits the Wall Street brokerage firms have been making for decades. And the day trader is not at a real disadvantage for being at home. Online orders can be executed in as fast as one second and cost as little as $5. By monitoring a real-time quote screen, the active day trader can literally make a living on the same small profits—1/4s, 1/8s, and even 1/16s—that make the large trading firms millions of dollars per year.
But that does not tell the whole story. Though Internet day traders have advantages today that they have never before had in trading, they are still at a slight disadvantage compared to the "real" players in the marketplace, namely the market makers and the specialists. The Internet day trader is on the outside, not the inside. Successful day trading requires an acceptance of this reality. To make a living trading, you have to gear your whole strategy around this fact. This will become clear as you get further into the book.
The trading strategies outlined in this book encompass a wide area of the universe of stock speculation. With this in mind, I am reminded that the financial world is vast. This book will touch on many subjects, each important in its own right. I write from experience, and I only write about things that I think will affect your bottom line—trading profits. Along the way, your understanding of how the game really works will deepen tremendously. You must be patient and give yourself time to understand these concepts. To the beginner, they are not easy. But they will come with time. And the better you understand them, the more profitable you will become.
Here is a summary of the major themes of the book:
1. In the short term, the stock market is inefficient, irrational, and imperfect. The system is flawed and can be exploited for quick profits.
2. Wall Street earns its profits at the expense of the investing public, by trading against its customers.
3. Day traders earn their profits at the expense of Wall Street, by beating it at its own game.
4. The system is flawed because in stock trading, as in a casino, the odds are always with the house. Over the long term, the house always wins.
5. The house in this case is the Wall Street firms who control the trading in stocks. The house always wins because of a mechanism called the bid-ask spread.
6. Because of the bid-ask spread, it is very difficult for day traders to be consistently profitable by betting against the house—trading against the Wall Street firms.
7. Day traders should only trade when they have an edge, when the odds are in their favor. And the only time the odds are truly in their favor is when they trade with the house, by being on the same side of the trade as the Wall Street firms. This is called exploiting the bid-ask spread, and it is the way day traders take food out of Wall Streeters' mouths.
8. Unlike the casino, the New York Stock Exchange has rules in place that allow individual traders to bet with the house. This gives traders the same edge and access to profits that the Wall Street has always had. This is buying on the bid and selling on the ask. The investing public is generally not aware that these rules exist. The public's ignorance of this rule is the key to the day traders' profits.
9. By exploiting the bid-ask spread, day traders are able to make consistent, low-risk profits even in stocks that don't move. The stock does not have to go up or down for day traders to make money.
10. The fact that day traders can make money in stocks that don't move means they don't have to trade volatile stocks to make a living. They can make just as much money trading slow-moving stocks such as closed-end funds, utilities, and real estate investment trusts.
11. In NASDAQ, the market makers have a huge advantage over the Internet day traders. Thus, trading NASDAQ stocks requires a slightly different strategy.
12. The online brokers are in the business, directly or indirectly, of trading against their customers. That is why the trades are so cheap. This further amplifies the fact that the house always wins.
So how do you trade with the house? A major portion of this book will be devoted to answering that question.
THE HOUSE EDGE
The basic premise of day trading is that you are attempting to make a living by profiting off tiny inefficiencies in the stock market. In layman's terms, this means buying stocks and reselling them to someone else at a higher price. The best trades are the ones where you resell the stock for a profit seconds after you buy it. So how is this possible? The markets do not give away money. Especially not to the day trader. It's because the markets are inefficient and the system can be exploited for profit. It's that simple.
Day trading is a zero-sum game. The profits you make come directly at the expense of someone else. Sometimes it's at the expense of the market makers, sometimes at the expense of the investing public. Nonetheless, if you know what to look for, the profits are there for the taking—and if you don't take them, someone else will.
Day trading, like many other lucrative professions, is an extremely competitive business. The profits certainly don't come easy. The only way to prosper in this environment is to have an edge in the marketplace. But the system does not give you the edge. So the only way to gain the edge is to exploit the system in some way. Without an edge, you don't stand a chance.
Let's draw an analogy to the casinos. In 1996, over 30 million people visited the casinos in Las Vegas, leaving behind over $2 billion of their hard-earned money. How did this happen? The casinos did not steal the money. It's because of something called the house edge, a slight and virtually invisible statistical advantage the casino has over its gambling guests. Every single transaction the casino engages in is the end result of exhaustive mathematical research to determine if the risk the house is taking is justified. Not a single penny of the casino's capital will be risked unless the odds are in the house's favor.
The key to success is that the casino doesn't get greedy. Its owners are perfectly content with paying out a majority of their profits and only keeping a small percentage for themselves. They do not do this because they like to give their money away. They just know that if you stay at the blackjack table long enough, chances are you will leave with less money than you came with. Over time, this house edge will destroy even the best recreational gambler.
But as strong as the house edge is, there are some people who have devised ways to overcome it. If you ask the pit bosses who poses the biggest threat to the casinos' earnings, they would all undoubtedly say that card counters are among the most dangerous. This is because these blackjack hustlers beat the casinos at their own game. They do this by raising their bets as the odds tip in their favor. By counting cards, a player is able to gain a slight statistical advantage over the dealer in predicting which cards will be dealt next. This edge becomes more exaggerated and more profitable the longer the gambler stays at the tables. There are numerous people who make a living by doing this. These are the true professional gamblers.
The only problem with this line of work is that the casinos prohibit card counting. The casino managers are not stupid. They are not about to give their hard-earned money away to people they consider card cheats. In fact, Las Vegas spends millions of dollars per year to protect itself from these "parasites." Consistently profitable blackjack players will last only so long at the tables before the casinos pull the plug. Well-known professional card counters can't even set foot in the large casinos without being asked to leave. Many have to resort to disguises just to go unrecognized long enough the make their profits. They are the most despised people in the gaming industry. It's funny how the casinos devote so much energy to preventing a practice that can essentially be taught and used by anyone sitting at the blackjack tables.
Yet these are the same casinos that welcome you and me with open arms. Every single service the Las Vegas casinos provide is aimed at keeping you at the tables. From the free drinks to the 24-hour room service to the fresh air that is pumped into the gaming rooms, you are made to feel as comfortable as possible. The casino is open 24 hours a day, but you can't find a clock anywhere. That way you are unaware of the time you have spent on the tables. This all revolves around the premise that, unless you have an edge, the longer you gamble, the less likely you are to win. The Las Vegas skyline was built with the hardearned money people like you and me have left behind at its tables.
There is another industry where the edge is more subtle and less understood, but produces the same results—Wall Street. Did you ever wonder how Wall Street is able to make so much money year after year? Whether or not the great financial institutions would like to admit it, and whether or not the general public is aware it is happening, the Wall Street brokerage firms do to the individual investor exactly what the Las Vegas casinos do to their gambling patrons. In the gaming world, the house edge is probability. In the world of investing, the edge is known as the bid-ask spread. In the financial markets, the effects of the house edge are more dangerous. These forces go unseen, unfelt, and undetected by the ordinary investor, especially in a bull market where the feeling is that everyone is making money. But the house edge has always been there. While the casinos deal in craps, roulette, and blackjack, Wall Street deals in stocks, bonds, and commodities.
In many ways, the successful day trader carries the same persona on Wall Street as the blackjack hustler does in Las Vegas. Day traders' profits are made by exploiting the system. The system they exploit is controlled by forces much more powerful than the individual trading over the Internet. The Wall Street establishment that sets the odds does not take kindly to the intrusion of the day trader. As the casinos will do anything and everything possible to destroy the card counters, so will the Wall Street market makers do all in their power to prevent the day trader from being profitable, because the profits the day trader makes come directly out of the market maker's pocket. Like the unpopular guest sitting at the poker table with a weak hand, you must recognize that, as a day trader, the odds are inherently against you and there are many people who will revel in your failure. The key to profitable day trading is to recognize this fact, and, like the card counter in blackjack, to trade only when the odds are in your favor.
The great thing is that throughout the trading day there are an infinite number of times when the odds are in your favor. In the short term, the markets are irrational and incredibly inefficient. The markets are moved by fear and greed. This creates a tremendous opportunity for quick profits, if you know what to look for. The secret to success is to take the clues the market gives you and use them to interpret the intentions of the other players. With the odds in your favor, you can beat the players at their own game. To do this, you need to understand the components of Wall Street's version of the house edge, known as the bid-ask spread.
THE BID-ASK SPREAD
I remember the first time I ever visited Wall Street as a child. I recall feeling awestruck by the sense of wealth and power: I could feel it in the air. Did you ever wonder how this wealth is created? How do the large trading firms afford to pay the rent on those high-rise buildings in New York's financial district, which is some of the most expensive corporate real estate in the country? How do they afford to pay their top traders multimillion-dollar salaries? The money is earned at the expense of the investing public. As you know, the essence of the stock market is a difference of opinion. For every buyer, there is a seller. The large banks and brokerage firms make a sizable percentage of their profits by taking the other side of customer orders. When the customer buys, one of these financial institutions is usually on the other side of the trade. The key is that, like a used car dealership buying and selling cars, the trading firms buy low and sell high, skimming a few cents per share on the trade. Contrary to popular belief, Wall Street does not make its money by hitting home runs on huge one-time gains. Like the casinos, it makes its money on small, consistent profits of 1/16-, 1/8-, and 1/4-point gains. This is done through the market maker system and the mechanism known as the bid-ask spread.
The market maker system is the glue that holds the financial markets together. Basically, the market makers are the intermediaries in the buying and selling of stocks. On the New York Stock Exchange and the American Stock Exchange (AMEX), market makers are known as specialists. Each individual stock has one specialist who is its sole market maker. On NASDAQ, the market makers are the numerous firms that trade in the stock. There are several market makers for each individual NASDAQ stock. The various exchanges have slightly different methods, rules, and systems for trading stocks, but the underlying principles are inherently the same. The role of the market makers is to maintain an orderly market.
The recent high-profile merger between the AMEX and NASDAQ exchanges will undoubtedly bring certain changes in the rules that govern the trading of stocks on those exchanges. For the purposes of this book, we will assume that the traditional trading rules specific to each exchange are still in place, because it would be impossible to speculate with accuracy as to what those changes will be in the future.
When it is said that specialists make a market, it simply means that at all times and under all circumstances they are both buyers and sellers of the stocks they trade. There is always a price at which specialists will buy stock from the public and sell stock to the public. They are always risking their own money to take the other side of your trade. If you want to buy 1,000 shares, the specialist will sell you 1,000 shares from his or her own account. If you want to se!l, the specialist will be there to buy the stock from you, assuming there is no one else in the market. This is another way of saying that he or she is adding liquidity to the market by buying when there are no buyers and selling when there are no sellers. The specialist does this by keeping an inventory in the stock. This is essential to ensuring that stocks can trade freely.
But there is a catch. Specialists do not provide this service for free. The price at which a specialist sells stock to you is always going to be higher than the price at which he or she buys it from you. Consider this a price markup for maintaining an inventory in the stock. This markup is what enables specialists to skim the 1/16s, 1/8s, and 1/4s all day from the order flow. The more trading volume, the more money they make. So how is this legal? It is very simple. The specialists are risking their own capital by maintaining an orderly market, and as such, are exposing themselves to a substantial amount of risk. The risk they take is what justifies the compensation they receive. Imagine being forced to buy stock during a time when large mutual funds are dumping the stock. This is like trying to catch a falling knife. Even worse, imagine having to sell stock to fill an influx of buy orders on a stock that is going through the roof. Either case could easily steamroll the market makers, leading to huge trading losses.
Acting as a market maker is a very risky and dangerous job. Yet, most of the time, the trading firms involved in this part of the business are able to make huge profits. How is this possible? Through the bid-ask spread. As we said, to maintain an orderly market, the market makers must always make a market in the stock they are assigned to, by setting a price at which they will both buy stock and sell stock simultaneously, even if they don't want to do either. Obviously, they will buy cheaper than they will sell. This is called keeping a two-sided market. The market makers are risking their trading capital to ensure that investors will always receive a fair execution, buy or sell. This guarantees that, so long as customers do not put limits on their prices, at some price their orders will be executed. The specialist system is the grease that keeps the stock market running smoothly. When the markets are quiet, this does not seem like such a big deal. It is when the markets are volatile that the market makers really earn their paychecks.
As we said, market makers do not provide this service for free. They must be compensated for the risk they take. For this reason, they are not expected to simultaneously buy stock from the public and resell stock to the public at the same price. It is simply too risky to expect this. Why would anyone risk his or her own capital not to make any money? Capitalism doesn't work that way. Thus, market makers are allowed to maintain a spread in the stock. This means that the price at which they will buy from the public is always going to be slightly lower than the price at which they will sell stock to investors. This is no different than the used car dealer who buys a vehicle for $5,000 on a trade-in and resells the same vehicle for $6,000. The $1,000 profit is the dealer's "cost of carry" for the risk of taking on inventory. There is no guarantee that the dealer will be able to resell the car, so the profit is justified. Instead of a car, the market maker will buy IBM at 105 and sell it at 105 1/8. The buying price is known as the bid. The selling price is the ask. And the difference between the two is the spread.
The spread is determined by how volatile the stock is. When it is said that the spread is wide, this means that the difference in price between where the market makers are buying and where they are selling stock to the public is large. The more volatile the stock, the wider the spread. This is justified because the specialists are unsure of the future direction of the stock. The wide spread is the market makers' only way to protect themselves in the event the stock moves against them. The markup or spread between where the market makers buy and sell might be as wide as $1 in some volatile stocks. This means that, even if the stock doesn't move, the market makers might be buying from the public at $99 and selling at $100. This means they're making $1,000 for every 1,000 shares bought and sold. But there is no telling in which direction the stock is going. It could be on its way to $110—or to $90. Even the specialists don't know. Remember, the market makers must provide liquidity in a stock at all times. This means that, even if they don't want to, they are forced to be the buyer of last resort if they can't match the public sell orders with buyers. In volatile markets, this usually means that market makers accumulate large positions when the stock is falling (if there are all sellers, and the market makers are the only buyers) and get short the stock when it is running (if there are all buyers, and the market makers are the only sellers). Even the best traders cannot turn a profit under these circumstances. In most cases, the market makers will suffer substantial losses under these market conditions.
There are times when the opposite is true. The most profitable time for market makers is when the stock is trading in an orderly manner. This allows them to make a few cents per share without much risk. For example, in a $25 stock, this would be done by buying from the public at 25 and selling to the public at 25 1/8. The spread is 12.5 cents, or 1/8 point. If the stock doesn't move and the buying and selling is equally distributed, the market maker will have made 12.5 cents per share on each trade. Imagine how much is made if the stock trades over 1 million shares per day: That's a $125,000 profit. This is justified because, even though the stock isn't moving, there is always a certain degree of risk involved in making a two-sided market. Suppose bad news comes out about the stock; the selling pressure could inundate the market maker. That is the risk market makers must take. Over the course of a year, it is the house edge of a few cents per share that compensates them for the few times they suffer huge losses. That is how a few cents per share can translate into millions of dollars in trading profits in the course of a year.
Another way to look at the bid-ask spread is as a form of risk premium. Imagine that the stock, instead of moving in one direction, is trading in a choppy manner. This is generally how volatile stocks trade. Under these conditions, the market makers must keep the bid-ask spread wide to protect themselves from the onslaught of day traders and speculators who will try to profit in the event the market makers are "off their market." Most of the time, the wide spread makes it very difficult to "pick off" the market maker. Because the profit the day trader makes usually comes at the expense of the market maker, market makers will not just give their profits away. Their only defense is to make it as difficult as possible for day traders to predict movement in the market makers' stocks.
As you can see, the bid-ask spread is the market makers' advantage over the investing public. So where does this leave day traders? In the best of all possible positions. Even though the specialists and market makers have the advantage, and even though they set the odds, the playing field is more level today than at any time in history. This is because the regulatory agencies are protecting the interests of the individual investors. Luckily, in the eyes of these agencies, even day traders is considered individual investors.
Let's be honest. Wall Streeters would get away with everything they could if there were nothing to stop them. But there is something to stop them. There are rules in place that force specialists to give priority to customer orders over their own. On the New York Stock Exchange, these rules essentially let day traders take the same side of the trade as specialists in filling customer buy and sell orders. This allows day traders to trade just like specialists and to gain all the advantages of the house edge by participating with the specialists in taking the other side of customer orders. This enables day traders, like specialists, to make a living on 1/4s, 1/8s and 1/16s on the investing public's order flow.
As you can see, day traders are in a very precarious situation. They rely on their own abilities to beat Wall Street at its own game. Although day traders have the rules on their side, they are able to exist, survive, and prosper only as far as their trading ability takes them, because the odds are not with success, but against it. Day traders are going up against much bigger forces possessing deeper pockets and more information. But, that should not faze you, however. The game is difficult, but it is not without rewards. Undoubtedly, you have seen the colossal amounts of money Wall Street firms are capable of making in a single year. This same reward is there for you as a day trader. It is just a matter of going out and staking a claim to it.
Table of Contents
Preface xiiiAcknowledgments xix
Introduction 1
Section I The World of the Day Trader 5
Chapter 1. Exploiting the Excesses of Capitalism 7
The House Edge 9
The Bid-Ask Spread 11
Section II Introduction to Day Trading 17
Chapter 2. Trading 101: Buying on Bad News and Selling on Good News 19
The Mind-set of an Online Day Trader 19
A Buyer When the Market Needs Buyers 20
Hit Singles, Not Home Runs 20
Brokerage Commissions Can Destroy Profits 21
Buy in on Fear, Sell in on Greed 22
The Slow Execution 23
Is the NYSE an Easier Market to Trade? 24
Section III How to Beat Wall Street at Its Own Game 25
Chapter 3. Exploiting Wall Street’s Conflict of Interest: Market Orders versus Limit Orders 27
Understanding Wall Street’s Conflict of Interest 27
Price Makers versus Price Takers 29
The Bargaining Process 30
Price Negotiation—Market versus Limit Orders 32
Wall Street’s Prey 34
Prelude to the Bid-Ask Spread 35
Chapter 4. The Day Trader’s Crystal Ball: Understanding the Bid-Ask Spread 37
A Snapshot of a Moving Picture 37
The Mechanics of Price Movement—Understanding What Makes a Stock Move Higher 39
Example 1: The Quote—Snapshot of a Moving Picture 41
Example 2: The Market Order to Sell—Hitting the Bid 46
Example 3: The Market Order to Buy—Lifting the Offer 48
Example 4: The Limit Order to Buy—Bidding for Stock 50
Day Orders versus Good-until-Canceled (GTC) Orders 52
Example 5: The Limit Order to Sell—Offering Stock 54
Haggling Over Nickels and Dimes 56
Example 6: Moving the Stock Higher 57
Chapter 5. The Role of the Specialist on the New York Stock Exchange 61
Using the Specialist System to Your Advantage 64
What If There Were No NYSE Specialist? 66
Buyer of Last Resort 67
Is the Profit the Specialist Makes Justified? 68
A License to Steal? 68
The Specialist’s Limit Order Book 69
Being on Both Sides of the Market 71
Narrowing the Bid-Ask Spread 72
Wide Spreads Protect the Specialist from Volatility 73
Handling a Large Sell Order 74
The Real Intentions of the Specialists 77
Beware When the Specialist Takes the Other Side of Your Trade 77
The Day Trader as a Shadow Specialist 78
The NYSE’s Fair Order Handling Rules 80
Never Reveal Your Hand 85
How Can You Determine Where the Specialist Lurks in the Stock? 85
Jockeying for Position 87
How Do You Know Where You Stand in Line? 89
When in Doubt, Ask the NYSE Floor 89
Tipping the Odds in Your Favor 92
Beware of the Specialist 93
Section IV Introduction to Scalping The NYSE: Taking Food Out of the Specialist’s Mouth 95
Chapter 6. The Day Trader’s Secret Weapon: Exploiting the Bid-Ask Spread 97
How Can You Make Money Trading Stocks that Don’t Move? 98
The Role of the Scalper 99
Hit Singles, Not Home Runs 100
Operating under the Radar 100
Avoiding the Glamour Stocks 102
Exploiting the Bid-Ask Spread 103
Finding the Trade’s Sweet Spot 103
Simplifying a Complex Process 104
Other Moving Parts to This Trade 105
A Bet with the House? 109
Too Much Work for Only $100 in Gross Profits? 110
A Few Words on Risk 110
Section V Trading The Market’s Momentum: How to Profit from Volatility 113
Chapter 7. Exploiting Market Volatility and Momentum: Strategies for Trading Volatile Stocks 115
The Specialist and the Upper Hand 116
Playing the Gap Open—A Strategy for Betting with the House 117
Buying on Bad News 118
Betting on the Specialist 119
Parameters of the Gap-Opening Trade 122
How to Tell If the Opening Trade Will “Clear” the Specialist’s Limit Order Book 124
Selling before the Second Wave 125
Trading Tick for Tick with the Market Indexes 127
Why Limit Orders Don’t Work in a Rally 127
Using the S&P Futures to Gauge the Sustainability of a Rally 129
Lightning-Fast Market Upsurge: How Offers Vanish in the Vapor Trail 129
Stock for Sale Becoming Scarce 130
Nasdaq and the Role of the Market Makers 131
A Few Words on Short Selling 135
Two Methods for Day Trading Nasdaq Stocks 136
The Apple Computer Trade 139
Buying Strong Stocks on Pullbacks 140
Opening the Stock Abnormally High 141
The Dangers of Buying a Strong Stock on the Opening Trade 141
Inflicting Heavy Damage on the Market Makers by Attacking Their Vulnerability 142
Chapter 8. The Day Trader’s Ticket to the Poorhouse: How I Managed to Lose $12,000 in Less than 24 Hours 145
The Pain of Missing a Trade 147
How Could the Stock Go Any Lower? 147
The Terrifying Feeling of Getting Caught in a Downdraft 148
A Feeling of Irresistible Greed 148
The Need to Break Even 150
Buying the Stock for the Third Time 151
Feeling of Devastation Leads to Useful Insights 152
Learning from the Mistake and Moving On 156
Can the Quoted Market Always Be Trusted? 156
A Fool and His Money Are Soon Parted 159
Appendix A.
The Day Trader’s Arsenal: Online Brokers, Trade Commissions, Real-Time Quote Systems, and the Home Office 161
Choosing an Online Broker 161
Negotiate the Best Possible Commission Rate 163
Make Sure that the Broker Can Route Directly to the NYSE 163
Per-Share versus Per-Trade Commission Rates 164
Setting up at Least Two Accounts 164
System Crashes and the Late Fill 165
Customer Service, Back-Office Problems, and Trade Discrepancies 167
The Remedy—Keep Good Trading Records 167
The Home Office and the Virtual Trading Floor 169
Appendix B.
Considerations for Trading for a Living: The Allocation of Trading Capital, the Pattern Day Trader Rule, Using Margin and Trading Part-Time vs. Full-Time 173
Allocation of Trading Capital 174
The Pattern Day Trader Rule 177
Trading on Margin 177
Margin Calls 178
Part-Time versus Full-Time Trading 179
Index 183
Preface
It's 9:00 Monday morning, and I awake to the sounds of my alarm clock. I couldn't be happier: It is the beginning of another trading week. I roll out of bed," commute" into the next room, and turn on my computer. The work week has begun.
But this is not your typical 9-to-5 job. There is no office to go to, no car pool, and no "good mornings" to co-workers. There is no boss in the next room. I don't produce a product, nor do I sell one. When people ask me what I do for a living, I pause. In fact, I don't really "do" anything. There are no clients, no projects, and no deadlines. There are no co-workers, no staff, and most of all, no friends. I am known by account number only. I am in total isolation. The entire day I may not see or speak to another soul. The work is extremely intense. The pace is fast. In many regards, this is warfare. It is a job unlike any other in the world.
Sometimes I do feel guilty. I am 25 years old and I answer to no one. My day is spent in the comfort of my own home. People may criticize what I do, but on a good day I can make more money in a single afternoon than most of them may make in three months, without ever leaving the house. Still, I am not providing a service to anyone. Is the world a better place because of what I do? Sometimes I don't think so. Very few people understand. They think it's gambling: I tell them it's not.
I am a day trader. My job is to buy and sell stocks for a living. I do not work on Wall Street. My seat is not on the floor on the New York Stock Exchange, it is in cyberspace. This is rarefied air. These are untested waters. I am among a new breed of entrepreneur and this is a new frontier. But do I have what it takes? Mentally, am I strong enough? I've been doing this for almost two years. In the past I have made very good money. But the past is for cowards. And there are no guarantees. Today I must make money.
It is now 9:30. The bell has rung and the stock market is open. I take my seat at the table with the world's biggest banks, brokerage firms, and mutual funds. The chess match has begun.
The explosive growth and low cost of online trading has created a new class of investors who can make a living buying and selling stocks over the Internet in a way once reserved for Wall Street's most powerful brokerage firms and investment banks. The goal of this book is to provide a one-stop, comprehensive overview of how to make a successful living, whether full-time or part-time, by day trading over the Internet. We will examine all aspects of this new and untested area, from what it takes to get started, to the dangers and pitfalls of using online brokers, to an in-depth analysis of which trading techniques work and which don't.
The information provided here will reveal closely held and profitable short-term trading secrets that can only be learned from having worked on one of Wall Street's trading floors, combined with the real-life experience of someone who makes a living trading over the Internet. Quite simply, this is information that most stockbrokers, financial planners, and everyday investors do not possess. With this in mind, the emphasis is on simplicity. The best and most successful traders are those who keep things simple. This is a book on trading, not investing. Therefore it is written in a practical, nontheoretical manner for the reader who might have little or no investment experience, but only the desire to learn more about one of the most exciting and profitable businesses of the next millennium.
For me, day trading is an obsession. I absolutely love what I do. In this book, I hope to share that excitement with you. I am 25 years old. Since graduating from Colgate University in 1995, I have never wanted to do anything with my life but trade. I felt then, and I feel now, that trading is and will always be the most lucrative job on the face of the earth, if and only if you know what you are doing.
I began my career out of college working for two large brokerage firms: first for Olde Discount in Detroit, then for Gruntal and Company on Wall Street. At the age of 22, I was trading literally millions of dollars of the firms' capital. It didn't take long to learn how Wall Street made its money. There was a system in place, and there were traders such as myself whose sole job it was to exploit that system for profit. That's when I came to the realization that the knowledge I had, if used the right way, could make me substantial amounts of money. I also decided I had wasted enough time making other people rich.
This was around the same time online trading was beginning to come into its own. The landscape of investing was changing, and thanks to the Internet, trades were becoming extremely cheap. It was slowly becoming clear that it was no longer necessary to work on Wall Street to participate in this game. The rules were changing, and the Internet was the key.
That was all I needed to know. For me, this was the opportunity of a lifetime, and I wasn't going to waste another minute. At the age of 23, I left Wall Street and began an exciting journey that has led me to write this book. I moved back home to upstate New York, bought a computer, renovated my old bedroom into a home office, and began trading full-time for myself. From that old bedroom, I have traded over 15 million shares of stock over the Internet (almost $400 million in transaction value) since I started. My hedge fund, the Farrell Preferred Stock Arbitrage Fund, LP, returned over 65 percent in its first year using these methods. There is really no other way to put it: The trading strategies mentioned in this book work, and they work well.
And the lessons I have learned along the way are invaluable. Over the last two years I have made money and I have lost money, but I have enjoyed every step of the way. In this game, if you can weather the storms, ride out the inevitable ups and downs, limit your risk, and have confidence in your own abilities, you will prosper. You always have to remember that what you are doing is truly special. The job of the Internet day trader didn't even exist 10 years ago. I have been fortunate enough to be able to make a very good living in a way that many people can only dream of. And I wouldn't change that for the world.