Chapter 1

Doing Day Trading Right

IN THIS CHAPTER

Figuring out just what day traders do

Setting up a trading business

Knowing what being a successful trader takes

Dispelling a few day trading myths

Looking to conquer the markets from the comforts of home? Some people can. But day trading is a crazy business. Traders work in front of their computer screens, reacting to blips, each of which represents real dollars. They make quick decisions because their ability to bring in profits depends on successfully executing a large number of trades that generate small profits. They close out their positions in the stocks, options, and futures contracts they own at the end of the day, which limits some of the risks. A lot can happen in a year when you're a day trader, increasing the likelihood that your trade idea will work out, but in a day? You have to be patient and work fast. Some days offer nothing good to buy. Other days, every trade seems to lose money.

The individual human day trader is up against a tough opponent: high-frequency algorithms programmed and operated by brokerage firms and hedge funds that have no emotion and can make trades in less time than it takes to blink your eye. Artificial intelligence has the potential to level the playing field, but the market will still crush unprepared players all the time.

In this chapter, I cover what day traders do, share the advantages and disadvantages of day trading, list the personality traits of successful day traders, and give you information on your likelihood of success if you choose to be a day trader. The more you know before you make the decision to trade, the greater your chance of being successful. If you decide that day trading isn't right for you, you can apply strategies and techniques that day traders use to improve the performance of your investment portfolio.

Defining Day Trading: It's All in a Day's Work

The definition of day trading is that day traders hold their securities for only one day. They close out their positions at the end of every day and then start all over again the next day. By contrast, swing traders hold securities for days and sometimes even months; investors sometimes hold for years. The short-term nature of day trading reduces some risks, because nothing that happens overnight will cause losses. Meanwhile, many other types of investors go to bed thinking their position is in great shape only to wake up the next morning to find that the company has announced terrible earnings or that its CEO is being indicted on fraud charges.

Ah, but there are two - or more - sides to every story: The day trader's choice of securities and positions has to work out in a day or it's gone. Tomorrow doesn't exist for any specific position. Meanwhile, the swing trader and the investor have the luxury of time, because it sometimes takes a while for a position to work out the way your research shows it should. In the long run, markets are efficient, and prices reflect all information about a security. Unfortunately, a few days of short runs may need to occur for this efficiency to kick in.

Day traders are speculators working in zero-sum markets one day at a time. That makes the dynamics different from other types of financial activities you may have been involved in. When you take up day trading, the rules that may have helped you pick good stocks or find great mutual funds over the years no longer apply. Day trading is a different game with different rules.

Speculating, not hedging

Professional traders fall into two categories: speculators and hedgers. Speculators look to make a profit from price changes. Hedgers look to protect against a price change. They make their buy and sell choices as insurance, not as a way to make a profit, so they choose positions that offset their exposure in another market.

As an example of hedging, consider a food-processing company and the farmer who raises or grows the ingredients the company needs. The company may look to hedge against the risks of price increases of key ingredients - like corn, cooking oil, or meat - by buying futures contracts on those ingredients. That way, if prices do go up, the company's profits on the contracts help fund the higher prices it has to pay for those ingredients. If the prices stay the same or go down, the company loses only the price of the contract, which may be a fair tradeoff to the company. The farmer raising corn, soybeans, or cattle, on the other hand, benefits if prices go up and suffers if they go down. To protect against a price decline, the farmer sells futures on those commodities. Their futures position makes money if the price goes down, offsetting the decline on their products. And if the prices goes up, they lose money on the contracts, but that loss would be offset by their gain on their harvest.

The commodity markets were intended to help agricultural producers manage risk and find buyers for their products. The stock and bond markets were intended to create an incentive for investors to finance companies. Speculation emerged in all of these markets almost immediately, but it was not their primary purpose.

Day traders are all speculators. They look to make money from the market as they see it now. They manage their risks by carefully allocating their money, using stop and limit orders (which close out positions as soon as predetermined price levels are reached), and closing out at the end of the night. Day traders don't manage risk with offsetting positions the way a hedger does. They use other techniques to limit losses, like careful money management and stop and limit orders (which you can read about in Chapter 2).

Markets have both hedgers and speculators in them. Knowing that different participants have different profit and loss expectations can help you navigate the turmoil of each day's trading. And that's important, because to make money in a zero-sum market, you only make money if someone else loses.

Understanding zero-sum markets

A zero-sum game, discussed in Chapter 2, has exactly as many winners as losers. And options and futures markets, which are popular with day traders, are zero-sum markets. If the person who holds an option makes a profit, then the person who wrote (which is option-speak for sold) that option loses the same amount. There's no net gain or net loss in the market as a whole.

Now some of those people buying and selling in zero-sum markets are hedgers who are content to take small losses in order to prevent big ones. Speculators may have the profit advantage in certain market conditions, but they can't count on having that advantage all the time.

So who wins and who loses in a zero-sum market? Some days, whether you win or lose all depends on luck, but over the long run, the winners are the people who are the most disciplined: They have a trading plan, set limits and stick to them, and can trade based on the data on the screen rather than on emotions like hope, fear, and greed.

Unlike the options and futures markets, the stock market is not a zero-sum game. As long as the economy grows, company profits grow, which in turn leads to growing stock prices. The stock market really has more winners than losers over the long run. That doesn't mean that any given day will have more winners than losers, however. In the short run, the stock market should be treated like a zero-sum market.

If you understand how profits are divided in the markets that you choose to trade, you have a better awareness of the risks that you face as well as the risks that the other participants are taking. People do make money in zero-sum markets, but you don't want those winners to be making a profit off you.

Some traders make money - lots of money - doing what they like. Trading is all about risk and reward. The traders who are rewarded risked the 90 percent washout rate. Knowing that, do you want to take the plunge? If so, read on and check out Chapter 6 where I discuss risk and reward in greater detail. And if not, read on anyway, because you may get some ideas that can help you manage your other investments.

Being disciplined: Closing out each night

Day traders start each day fresh and finish each day with a clean slate. This daily regimen reduces some of the risk, and it forces discipline. You can't keep your losers longer than a day, and you have to take your profits at the end of the day before those winning positions turn into losers.

That discipline is important for day traders. When you day trade, you face a market that doesn't know and doesn't care who you are, what you're doing, or what your personal or financial goals are. There's no kindly boss who may cut you a little slack today, no friendly coworker to help you through a jam, no great client dropping you a little hint about their spending plans for the next fiscal year. Unless you have rules in place to guide your trading decisions, you'll fall prey to hope, fear, doubt, and greed - the Four Horsemen of trading ruin.

So how do you start? First you develop a business plan and a trading plan that reflect your goals and your personality. Then you set your working days and hours, and you accept that you'll close out every night.

In other words, you prepare and have a plan. That's a basic strategy for...