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Day Trade Online - Christopher A. Farrell
INTRODUCTION
Betting with the House
Trading the stock market is a little bit like poker. You can bluff, you can posture. You can pretend to do something different. If I have 100,000 or 5,000 to sell, I can show you 500 shares. As the bell is closing in on me, as the day comes to a close, all of the bluffing and the posturing disappear, and you do what you have to do.
—Art Cashin, Director of NYSE Floor Operations,
UBS on CNBC, Nov. 13, 2007
The stock market is perhaps more volatile today than at any time in history. Markets move suddenly and without warning, creating and destroying wealth in ways the majority of market participants simply do not understand. In the rarefied air of stock speculating, fortunes can be made and lost in a matter of seconds. The naive and inexperienced will quickly learn that it is not a place for the faint of heart. Still, many people would love to trade for a living, if only they knew how.
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 long before the market inevitably crushes them. In fact, statistics show that the majority of day traders lose money. 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 thousands of dollars in a single day. Bad traders can lose that much or more. You have to proceed cautiously. With that in mind, it is my hope that this book will act as a good primer so that you may successfully compete in the world of stock trading.
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 system, 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 more conservative approach that focuses on exploiting short-term inefficiencies in the way that NYSE-listed stocks trade, starting with lower-volatility stocks, before venturing into the volatile, high-risk, high-reward domain of more volatile stocks. This way, you will become acquainted with the principles of supply and demand in areas that are slower moving, instead of jumping headfirst into the volatile sectors of the market. When you finish with the book, my hope is that you will see that day trading is far different than you first thought it was.
The trading strategies outlined in this book encompass a wide area of the universe of stock speculation. 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 the bottom line—trading profits. Along the way, your understanding of how the game works will hopefully 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. The better you understand them, the better your chances success will be.
Here is a summary of the 16 major themes of the book:
1. Wall Street is in the business of trading against its customers, and earns its profits at the expense of the investing public.
2. The day trader earns his or her profits at the expense of Wall Street, by beating it at its own game.
3. Day trading has very little to do with long-term investing. The time horizon on the day trader is so short that, in general, the principles of buy-and-hold investing do not apply.
4. Day trading is the art of anticipating and exploiting temporary supply and demand imbalances in the trading of stocks. Some imbalances may last for several hours, minutes, or only seconds.
5. Opportunities for day trading exist because, in the short term, the stock market is inefficient, irrational, and imperfect. The system is flawed and can be exploited for quick profits.
6. 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.
7. The house, in this case, is the Wall Street firms who control the trading in stocks, namely, the specialists on the floor of the New York Stock Exchange and the market makers on Nasdaq. The house always wins because of a mechanism called the bid-ask spread. When the house wins, the investing public loses.
8. The majority of day traders lose money. This is because the system is geared toward their failure. In other words, 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. If you bet against the house long enough, eventually Wall Street will have all of your money.
9. Day traders should trade only when they have an edge, when the odds are in their favor. Even though the odds are usually against them, there are numerous times throughout the trading day when the odds swing drastically into the day trader’s favor, and that is when they must place their bets.
10. 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 traders on the floor of the New York Stock Exchange (the specialists). When the specialists are risking their own capital to buy, so, too, should the day trader.
11. 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 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 favorable rules exist, and that is key to the day traders’ profits.
12. Buying on the bid and selling on the ask is called exploiting the bid-ask spread, and it is the way day traders take food out of Wall Streeters’ mouths. The practice of exploiting the bid-ask spread is called scalping.
13. By exploiting the bid-ask spread, day traders can make consistent, lower-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.
14. 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.
15. The recent changes to the structure of the New York Stock Exchange, including the move toward a hybrid-electronic trading model and the increased transparency of the NYSE specialists’ order books, have benefited the investing public immensely. As a result, it has created trading conditions that are much more favorable to short-term speculators than they had been in the past.
16. Although the playing field is still not truly 100 percent level, these changes to the NYSE have decreased the trading edge that NYSE specialists have over the trading public, and in the process, have greatly increased the day traders’ opportunities to bet with the house.
So how do you bet with the house? A major portion of this book will be devoted to answering that question.
SECTION I
The World of the Day Trader
Day trading is the practice of anticipating and exploiting temporary supply and demand imbalances in the trading of stocks. What does this mean? It means that long-term trends and market conditions are not the primary focus. Neither is reading the Wall Street Journal cover to cover, nor combing through piles and piles of analyst research. These will not put food on your table. Why? Although these may be helpful to the long-term investor, they will not increase the odds of a profitable trade when your time horizon is only hours, minutes, or even seconds.
This is the short term, and the only thing day traders should be concerned about is the immediate supply and demand picture in the stock. Every trade must be a precise, well-calculated move, where trading capital is put at risk only when the odds of a successful trade are substantially in your favor. Otherwise, you are throwing your money away, as it is far easier to lose money in this game than it is to make it. Welcome to the world of the day trader.
CHAPTER 1
Exploiting the Excesses of Capitalism
Did you ever wonder how the top trading firms on Wall Street are 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, a slight statistical edge that the casino has over the gambling public. The more you gamble, the less likely you are to win.
While the casinos deal in craps, roulette, and blackjack, Wall Street deals in stocks, bonds, and commodities. In the financial markets, the effects of the house edge are more mysterious and dangerous, because unlike the casino, where most gamblers understand that the odds are stacked against them, on Wall Street it can go unseen, unfelt, and undetected by the ordinary investor. This hidden force is known as the bid-ask spread. The spread is the mechanism that transfers wealth from the investing public into the hands of the Wall Street brokerage firms. The odds dictate that the more you trade, the less likely you are to win. And when Wall Street wins, the investing public usually loses. The key to profitable day trading is to recognize this fact, and, like the card counter in blackjack, to place your bets only when the odds swing overwhelmingly in your favor.
Taken at face value, conditions seem 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. 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. It is possible to exploit market moves in less time than it takes to pick up the phone, allowing those with the quickest hands to capitalize on opportunities created by markets that can change drastically in just a few seconds.
We have come a long 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 aggressively trading their stock portfolio. 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 hundred dollars or more for the order. Imagine buying 1,000 shares of IBM and paying a $500 commission! The stock would have to move a half point just to break even. And that doesn’t count the commission you’d pay on the way out. There was simply no way to trade actively under the burden of such high commissions. If you were in the market, you were in it for the long term. You had no other choice.
But times have changed. Thanks to online trading, the individual who is trading from home now has access to the same profits the Wall Street brokerage firms have been making for decades. Online orders can be executed in as fast as one second, and can cost as little as a few dollars. By monitoring a real-time quote screen, the active day trader, if successful, can literally make a living on the same small, high-percentage profits that have made the large trading firms millions upon millions of dollars per year.
But that does not tell the whole story. Although the online traders have access to the markets today in a way that they have never had before, they are still at a slight competitive disadvantage compared to the "insiders in the marketplace—namely, the market makers and the specialists on the floor of the New York Stock Exchange. The independent trader is on the outside looking in. The fact that the majority of day traders lose money further supports this fact. Successful day trading requires an acceptance of this reality. This will become clear as you get further into the book.
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 you and me. It’s because the markets are inefficient and the system can be exploited for profit.
Day trading, like many other lucrative professions, is an extremely competitive business. The profits certainly don’t come easy. 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 Wall Street trading firms, 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.
Let’s draw an analogy to the casinos. Tens of millions of people visit the casinos in Las Vegas, leaving behind billions of their hard-earned money. How does 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 that 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, some people have devised ways to overcome it. Undoubtedly, you have seen the stories of card counters and other hustlers beating the casinos at their own game. They do this by raising their bets as the odds tip in their favor. In the past, by counting cards, a player was able to gain a slight statistical advantage over the dealer in predicting which cards would be dealt next. This edge became more exaggerated and more profitable the longer the gambler stayed at the table. There were numerous people who made a living by doing this. These were the true professional