Author: Daniel Major

Volume weighted average price (also abbreviated VWAP) is a formula used to calculate the average price a stock trades at, weighted by volume transacted at each price level.  Normally traders are concerned with the volume weighted average price over a 1 day trading period, but some may be interested in longer or shorter term periods.

Day traders may track VWAP because this calculation is very significant to the trading of many mutual funds and most pension funds.  When the current intra-day price varies significantly from the VWAP, there may be pressure for the price to move towards the VWAP.

This calculation is important to large passive institutional investors who are simply trying to match their average transaction price to the average price transacted over the course of a trading period.  By matching the VWAP as closely as possible, they may reduce their market impact costs, which are the costs incurred by large traders whose trades are so large they move prices.  They also reduce the risk that incorrect market timing will result in their average transaction value being significantly worse than what the market as a whole received.

How Volume Weighted Average Price is Calculated

Volume weighted average price is very simple to calculate.  One takes the total value traded over the time period being analyzed, and divides by the total quantity traded.

VWAP =   Quantity of  Shares Bought at Each Price * Price of Each Transaction / Total Volume

Or more simply

VWAP= Total Value of All Transaction / Total Volume

Here is a simple example.

Transaction 1 = 100 shares at $10

Transaction 2 = 300 shares at $10.20

Total Value = (100* $10) + (300*$10.20) = $1000 + $3060 = $4060

Total Quantity = 100 + 300 = 400

VWAP = $4060 / 400 = $10.15

Practically speaking a trader could not keep track of VWAP in real time without computer calculating assistance.  Many charting software packages do include VWAP tracking capabilities.

Exchange Traded Fund (or ETF)

An exchange traded fund, abbreviated ETF, is a fund that trades like a stock, and tracks an index, an asset class, a commodity, or basket of commodities.  Like a stock, an exchange traded fund will transact throughout the day, and does not necessarily trade at it’s intrinsic value, or net asset value (NAV).  This is unlike a mutual fund, which only trades on market close exactly at the net asset value.

Unlike a mutual fund an ETF is not actively managed, meaning its performance is meant to mimic the underlying asset(s) tracked as closely as possible, either on an intra-day or long term period, depending on the ETF.  Exchange traded funds typically have much lower expense charges than mutual funds, making them attractive to some investors.  ETFs are also attractive to day traders, who can trade an index or commodity with an equities trading account, rather than a futures or commodities account.

Some exchange traded funds are meant to trade double or even triple the volatility of the underlying index or asset tracked.  These funds are solely for the purpose of day trading, and never should be held long term as they have considerable decay in their net asset value.  The reason for the decay is the use of leveraged products to create the extra volatility.  Recently these funds have come under more regulatory scrutiny because by design, they will all eventually be worth $0.  They also create extra volatility in the market as a whole as the funds must rebalance their own assets during the trading day.

While an exchange traded fund is not necessarily required to trade at a share value which would correspond exactly with the true NAV, any significant deviate would qualify as an arbitrage opportunity, and any inefficiencies in pricing are typically rooted out very quickly by high frequency traders.

ETF volume accounts for hundreds of millions of shares of market volume daily, and these products have become very popular amongst both investors and traders.  The most popular ETFs include: SPY (S&P 500), EEM (emerging markets), GDX (gold miners), VXX (S&P 500 VIX), and XLF (Financials).

Sometimes an ETF may be useful to a trader acting on sector specific news, when the trader is unsure how one particular asset within the sector will be affected.  An example is when the US Government decided to increase capital holding requirements of banking institutions.  Without a full analysis of each bank, a trader would not know how significantly each would be affected.  Instead knowing that the industry as a whole would likely decline in price on the news, the trader may have decided to short the XLF (Financial Sector)

Traders and investors alike should educate themselves on exchange traded funds as they provide a useful alternative to other assets.

Market Order

A market order is an order that a trader enters that does not specify a specific price to execute.  A market order will seek liquidity at progressively further prices from the current bid and offer until the order is completely filled.  The purpose of the market order is to ensure that the transaction is completed instantly.  This can be very useful to traders in a fast moving market because they are assured of the order executing.  A market order is the opposite of a limit order, which is an order that must execute at a certain price or better.

A market order can be a buy or a sell order.  If the order is a buy order, it will first remove liquidity from the offer.  If this does not completely fill the order, the market order will continue to seek liquidity at progressively higher prices until the fill is complete.  Conversely, if the order is a market sell order, it will remove liquidity from the bid and progressively lower prices until the order is completely filled.

The obvious benefit of the market order is the speed and surety of execution.  A market order will always fill, and it will always fill almost instantly.  If a stock is very quickly changing prices and it would be difficult to take the time to enter a specific price a market order can be extremely useful.

This works very well for traders if the order is small, or if there is a lot of liquidity posted in the stock.  This type of order can potentially be very dangerous for traders as well.  Because price is not specified, the order can legally transact at whatever price is necessary to complete the order.  If a trader enters a very large market order relative to the liquidity available in the stock, he risks moving the price significantly away from the current bid and offer.  Because high frequency trading programs can remove posted liquidity so quickly, there is always a risk that the programs will remove liquidity before the market order is even able to access it, resulting in an even worse execution for the trader.  Traders should always be aware of how large their order size is in relation to the available posted liquidity for a particular stock.  All stocks are different in this regard, and the same stock can be different during different days or even during different times of the day.  This is yet another reason why traders must always watch the book of a stock while trading.

It should be noted that using a market order in the dark pools can access more liquidity than can be seen on the books.  Sometimes this can result in a much better fill for a trader, other times the light pools will pull orders when a large market order is entered into the dark pools.  If you have access to a sweep order that will seek both light and dark liquidity it is most beneficial to trader entering the market order.

A market order is simply one more tool in a traders toolbox.  It is useful in fast moving markets with ample liquidity.  Used at the right time it can be tremendously useful, used at the wrong time it can cost a trader a lot of money.  Traders must always be aware of the circumstances when deciding between using a market order or a limit order.

What Is A Stocks Volume

Volume is the total quantity of shares which have transacted in a given time frame.  Traders use volume as a measure of a stock’s volatility or potential volatility.  Higher volume will generally signify that a lot of parties are interesting in trading the stock, and the stock is likely to move as a result.  Volume measurements are also used as a signal of liquidity of a security, so a trader can judge his ability to enter or exit a position at current market values.

Higher volumes are generally favorable to traders, but may only be beneficial to a point, or may not be beneficial depending on the exact strategy. A trader may also look at average volume at a daily level, or may even break this down in smaller increments of the day to judge when he may best employ a strategy.

Volume does not double count transactions, meaning if a trader purchases 100 shares from another seller it results in 100 shares of volume, not 200.

Typically in charting software volume is displayed below the price chart.  Volume is normally displayed for every price bar, so that if a chart is displaying 1 minute price bars volume will display for each minute.  The chart and volume together typically will look something like this:

This is a daily chart of GE, with the volume displaying for each price bar directly below the bar.  In general it can be noted that days with lower volume also have a smaller range in price.

Volume is NOT an indication of price direction by itself, it simply is a signal that traders use to judge if a stock is likely to move.  Often times traders will watch screens displaying the stocks with the highest volumes, or displaying sudden spikes in volume, which is can be a sign that news was released, or at least that the stock will be moving.

Traders who are relatively new and are working on refining their strategy will be well served to watch how volume impacts trading.

What are the Stock Market’s Trading Hours

The stock market’s regular trading hours are from 9:30 a.m. to 4:00 p.m. Eastern Standard Time.  There are is also a pre-market session every day from 4:00 a.m. to 9:30 a.m. EST and a post-market session from 4:00 p.m. to 8:00 p.m. EST  Check the NY Stock exchange’s website for hours and holidays.

The regular trading session from 9:30 a.m. to 4:00 p.m. is the typical market session that most people refer to as the “day’s trading session”.  This is when the vast majority of the day’s volume transacts and when most market participants are active.  Because there is more volume posted to stock’s books during the regular session it is arguably more predictable and a safer time for day traders to be involved due to the higher likelihood of having liquidity available to execute orders.  Some day traders prefer pre-market or post-market sessions however and only trade these times.  Generally it is recommended that only experienced traders participate in the extended hour’s sessions however due to the possibility of extreme volatility.

Some stocks are very active in the pre-market and post-market sessions, and some have no activity at all.  The spread will often widen significantly at non regular session hours and it can be very difficult to enter and exit large positions.

It is very important for a trader to understand the stock they are trading and the likelihood of liquidity being available after the closing bell.  If a trader accidentally does not exit a position by 4:00 p.m. it can be very tough to exit after the close, and with a wider spread significant price slippage can occur.  This can needlessly cost a trader a lot of money.

Only experience can give a trader a feel for the differences; but it is crucial to understand the differences between sessions and the differences between how particular securities trade during these times.  Always trade a light position until you understand the risks and movements of the hours you are trading.

What is A Share of a Stock?

A share of a stock represents ownership in the company that the share is issued for.  Share ownership entitles the investor to share in the profitability of the company (or lack thereof) as well as a say in company matters put to a vote of investors.  Stock investors purchase shares issued by corporations in hopes that the company will become more valuable through increased profits and business prospects.

One share of a corporation may represent different percentages of total company ownership based on the number of shares outstanding for each particular corporation.  For instance, if there are 10,000 shares outstanding for a given corporation, one share represents ownership of 1/10,000 of the company, and the shareholder has 1/10,000 of the total vote in shareholder votes on company matters.  If a shareholder owns 5,000 out of 10,000 total shares, they would own 50% of the company and have 50% voting rights.

Shares bought and sold on the stock market represent true ownership of a corporation, and entitles owners to the benefits and pitfalls of ownership.  A nice perk for investors of publicly traded corporations is that while they are entitled to share in the upside if company profits soar, an investor can not lose more than his or her investment if the company goes bankrupt.  In other words, owners of shares are not required to pay back company debts personally if the corporation can not meet its debt obligations.

Some people think of a share as something intangible that goes up and down in price almost randomly.  The reality is this is far from the truth. The price of shares is based on buying and selling, most of which is is performed by large institutions like hedge funds and mutual funds.  They decide to buy and sell based on exhaustive research and financial modeling of all available information on a corporation’s current profitability, current and project future asset values, and future profitability estimates and potential.  The price of a share, and the value represented by the share is no arbitrary matter.

The ability to break a corporation into many shares which can be sold to many investors has allowed owners of large companies to sell their companies, which would otherwise be too large to purchase for any single investor.  It has allowed average citizens to partake in the benefits of company ownership when they otherwise would not be able to, and this investment propagates economic growth, allowing companies to use investor money to expand operations and hire additional workers.  When a company first breaks itself into publicly traded shares, it is said to have an IPO or initial public offering.  When a company issues additional equity to the public after an IPO this is known as a secondary offering.

A trader should never lose sight of the fact that while their ownership may be short term, the instruments they are trading represent real tangible value, often in some of the world’s largest corporations.

What Is A Stock Trade

A stock trade is actually a transfer of ownership in a publicly traded corporation. The trade refers to the exchange of money for ownership rights, which are denoted in shares of stock.  In common parlance, the term trade has come to mean a shortly held position taken with the intent of capitalizing on near term volatility.  Those who do this for a living are known as day traders, but many people will buy or sell stock in shortly held positions with the hopes of making a lot of money.

An example of how this is done:

A trader buys 1000 shares of stock ABC at $50.  The stock price moves up to $54 dollars after a positive earnings announcement creates buying interest. The trader sells his 1000 shares at $54 and makes $4 of gain per share on the position.  Total earnings are 1000 x $4 = $4000.  The trader made $4000 in a short time period, or an 8% gain on his investment of $50,000.  Traders will also use some tools such as margin buying power and options to create leverage, and magnify the extent of their gains.  Caution must always be taken by the trader however as losses are also magnified by leveraged positions.

Generally speaking short term trading is discouraged by the government, both for the safety of the trader’s capital as well for general healthy functioning of capital markets, since trading increases volatility.  Let’s not forget that the purpose of capital markets are for corporations to access public wealth so they may make investments in their businesses, and for the public to invest in corporations that they believe will make money for them, so that their personal wealth will grow.  This relationship is beneficial to both parties and it is why capital markets are such positive drivers of economic growth.  The value of having short term traders involved in these markets is always up for hot debate, especially with the explosion of high frequency algorithmic trading.

No matter which side of the issue you are on, you should always understand what you are doing when you place a trade.  Always understand what exactly you are trading, the maximum amount of money you can lose, and how you can be most effective in placing your orders.  This includes understanding how your broker works, how much you pay for commissions, the types of orders you are placing, and how you are determining that a particular moment is the best time to place the trade.

What Is A Day Trader

A day trader is someone who buys and sells securities, usually equities but possibly bonds, derivatives, futures, currencies or options, with the intent of taking advantage of short term price movements to create profits for their account.  Day traders may occasionally hold securities overnight, but normally close all positions by the end of the day, hence the term “day trader”.

A day trader works to establish a trading strategy that will result in the trader either only taking trades with a higher probability of being profitable than not, or with the probability of a winning trade creating profits such that over time the profits will be greater than the losses, even if there is a higher probability of the trade ending in a loss. Once developed a trader’s goal is to adhere to the strategy as strictly as possible, gradually using greater and greater trade sizes in order to increase their profits over time.

Strategies for equity traders may including reading a stock’s tape and order book to spot large buyers or sellers, going with price momentum during times of high volume or rapid price movement, or reacting to technical or algorithmic signals.  Some day traders work exclusively by writing algorithms, often times ones that operate on extremely short time frames, taking advantage of small inefficiencies in the market.  The trader will then let their algorithm work throughout the day, usually monitoring it constantly and adjusting it in response to changes in market conditions.  If you have the ideas but don’t have the computer skills to program your own algorithm, Cyborg Trading offers traders a fantastic resource by taking the need to know programming languages out of the equation for the trader.

Day traders may work for a proprietary trading firm, such as WTS, T3 Trading, or Bright Trading, or they may trade their own accounts with a retail brokerage such as TD Ameritrade or Interactive Brokers.  A trader will work with a proprietary trading firm to get increased leverage and more professional trading tools, or a retail brokerage in order to keep 100% of their profits.  A proprietary trading firm may have lower commission charges than a retail brokerage, but may require the trader to pay for some monthly costs such as software and ECN access, and will generally keep a percentage of the trader’s profits.  A proprietary firm will provide a trader with firm capital, however, and may increase a trader’s total profits significantly.  The right choice is an individual decision for each individual.

A day trader is a participant in the markets, always working on their strategy to predict short term price movements in order to create profits for their account.

What Is Trading On Margin

Trading on margin is the ability to buy or sell more of a security than you would normally be able to with your account equity.  It is basically a loan from the brokerage provided as a service to clients.  By law you cannot have more margin value loaned to you than you have in equity.  Put another way, you can borrow up to 50% of the value of your purchase.  You are also free to borrow less if you wish.  Some brokers will require a higher percentage of account equity of the total margin purchase.

This applies to retail accounts, and accounts must be specifically given privileges as margin eligible accounts.  A broker will require an affidavit from the account owner stating that they understand all risks associated with trading on margin, and are in a strong enough financial position to assume those risks.  Margin accounts require a minimum deposit of $2,000, and some brokers will require a higher deposit.

Traders use margin in hopes of magnifying their gains.  If they are buying a position that is twice as big as the equity in their account, the hope is that they will make twice as much money from it.  This is sometimes the case, but unfortunately there are no guarantees.

Buying on margin is risky by nature.  When you have twice as much equity invested in the position than equity in your account, every price increase or decrease will have double the effect on your account equity.  This is very good if the position goes in your favor, and will at least double the damage if the position moves against you.  A trader should only use margin if they fully appreciate the risks and rewards.

Margin is also not free.  It can be thought of as a loan from the brokerage, and like all loans there is an interest rate attached.  The interest rate will vary amongst brokerages but will often be indexed to an established rate, for example the rate may be libor+ standard markup, or the rate could just be a flat rate.  Either way every day you are using margin, you are obligated to pay interest.  The interest is deducted from your account, and it usually behooves the trader to only hold positions on margin for short time periods.

If a trader is holding a security on margin, and the value of the position declines substantially, a trader may be subject to a margin call.  A margin call is a call made by the broker to add more funds to an account when the equity declines to a certain percentage of the total position value.  This happens to help assure the brokerage that they will not lose their own money on the position.  Different brokerages may have different standards for when a margin call is placed, but if funds are not added in time the brokerage will liquidate the position to a point where the account equity is an acceptable percentage of the position value.

Trading on margin can be beneficial for day traders as long as they have controlled risk parameters, but essential to understand the full consequences of using it.

Stock Market Terminology: Volume Share Stock Trade Day Trader Trading on Margin

Volume is an important concept in stock market terminology.

It refers to the total quantity of shares that have been traded within a given time frame.

Traders use volume as an indicator of a stock’s volatility and liquidity.

Higher volume signifies increased buying and selling interest which can result in price movements.

Traders often monitor stocks with high volumes or sudden spikes in volume as it can indicate significant market activity or news releases.

Shares represent ownership in a publicly traded corporation.

When investors purchase shares they become partial owners of the company and have a say in company matters put to a vote of shareholders.

The percentage of ownership is determined by the number of shares outstanding.

Shareholders can benefit from the company’s profitability as well as participate in growth opportunities.

A stock trade involves the buying or selling of securities such as stocks or bonds with the intention of capitalizing on short-term price movements.

Day traders in particular aim to take advantage of these short-term fluctuations to make profits.

They typically close all their positions by the end of the trading day.

Traders study market patterns order books and technical indicators to identify potential opportunities for profitable trades.

Trading on margin allows traders to buy or sell more securities than their account equity would typically permit.

It provides leverage by borrowing from the brokerage but it also increases both potential gains and losses.

Traders should use margin with caution and fully understand the risks involved.

Interest is charged on margin accounts and failure to meet margin requirements can result in margin calls and liquidation of positions.

Understanding these terms is essential for investors and traders in navigating the stock market.

Volume and share information help assess market activity and liquidity while knowledge of stock trades and day trading strategies empowers traders to make informed decisions.

Awareness of the risks and rewards of trading on margin is crucial to managing investments effectively.

A common term amongst traders is capitulation.  This term has meaning outside of the trading world, which is basically giving up or surrendering completely.  Applied to trading, this is a common observation during a period of selling, both in long and in short moves.  Simply defined, capitulation occurs when a significant amount of long positions are abandoned, creating a sharp period of selling and price decline.  Capitulation is actually a very intuitive concept, especially when one considers the emotional aspects of capital market trading.  Periods of capitulation also offer one of the most excellent inefficiencies in the market which can be exploited by savvy traders.

Capitulation can mean two ways to make money to a trader who successfully can identify the moments it is taking place.  The shortest term traders understand that taking a short during this period of time is about as close as trading gets to “free money”.  The selling is often so rapid and so fast, that a trader only needs the courage to take a position short, and often the position will quickly be in the money, and remain in the money until the end of the selling.  These traders must understand the moment the selling is over though, because to longer term traders this moment signals an excellent opportunity to buy at an “inefficiently cheap” price. Capitulation most often marks the bottom, or very close to the bottom of a decline in price.

Here is an excellent example of capitulation in GE.  Capitulation occurred on March 4th of 2009.

True capitulation is marked by an extreme increase in volume as sellers are scrambling to exit positions, and not enough buyers are present to control the pace of selling.  Notice the massive spike in selling volume on March 4th, 2009. Notice as well how this marked the exact bottom of the decline in price.  From this point GE went on to more than double in price in only 2 months!  This is obviously not a “day trade” but imagine how much money was made by some traders who identified this final push down as the capitulation point.  The volume uptick coupled with the sharp decline provided a very clear signal that many long positions were selling out.

As more sellers paniced out of their positions, it created more downward pressure on price.  This had the effect of both forcing other long positions to realize their loss before it got even bigger, and making potential buyers step out of the way as the downward pressure was so hard.  The lack of buying meant sellers had an even greater effect on price than they would have during other periods.

At some point the panic selling stops, and buyers realize that the price has moved far from its rational value.  Timed correctly, buyers often have large gains when rational behavior returns and prices move back to more efficient levels.

While this is an example on a very large scale, capitulation can be seen intra-day at points when many traders and trading algorithms are forced out of their positions at the same time by a large seller, and the price falls quickly accompanied by sharp volume to inefficient levels.  For those who identify the move as capitulation it can provide excellent trading opportunities.

Identifying Capitulation: Trading Opportunities in Market Panic

During periods of market capitulation traders can capitalize on the panicked selling and price declines.

Capitulation is characterized by an extreme increase in volume as sellers rush to exit their positions overpowering any buyers present.

This surge in selling pressure creates an opportunity for short-term traders to profit by taking short positions.

The rapid and intense selling often leads to sharp declines in price making short positions profitable.

However it is crucial for traders to identify the end of this selling frenzy as it marks an excellent opportunity for longer-term traders to buy assets at inefficiency cheap prices.

Capitulation typically marks the bottom or near-bottom of a decline in price.

By carefully monitoring volume price movements and historical market data traders can successfully identify instances of market capitulation and navigate these periods to their advantage.

The relative strength index of a stock is a technical indicator that is used to calculate whether a security is currently in an overbought or oversold state.  This is a very important and fundamental indicator that has been used by traders since it was developed in 1978 by J. Welles Wilder, Jr., an American mechanical engineer who is known for his groundbreaking work in technical indicator development.

Calculation

Relative strength index, or RSI for short, is calculated as follows:

RSI = 100 – 100/(1+RS)

RS= the average of x up days closes (AU)/the average of x down day closes (AD).

AU= sum of previous x days up closes value (SU)/x

AD= sum of previous x days down closes value (SD)/x

X normally is set to a 14 period but users can most often edit this is charting software.

An up day value is calculated as follows:

Current close – previous close= up day value

down day value is assigned as 0 on an up day

A down day value is calculated as follows:

previous close –  current close = down day value

up day value is assigned as 0 on a down day.

Example

Over the previous 14 trading days, stock ABC has a sum of up day values of 20.  During the same 14 day time period the sum of down day values is 10.

AU = 20/14 = 1.4

AD = 10/14 = .7

RS = 1.4/.7 = 2

RSI = 100 – 100/(1+2) = 100- 33 = 77

As you can see a higher relative up day average results in a higher RSI value, while the opposite is true of greater relative down day averages.

A longer time period will result in a calculation that is less sensitive to moves and is more likely to result in RSI values closer to 50, while a shorter time period will result in a more volatile indicator which is more likely to show extreme values.

* It should be noted that current calculations of RSI often use exponential moving averages for AU and AD values.  The math for this is even more complex but essentially results in higher weighting being placed on more recent values.  If you understand this framework the logic behind using exponential moving averages is not hard to grasp, even if the actual calculations are.  It is rare that a trader would actually have to calculate a relative strength index by hand since it is included on almost any charting software.

Application as an Indicator

After obtaining a value from the relative strength index calculation, normally the value is plotted on a graph which is either superimposed over a price chart or placed underneath.  Due to the construct of the RSI formula, values are bound between 0 and 100.  Normally a value of 30 or lower is considered oversold,   while a value of greater than 70 is considered overbought.  Sometimes the thresh hold level is adjusted to 25-75 or even 20-80 to increase the rarity of the indicator threshold being met.  A trader may use the meeting of the indicator with a top threshold to mean a short or sell signal, while the meeting of a bottom threshold may be used as a buy indicator.  Let’s take a look at how an RSI appears on charting software.

The S&P 500 has been trending steadily up over this time period, but you can see that even in this strong uptrend oftentimes when the upper 70 level threshold is met short term selling has followed the majority of the time.

While it may not be the only technical indicator a trader uses for entries and exits, every good trader is aware of RSI levels as they are a tried and true method of identifying overbought and oversold conditions.

A stock option is a contract between the seller and the buyer of the option which gives the buyer the right to purchase or sell the stated amount of shares in the future at an agreed upon price.  The buyer of the option is not required to exercise his right to purchase or sell the actual shares from the seller of the contract.   If there is no advantage to exercising it the contract will normally expire worthless.

What does this look like in the real world?  All option contracts bought and sold through brokerages are for 100 share lots, and are sold at various price increments (known as strike prices) depending on the underlying symbol.  The contracts being sold expire at various time periods in the future, which are standardized and normally fall on the third Friday of the contract month.  A buyer may buy either put or call options, and the distinction is very important.  A trader can see the full list of options contracts available to trade on what is known as an options tree.

A call option gives the buyer the right to purchase shares of stock in the future at the designated price.  A buyer will purchase a call option contract when he believes the price of the stock will increase to more than the strike price plus the cost of the option.  If the price increases, the value of the contract is likely to go up with it.  If the stock at the end of the expiration date has a higher price than the option price, the owner can then purchase the stock for the option price and if he wishes immediately sell those shares in the open market at a higher value.

A put option gives the buyer of the option the right to sell a stock security at an agreed upon price in the future.  A buyer of a put option believes that the price of a stock will fall below the strike price of the option plus the cost paid.  If on the expiration date of the option the stock is trading at a lower price than the exercise price, the owner may purchase shares from the open market at the lower price and then sell them for the agreed upon option price to the seller of the contract, and will profit the difference (minus the original cost paid).

Option contracts give traders a way to increase their profits in a trade over simply buying or shorting shares on the open market.  How do options do this?

As an example let us say that a particular stock is trading at $48.  The trader believes that by the option expiration date, the stock will be trading at $52.  Currently $50 call options are being traded at .50 per share, or $50 for the contract.  If a trader buys the contract today for $50, and he is right and the stock goes to $52 at expiration, he has now made the $1.50 difference $52 market value – $50 strike price -.50 cost paid.  So the $1.50 multiplied by the 100 shares in the contract means the trader has profited $150 on his $50 investment, a return of 300%!

If the trader invested the same $50, well $48 dollars, to buy the stock on the open market, he could have bought 1 share, and his profit would have been $4, a return of 8.3%.  The same investment in an option in this example resulted in a profit of $146 more!

The caveat to this is that option contracts do not necessarily end up being worth any money.  If the price on the expiration date was $50 or less, the contract would be worthless and the trader would lose 100% of his investment in the option.

Because there is a potential to lose 100% of your investment (investment used loosely as options are used more for short term trading) brokerages typically will require the trader to be sophisticated enough to understand how the contracts work before they will give you privileges to actually trade them.  There are also varying degrees of option privileges as more sophisticated traders are also allowed to sell option contracts, which can expose the trader to enormous amounts of risk.

I should also mention that options are used by sophisticated investors as a way to hedge risk.  If they are long a position they may also purchase put options to provide protection should the price fall dramatically, as the put options will increase in value to offset the decline on the principal investment.  Call options can also similarly be used as hedges.

There are many options trading and hedging strategies, which can become very complex.  The most important factor for a trader new to options to understand is that they increase leverage, which magnifies gains and potentially losses.  It is crucial that the trader understands how the option he purchases will change in price in various scenarios, both upon expiration and before.

The stock market is the term we use to refer to the collective marketplace where stock securities are exchanged for agreed upon prices.  The stock market as a whole is actually a collection of loosely tied together exchanges which facilitate the actual trading.  When most people in the United States think of the stock market, they think of the New York Stock Exchange with hundreds of brokers screaming to buy and sell securities rapidly throughout the day.  While this may have been how all the stock trading was facilitated in the past, today improvements in technology have vastly changed the landscape in which buyers and sellers interact.

Today most stock volume is transacted over electronic communication networks which are publicly viewable electronic exchanges, also called ECNs, as well as in dark pools, which are another form of electronic trading where the buyers and sellers are hidden until an agreed upon price is matched.  These various exchanges and dark pools are tied together through quoting systems to form the order book of a stock.  The highest bid (coming from any exchange) and the lowest offer (also coming from any exchange) make up the national best bid and offer.  It is now illegal for most transactions to occur away from the national best bid or offer (NBBO), so even though the market is fragmented amongst various exchanges, a retail trader is still guaranteed the best price possible at any given time.  There are some exceptions where institutions may trade with each other away from the NBBO but this isn’t of much concern to any day traders.

The true purpose of the stock market is to allow corporations to access private wealth in order to make investments to grow their companies.  The benefit to private wealth is that when they invest in a company that grows, they realize the appreciation in value of that company by holding securities that increase in value.  So fundamentally if a company makes more money, and has expectations to make more money in the future, the price of the companies shares should go up.  As any market participant knows the correlation between earnings and share price is less than perfect, especially in the short term.

Of course from the way the market is structured, and the ease with which buyers and sellers can interact, traders are able to take shorter term positions in hopes of profiting from near term volatility.  The value or detriment of trading volume as compared to purely investing volume in the stock market is always being debated, but of course as long as it is legal you can count on a significant amount of total orders to be for the purposes of taking trades.

Participants in the stock market range from small “mom and pop” long term investors to high frequency trading hedge funds whose trades are directed on microsecond time frames with super powerful computers and algorithms.  Today for better or worse most volume is transacted by high frequency operations.  Some of this is a necessity to navigate the fragmented markets with large orders, while other volume is very predatory on small inefficiencies in price.  There is also a substantial amount of volume transacted in dark pools, so it would behoove any prospective trader to really understand what these are, how they operate, and how they are used.

The stock market as it exists today may be unrecognizable to past generations given technological advances, but it is none the less thriving as volume continues to generally increase year over year.

The reality is that no day trader in the world makes money every single day.  In fact, many day traders who make money over the long term actually lose money on more days than they profit.  Of course many prospective traders can not make money at all, and they rarely have profitable days.

The percentage of profitable days a trader has really depends upon the system being used by the trader.  Some systems are designed to make a small amount of money with a very high winning percentage, other systems are designed with the intent of losing small amounts of money many days, but occasionally having extremely profitable days which more than make up for the money lost.

An example of a system designed to take small profits a high percentage of the time would be a scalping system, either by hand or more commonly, using a high frequency algorithm.  Binary Options can also be used to leverage a scalping strategy.  Compare brokers here. While using high frequency trading systems was extremely profitable when it first became in vogue, fierce competition has quickly eliminated many of the inefficiencies in this niche.  Most of the profits are taken by large market making firms such as Getco and Citadel, as well as hedge funds that specialize in this arena.

A system that is designed to profit less often, but is also designed to take larger profits when correct may be an options trading strategy, or perhaps a tape reading strategy, or some combination of the two. If a trader can actually spot a large buyer or seller, or otherwise identify a time when a stock is likely to make a big move, they can take a large position with a tight stop loss, or take a position using options.  The trader can then capture a portion of the move with a leveraged position, and take a very large profit.  This recently seems to be where a high percentage of profitable hand traders are making money.

The lesson is that a trader can never believe a system that promises to make money 100% of the time, or on 100% of days.  Markets are always changing, and a system that was extremely effective yesterday could be worthless tomorrow.  The key is to always adapt, to use as many tools as you can at your disposal, and fiercely protect your account balance with a long term view in mind.  Many traders will make the bulk of their entire year’s profit in only a hand full of days, and the key is to be ready when the opportunity is present.  Find a system that works and exploit it as much as possible while it works, meanwhile always be testing new ideas and identifying future possibilities.

Risk management while trading is the practice of setting and maintaining tolerable loss levels given account size, trading technique, and personal thresh holds.   Effective risk management is put in place on every trade, and ideally is also monitored over longer time periods such as days, weeks and months.  It has been said that the biggest difference defining a professional trader from the rest is an ability to strictly follow predetermined risk guidelines.  Put simply a professional trader rarely will allow himself to lose more money on any one trade than he has decided is acceptable before entering into the trade.

Risk Management Techniques

A stop loss can be the most important risk management tool for a trader.  In its most basic form, a stop loss is simply a price at which the trader has decided to be the very largest loss he is willing to accept on a trade.  When a stop loss is reached, the position is liquidated or covered and the loss has been accepted.  A trader can accomplish this with either a stop market order or a stop limit order.  The difference is that when the stop price is reached either a market order to immediately exit the position is automatically placed, or if a stop limit has been chosen a limit order is placed and the limit order will execute if the security price reaches the limit price.  A stop limit order is not guaranteed to execute so it is best to be judicious when placing this stop order type.  The SEC gives a good description of stop limit and stop market orders as well.

A daily loss limit is another very effective risk management tool.  This sets a maximum loss level for a trader for any 1 day.  When this thresh hold is reached, the trader must either liquidate all positions immediately, or else be prevented from entering into new positions.

For profitable traders, it is also a good idea to systematically remove money from their trading account.  This can be a particular dollar amount every chosen period of time, or it can be a percentage of their account value, or it can even be anything above a particular thresh hold at which they decide that there is no benefit to holding a greater dollar amount in the account.  The point is that if money is systematically removed, the trader will never be bankrupt in a worse case scenario (think flash crash) and hopefully a declining percentage of total net worth is subject to risk in their trading account as they make money over time.

Why Manage Risk

The point of each of these techniques is limiting personal risk during a worst case downside scenario.  Every seasoned veteran knows that by nature, security price values are both unpredictable and volatile.  There are opportunities to make money consistently in the market, and there is no point in losing everything in one trade, day, or even month.  A professional will take the worst case scenario as a very real possibility, and plan accordingly so that they always live to make money another day.  A trader never knows if any one trade will make money, but if they are confident in their system they know they will make money in the long run.

A quantified loss limit also removes emotions from decisions, and for those who plan to be professional day traders it is a necessity.

In trading and investing, stock refers to a financial security that denotes ownership in an underlying corporation.  The stock is broken up into shares, which are easy to exchange over the stock market, or in private sale.  By owning shares of stock in a corporation, the holder is entitled to ownership rights of the corporation, which includes a right to participate in earnings and asset value growth of the company.  This is why investors buy stock, hoping the value and income of the underlying corporation increases.  Holders of common stock are also entitled to vote on company matters, either by attending annual and special meetings or by sending their vote by proxy, if they are a holder on the day of record.

The percentage of the corporation that one share of stock represents is different for every corporation, and depends on the total number of shares outstanding.  If there are 10 shares outstanding and a holder owns 1, he owns 10% of the corporation.  If there are 100,000,000 shares outstanding and the holder owns 1, he owns 1/100,000,000 (one one-hundred millionth) of the total corporation.

The shares that day traders exchange are in publicly traded corporations.  Day traders should be very happy that stock exists, as it makes it extremely easy to exchange small fractions of corporate ownership in thousands of corporations.  Publicly traded corporations are governed by the SEC, and holders have rights and limitations that may differ from privately held corporations.

While owners of stock are allowed to profit in the growth of a company, their liability for debts incurred by the corporation do not extend beyond their initial investment.  In the event of a bankruptcy, holders of the corporate stock are generally the last in security ownership line to receive any payment from the sale of all assets.  Some investors, and even some traders, will buy preferred stock in a corporation.  Preferred stock differs in that there are not typically voting rights associated with it, but in the event of a bankruptcy holders of preferred stock are ahead of the common stock owners in claiming a right to any value from the liquidation of the corporation.  Preferred stock may also receive a different yield in dividend payments, and are entitled to the rights to dividend payments before holders of common stock.

Traders should keep in mind that the stock they are trading represents real tangible value in the underlying corporations.  The nature of public stock and the public markets has made rapidly facilitating their exchange very easy, and without this day traders would not be able to function.