What Makes Trading Software Good

Software is extremely important when you trade.  There is not necessarily one software that is “best” but there certainly are software programs that are better than others.  There are a few points to keep in mind when a trader chooses a software program to trade with, or chooses a brokerage based upon their trading platform.

Low Latency

Every trader wants a trading software or a trading platform that is “low latency”.  This is a fancy way of saying that all of the quotes and information displayed by the software is extremely up to date, calculated to the microsecond.  This is crucial for traders because the markets move so quickly.  A trader needs the most up to date information possible, if they are to trade effectively.  This is more true every day, as more and more computer algorithms make up a bigger and bigger percentage of the total trades.  Computers act fast, and if a trader has a software that is not up to date, they will struggle, especially on short term trades, where pennies can make the difference between a profit and a loss.

At How We Trade we also recommend that you use the lowest latency software possible.  We would not want a trader to have any disadvantage, as trading is hard enough by itself.

Simple Design

It usually makes a trader more effective if the software has a simple user interface.  This is not to say that the software should be unsophisticated, or be lacking in formation or features.  The key here is that the design of the software allows a trader to navigate intuitively.  Not only does this allow a trader to move more quickly with less thought about how to interact with the software, but it also goes a long way to prevent user errors, popularly termed mistakes like “fat finger” trades.

At How We Trade we prefer a simple design.  Good software programs for day traders include platforms like Tradestation, Thinkorswim, or Sterling.  We also trade with Tradorax when we trade binary options, because they have a clean professional interface with their software.

Whatever choice you make regarding your preferred software, remember that it needs to be something that you are comfortable with, that you can navigate with ease and that you will not make order entry mistakes with.  Remember, accurate orders are a trader’s best friend.

Your Software Should Have Advanced Charting Features

Depending upon your strategy, you may use advanced charting features when you trade.  If your strategy depends upon charting moving averages, MACD indicators, Fibonacci signals, stochastic indicators, or something similar, you need to make sure that your software includes this.  Software and online platforms from many companies do include these indicators today, but if you use one or more of these in your trading, or you think you may incorporate them into your trading at some point, you should have software with advanced charting elements included.

Alternately, you could also use a third party trade indicator software if this is more effective for you.  There are a few of them out there.  Most do require you to pay a separate fee, which may be worthwhile if they are profitable.  As with any indicator, the key is in learning when it is effective and when it is not effective, because not all signals will be profitable and you will have to develop additional rules to using the indicators in most cases.

Eye Pleasing

This may sound a little silly, but trading is very emotional. When you trade, you want to be focused and in an upbeat mood.  Using a software with eye pleasing colors, layout, or a good looking scheme can help keep you in the right frame of mind for trading.  When emotions play such a big role in determining your ultimate success or failure, every edge counts, just like every edge in your trading strategy counts.  In fact we consider superior mastery of your emotions an edge when it comes to making profits.  Remember, when you think successful thoughts you have a higher chance of achieving your goals.  Software can play an important role in this area.

Most Software Packages Are Sufficient From A Mechanical Perspective

Today, most trading software and trading platforms are technologically advanced enough to provide trader with sufficient features and reliability to access the markets efficiently.  What this means is that most software can “get the job done”.  The best software packages do more than this though.  To succeed, you want your software to be lightening fast, eye catching, have elegance in its sophisticated yet simple design, and to have the tools you need to consistently profit from the markets!

Overcoming Emotions As A Day Trader

Emotions play perhaps the biggest role in determining whether a day trader ultimately succeeds or fails.  Developing a working system is an ability that most traders ultimately develop.  Some people even develop or find excellent trading systems that only need to be followed exactly as the system is intended to be followed, and the trader will make enormous profits.  Unfortunately, most traders do not follow their systems exactly because their emotions get in the way.  This leads to regret, anger, frustration, and ultimately failure.  Trading is hard enough without bringing emotions into it.  If you can learn to master your emotions, you will begin to master trading itself.

The Slimmest Margins Between Success and Failure

What many people may not realize is that the difference between success and failure in day trading is extremely narrow.  Look at this chart showing the net profit a trader of a binary security will make depending upon the percentage of time that their trade is a winning trade.
Payouts

If a trader is correct on less than 56% of his trades (assuming a binary payout of either 80% or 0 depending upon if the trade is a “win” or a “loss”) he will not make money.  If he is correct on 65% of his trades, he will have a net return of 17%, and if he is correct on 75% of his trades, he will have a net return of 35%.  A difference of 10% trade accuracy is the difference between losing money and making 17% return!

Because the margins between great success and failure are so slim, a trader can not let emotions cost him even a small amount.  Put another way, a trader who masters his emotions has the ability to make a lot of money day trading!

Identify How Emotions “Hurt” Your Trading

The first step to overcoming emotions during trading is to identify the ways in which emotions are harming your trading.  These are the most common ways that emotions hurt a trader, and cost him money, and steps to overcome them:

Being Reluctant to Enter A Position When the System Calls For It

This is one of the worst things that a trader can do, and unfortunately it is also one of the most common.  Not entering a position when the system calls for it for any reason (burned previously on a similar setup, down on the day, up on the day and protecting gains, not recognizing the opportunity, ect) begets feelings of intense remorse most of the time, especially when the position would have been a big win.  It also messes with the winning percentage of a system.  If you are not taking positions every time your system calls for you to, then you are missing out on more money over time if your system works.  You never want to miss a huge trade because your emotions made you too reluctant to enter into the position.

How To Overcome This

What traders need to realize is that no system works 100% of the time.  Even when you do everything correctly, even if you feel like all signs are pointing to a winning trade, a certain percentage of time it will not work.  Getting “burned” on a previous trade is a common reason that traders do not take a subsequent position.  The problem is that a system is not a system if you do not follow it every time.  If your system works, you need to follow it precisely, if your system doesn’t work, you need to shut your trading down and make adjustments in a demo or “sandbox” arena until you can systematically make money again.

A trader needs a short memory.  Always stay in the moment.  Do not pay attention to your profits/losses for the day, and forget about any prior trades.  Treat each opportunity as an individual entity, as a part of a systematic way to make money.

Taking Too Large A Position After A Win(s)

This is the flip side of being reluctant to enter a position.  Positive emotions can make you enter a position with much more size that your system dictates, because you are “feeling lucky”.  This can lead to big losses, and can lead to reluctance to enter future positions at all, or it can lead you to enter future positions with too small of a size.  Using too large of a position can lead to a loss that is nearly impossible to return from, or at best a loss that will ruin your profitability for a period of time.

How To Overcome This

The solution is similar to being reluctant to enter a trade.  Remember that your system is in place because statistically over time, it works.  If you feel that positive emotions are causing you to enter positions much larger than normal, stop yourself, and realize that you have to stay true to what has been proven to work.

 Not Cutting Loses Quickly Enough

Amateur traders almost always make the mistake of being overly optimistic about a trade that goes “out of the money”.  They think that if they hold their losses long enough, eventually the trade will become a winner.  The problem is that oftentimes, the trader becomes a larger and larger loss.  This leads to feelings of hopelessness and dejection.  If the loss is large enough, it can also ruin your account balance, and make it very difficult to regain a profitable enterprise.

The Solution

Always have a pre-determined “out point” or “stop loss“.  If the trade reaches a loss of a certain size, cut your position or exit your position all together.  You must stick to this religiously.  If you have the point pre-determined before you enter the trade, it does not leave wiggle room for you to rationalize holding a loss and letting it turn into a bigger loss.  There will be more trade setups in the future, endless opportunity is ahead of you.  Cut your losses quickly and move on to the next one.

 Letting Anxiety Take You Out Of Winning Positions Too Quickly

This is another very common mistake of new traders.  They find themselves in a profitable position, but they become very anxious that it will turn around on them.  They exit way to quickly, and take what would have been a big gain and make it a very small gain.

Overcoming This

The best way to overcome this is to resist the urge to exit positions completely.  Instead, exit a smaller percentage of your position (maybe 25%) and let the rest run.  This locks in some of the profits and takes away a lot of the anxiety around holding the trade.  Over time, you will train yourself to hold your winning positions longer.  There is nothing wrong with taking profits, but you have to make sure that you are holding your winning positions for a long enough period of time.

Letting Any Feelings Surrounding Other Aspects of Your Life Prevent You From Following Your Trading System

Day traders are all people (except the algorithmic traders).  People have good days, bad days, fight with spouses, have health issues, have other victories in life, and can have any number of things happen in their lives outside of trading affect their emotions.  The problem arises when these emotions influence a trader’s ability to follow their system.  If you are not following your system, you probably will fail to systematically be profitable.

The Solution

If you feel like you have emotions (negative or positive) that could prevent you from following your system you need to identify them, and you need to clear yourself of the emotions.  Some traders actually meditate, some sit quietly for a few minutes, others may take a walk.  Find what works for you, but it is very important to clear yourself of any strong emotions prior to trading.

Dejection

This is the emotion that no day trader wants to experience, but every trader on their journey to becoming a professional day trader experiences at some point.  If you feel like you can’t make money, you probably are not going to follow your system very well (or do anything very well).

Solving This

Dejection stems from a lack of trust of your system.  Sometimes this lack of trust is not displaced, and your system is not working.  Sometimes the lack of trust is simply a product of the up and down cycles of systematic profitability.  The key is to regain faith that you can systematically earn money from the markets.  Take a step back, and use your system in a demo account or with very small positions.  If you need to change the system, change your system.  Once you regain faith that your system will make money over time, resume trading as normal.  You need to have faith in your system to follow it!

Controlling Your Emotions Leads to Success

Only with a clear mind, and a willingness to jump on opportunities quickly will you succeed as a trader.  Ask any professional trader and they will tell you that the most important way that they grew as a day trader was by learning to control their emotions.  Control in trading correlates strongly with success.

How To Make Money In A Declining Market

You don’t need the stock market to go up to make money.  There are a number of ways that you can bet on an individual stock or the stock market as a whole to go down.  While this is a speculative strategy (as opposed to an investment strategy) it can provide a useful hedge if you have other long positions, or it can be a great way to make money when conditions are not favorable for a bull market.

When you are betting on an asset to decline in value, your position is known as a “short position“.  You may also see a trader who has a “short position” referred to as “being short” or “shorting”.  The most common ways to do this are by selling a stock short, by purchasing Put Options, by writing Call options, or by purchasing a Put binary option.

Ways To Profit From Short Positions

Purchasing A Put Binary Option

This is perhaps the easiest way for the average trader to take a short position.  A binary option is extremely simple (it pays out a pre-set amount if the trade is in the money, or expires worthless if the trade is out of the money).  Binary option accounts are easy to open, can be funded with a credit card, and do not require any special “margin privileges” like a traditional brokerage account that is option eligible.

High Risk High Reward

The trader takes a short position by purchasing a Put option contract and entering the dollar amount that they want to risk on the trade.  The “strike price” is determined by the price of the security at the moment the trade is entered.  The trade has a pre-set payout amount (usually between 60% and 90% of the amount risked).  If the option expires in the money, the trader wins their money back plus the payout percentage designated for the trade.  It does not matter how far in the money the option contract expires, the payout is always the same.  If the trade expires out of the money, the trader loses 100% of the amount that they risked.  In this way a trader can potentially make a lot of money from their short position, but they also will lose their entire position if it expires out of the money.

By using binary options, a trader can purchase put options for different time frames to place a bet that will pay if an asset declines in value.  This is a viable way for an average trader to profit from a stock, a market, or other assets falling in price.  There are various lengths of time available for binary option trades, usually ranging from 1 minute up to a period of a month or months.

Selling a Stock Short

This is the most common way that traders and investors, and especially day traders, can profit from a decline in prices.  A short sale involves selling a quantity of an asset (usually a stock) that the trader does not actually own.  The trader will sell at the current market price to the open market, and their brokerage will provide the shares to the purchasing party.  The trader is effectively being loaned the shares from the brokerage.

The trader’s account is credited with the value of the sale.  The trader is usually charged interest from the brokerage daily for the shares that are loaned to the trader.

When the trader decides to close the position, they purchase the shares back from the open market.  If the price of the security has fallen, the trader will purchase the shares back (to payback the loaned shares to the brokerage) for less than what they were sold for.  The trader can then keep the difference between the price it was sold for and the price it was bought back for.

Limitation On Profits And High Potential Risk

The highest amount of money that a trader can make from selling a security short is 100%.  A 100% profit would be realized if a security becomes completely worthless (the trader would not need to pay back the loaned shares to the brokerage because they have no value). Most assets which are shorted do not go to a price of 0 though.  In fact a decline in price of 20% for the most commonly traded securities would be considered significant.

It is important to note that if a position is out of the money when it is closed, the trader does not need to necessarily lose a lot of money.  A position which is closed out for a slightly higher purchase price than the sale price, for instance, will result in a very small percentage loss.

That being said, there is no maximum to the amount of risk that a trader is exposed to.  While their maximum return is 100%, the price of a security may double, triple, quadruple, or even go up higher in price.  While brokerages have risk controls in place in the form of “margin calls”, this is not a perfect system and it does not necessarily limit the risk effectively.  If for instance a security closed one day below a level which would result in a margin call, and opened the next day significantly above the price which would incur a margin call, the trader is responsible for paying the brokerage any losses, without limit.

Selling Short Takes More Capital

Because a short sale of a security typically provides the lowest expected return compared to the other ways discussed here to profit from price declines, it takes the most capital on the trader’s part to make money.  Short selling can also only happen in a margin approved account, which has minimum balance requirements.  While many day traders do engage in short selling, and some are very profitable from it, there are limitations and benefits unique to this form of short position.  It is important for every trader to understand this completely before choosing their method of taking a short position.

Purchasing A Put Option (or Writing a Call Option) Using Traditional Options

A traditional stock option works by giving the owner the right to either buy (a Call option) or sell (a Put option) a security at a future date, for a specified price.  The option has a value because it provides this right to the owner at a future date (and prices may change between the purchase time and that future date), and it may have a value because it is either above or below the strike price when the option contract is purchased.

Purchasing a Put Option

If a trader owns a Put option, it gives that trader the right to sell shares of that particular stock to the option writer for a specific price on a specific date.  If the price is below the strike price, the trader will execute the option.  This means that they will buy shares at the market price, and sell them for the higher agreed upon strike price.  By owning a Put option the trader is making a bet that the price will decline, and that they will be able to purchase the shares on the open market for below the strike price (which the option writer is obligated to pay).

Returns are Potentially High and Risk is Capped

The benefit of a Put stock option is that they rewards are potentially very high, the highest of each of these methods.  A trader has the ability to make multiple times the money that they purchase the option for.  If the option expires out of the money, the option expires worthless, capping the risk to the trader at the amount they spend on the option contract(s).  Some view purchasing traditional stock options as the most beneficial risk/reward profile of any type of position, for trading purposes.  The caveat is that while the risk is capped, an option that expires even slightly out of the money has no value.  An option that expires slightly in the money will have a small value, so while the upside has a lot of potential, the expected return may not be high enough to compensate a trader for the risk of losing the entire trade amount.

Option Decay

Every option has a time value, otherwise known as Theta.  This is the value in the amount of time left between when an option is purchased, and when it will expire.  Time has value because the price of a stock can move over time.  The more time remaining, the more potential a stock has to move further into a profitable position for the option.  Even if the price of a stock or underlying security doesn’t move, the time until the option expires is constantly reducing.  As time passes, the time value of the option lessens.  This reducing time value is known as option decay.

Writing a Call Option

A trader can also profit from a decline in an assets value by writing Call options.  The trader sells the call options that they write on the open market, and if the price drops below the strike price, the trader will keep 100% of the money he earned by selling the options. If the option is executed in the money, the writer will be obligated to sell shares to the option owner at below market value prices, potentially resulting in a loss on the position.

No Cap On Risk

Because the price of a stock hypothetically has no limit to how high it can rise, the potential exists for very large losses when writing Call options.  As an example of how writing a Call option can turn out especially poorly, let’s say a trader writes a Call option (100 shares) for stock XYZ at a strike of $50.  Let’s say that the trader sells this option for $2 (taking in $200 of revenue).  If the price of the stock rises to $60 when the option is exercised, the trader must sell the owner of the option 100 shares at $50.  Because it costs $60 per share to acquire the shares, the trader will lose $8 per share ($10 a share on the price difference minus the $2 a share in revenues from writing the option).  This position loses $800, and it only had a maximum potential gain of $200.  Writing options can result in unfavorable risk/reward profiles in some circumstances, and traders should have extensive option knowledge before writing any options of their own.

The Best Method Depends Upon the Trader

There is no “best” method for profiting on a decline in prices.  There are unique benefits and risks to each style.  We use Binary Options because there is a high payout no matter how far in the money the option contract expires.  This allows us to precisely control our risk/reward profile.  It is also well suited to traders who do not want to put up substantial amounts of capital (as the other methods require).

The highest potential payout is using traditional Put options, but there is option decay, and an option that is executed a little bit in the money will only provide a small return to the owner (who also took a significant risk by purchasing the option and possibly losing 100%).

It is important for every trader to understand the workings of each type of short position, and to thoroughly understand their chosen method.  For simplicity and for the predictable payouts on all winning trades, we use binary options.  If you would like to become a binary options trader and you need to open a binary option account of your own please sign up for an account today.

Do Day Trader’s Make Their Earnings Public?

The earnings of individual day traders are not usually made public.  There is good reason for this, as day trading for oneself does not require any type of public disclosure of earnings.  There is not any incentive for most profitable traders to publish their earnings, and if they do not want anyone else to know how they are making money they do not want to attract unneeded attention to themselves.

Usually when an individual trader makes their earnings public, they do so when they are selling a trading system, educational material, or school.  Anyone considering paying for a trading education from someone who publishes their earnings should be weary about the veracity of the claims.  If, for instance, the trader shows huge gains month after month and year after year without any drops in their account value, it is unlikely that they are being truthful.  Every trader experiences losses at some point (unless they are merely getting paid as an intermediary for an institution).

Many successful traders have the occasional massive trade, when they may make hundreds of thousands or even millions of dollars.  Unless you know them privately, you will probably never hear about it.

Big Bank Trading Revenues

Many people may be dazzled by the trading revenues at big banking institutions, and believe that this is attainable for them.  While this is possible, the revenues generated from trading at large institutions is mostly from providing liquidity to the markets and matching client orders internally and externally (for a profit to the bank.)  Banks have mostly been prevented from taking any sort of speculative trading positions from what is known as the Volker Rule.  To see the SEC page on how the Volker rule restricts banks from proprietary trading as a part of the Dodd Frank Act, view here.

Large banking institutions are mostly restricted to making money with market making activities (which can be quite profitable for a bank using high frequency trading algorithms but less so for an individual trader).

You Should Not Make Your Earnings Public

If you become a profitable day trader, you should keep your earnings private as well.  When you are using a profitable system, there will be many people trying to learn what you do, and how you do it.  The more people who learn, the less money available for you (in most cases).  If you don’t make money, you probably don’t want people to know that either.  Simply put, there is no advantage to telling others how much money you make as a trader.  If you want to publish your earnings, you are free to make whatever information public that you wish, but there is a good reason you will have a hard time finding any real traders who do this.

risk free trading

How To Get Risk Free Trades

Risk free trading is the holy grail of day trading. While stock traders have been scheming creative ways to mitigate risk for over a century, they are never really able to eliminate all risk.

Even a high tech hedge fund running a high frequency trading algorithm is open to the risk of flash crashes or technology errors disrupting their trading. See the story behind the line of code that almost took down the largest US market maker, Knight Capital.

Binary Options Brokers That Offer Risk Free Trades

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For small to medium retail traders, your typical day trader, there finally is actually a risk free trade proposition.  Tradorax is letting anyone who funds a binary options account have 2 risk free trades!  That means even if you lose, your account will not be negatively impacted.  It will be as if the trade never happened.

For an example of how much this can help you, think of a trader who places 4 trades.  Now, some traders are better than others, but overall, about 50% of trades will be winners, and 50% will be losers.  This means that from 4 trades, a trader who meets the averages can expect to be correct on 2 of them, and lose on the other 2.

This would result in an overall loss for the trader in his account if all trades are the same size.

Now imagine that the same trader has 2 winning trades, and 2 risk free trades that do not lose any money.  If each trade returns 80%, The trader will return an astounding 160% on his 2 winning trades, if all trades use the same amount of capital.

Also read:

He will not lose any money on the incorrect trades, and from 4 trades the trader has made a higher return in a short period of time than most pros make in a year!  Even if a trader only makes 4 trades and withdraws all his money, he can net a nice profit.

Risk free trading sounds too good to be true, but 24option and BancDeBinary have made it a reality.  Why would they basically give money away?  The first reason is they know only about 50% of the trades will be losers.  A trader has to choose the trade as his risk free trade before he initiates the order.

So even if the trader has a winning trade, he will still use one of his risk free trades.  This still is a huge advantage to traders though.  Some traders will end up losing on both of their risk free trades, and the savings will be immense.

The second reason they do this is because it is a great promotion.  They know that traders will not usually stop after the two free trades, and that they have an opportunity to generate profits in the long run.  The onus is on the traders to be smart and take their profits while they are still on the table.

So while risk free trading has until now been a bit of a myth, Tradorax has created a great new opportunity for new accounts with their brokerage.  If you want to take advantage of this offer while they are running the promotion, you must open and fund your account with their low minimum deposit.  Remember it always pays to be smart.

The Difference Between Equity Securities and Future Contracts For Traders

Everyone is familiar with equity securities.  These are the stock shares that trade on exchanges like the New York stock exchange, with traders yelling and hustling around the floor to buy low and sell high.  Equity securities, more colloquially known as stock, represents ownership in a corporation.  When this changes hands, the new owner instantly takes over ownership interest from the seller, and takes ownership at the execution price.

Future contracts are different from stocks, but the underlying security of a futures contract may be equity securities.  Futures contracts cover a wider universe of underlying securities than just stocks though, futures contracts may be made on commodities like gold or oil, interest rates, or even the weather!

A futures contract is a contract between two parties, in which the parties agree to sell and buy a set quantity and quality of some asset at an agreed upon later date, for an agreed upon price.  Futures prices also trade on exchanges just like equities.  Today, just like equities, most futures contract trading now takes place over electronic systems.  Both the Chicago Board of Mercantile Exchange and the New York Stock Exchange own futures trading platforms, and very little open outcry trading takes place worldwide anymore.

Futures contracts fluctuate in price just like shares of a stock.  The reasons for changes in price are the same principals of stock trading, as market conditions change, the future expected value of an underlying security changes, and the price of contracts adjusts accordingly.

For instance oil future contracts are very popular.  A 30 day contract may have a price of $100 per barrel, meaning the buyer is locking in his purchase price in 30 days at $100 per barrel.  If the price of oil in 30 days is actually $110, the buyer still only paid $100.  He now owns an asset worth more at current market value than the price he paid.  As the price of oil is rising, obviously the contract will not continue to trade at the same value, and the owner can either choose to hold the contract until expiration, or sell for a profit on the secondary market.

A key fundamental difference between an equity security and a futures contract is the way in which the market determines prices.  An equity security is always priced on what the market believes it is worth today. A futures contract will always be priced based on what the market expects it to be worth in the future, at expiration.  If an asset is spot trading at some price, while rare, it is possible that the market will expect a lower price in the future, and the futures contract price will imply a lower future expected value.

Equity securities are much more liquid in large quantities, and very efficiently priced with very low spreads.  Futures contracts are not necessarily as liquid, though popularly traded futures contracts are about equally as liquid from a retail trader’s perspective.  Spreads may be larger, however, and price may be more volatile.

For many people the benefit of futures contracts is that they can trade assets in a wider spectrum than equities, and for those who are shrewd, there may be more potential to profit from inefficient pricing.

Volume Weighted Average Price – VWAP

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.

What is an Exchange Traded Fund- 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 Capitulation: What is it and How to Identify

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.

Capitulation in GE
Capitulation in GE

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.

What is a Stock’s 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:

Daily Price Bar and Volume
Daily Price Bar and Volume

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.

Relative Strength Index- RSI

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.

RSI under a recent chart of the S&P 500 .
RSI under a recent chart of the S&P 500 .

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.

Searching For Your Trade? How to Find Your Strategy

Developing a strategy when you are a new trader is tough.  Even after you have been trading for a long time, it is very common to develop a dependency on one niche.  You stopped looking at other strategies because what you were doing worked so well, and why waste time and money on stuff that doesn’t work?  Then one day you realize that the trade is gone.  The trade that was once so dependable  now loses money!  Now there is nothing to fall back upon.  Sound familiar? What is a trader supposed to do?

Well the good news is there are always opportunities, it just takes work to find them.  So whether you are a green trader looking to break into the business or a seasoned veteran that needs a fresh perspective, here are my 5 keys to developing your niche.

Keys to Strategy Development

1. The first step is to take a deep breath and clear your head.  Approach the search with an open mind.  Opportunity exists everywhere in the market but you need to be open to it.  Remove anything in your head that says it doesn’t exist or that you can’t exploit it.

2. Start with a very broad perspective.  Look at the market and how it responds to positive news, and how it responds to negative news.  Notice that the reactions are rarely equal in severity.  What is the general sentiment?  What kind of stocks are in the news?  Maybe you notice that small pharmaceutical stocks with drug approvals normally will trade up for 2 days or even longer following the announcement, maybe this is something to keep an eye on.  Maybe you notice that blue chip stocks not in the news follow technical signals to a T for long periods of time.  Start thinking about what is moving and if it can actually be predicted with any reliability.

3. Research strategies people have published.  It rarely works to simply copy a public strategy robotically, but you may see some adaptations that you can profit from.  A great example is how we often use this indicator for trade entries, but only when it meets certain conditions that work for us, and we always use our own exit strategy. The point is to get a boost from what is out there, but adapt it to yourself.  In the same vein:

4. If you are experienced you need to understand what you do well and what you don’t.  Are you great at being aggressive in fast moving trades, in and out in 10 minutes with a huge profit, or do you read a monthly chart and know that at some point in the next week a stock is going to hit that target?  Do you get scared out of positions when you watch them too closely, or are you a master at ignoring the noise? The point is it helps to narrow down the time period that you are analyzing.  Some traders place 10 trades a year and win big on 8 of them, other traders place 20 trades a day and win on 6 of them, but both are capable of making money.

5. Consider other ways to profit from movement.  Maybe if you often get scared out of trades you won’t mind making small option contract purchases with the opportunity for big upside.  A vanilla equity strategy with a very low rate of return after commissions may have huge returns on options when handled correctly.

Real Traders

Remember that you never have to feel like any “type” of trader.  Real traders simply find a way to make money, they don’t try to conform to any mold.  Always trust yourself more than anyone else, and apply discipline while removing emotion from your trading.  Finally never stop evolving, there are always new resources, changes to the market, and new technologies that impact trading.  Nothing will work forever, but there will always be opportunity.

The Relevance of the Bid-Ask Spread to Traders

The bid ask spread is the difference between the bid price and ask price of a stock.  In most high volume US stocks, the spread is normally just 1 penny, meaning the offer price is one cent higher than the bid.  This is the lowest denomination that can be published on the book of a stock, although in dark pools transactions may occur at fractions of a penny so the spreads here are effectively smaller at times.  Even though in many high volume securities the spread is one penny, it is not required or mandated to be so small.  In fact there are many instances where we may see larger spreads, and traders should be aware of why they may differ and change.

Although high volume low price stocks will normally have the smallest spreads, many popular US stocks regularly trade with spreads of larger than one penny.  These are the factors  most likely to affect the spread in a stock.

  • Price of stock
  • Volume of stock
  • Volatility of stock
  • Market maker activity

These factors are not necessarily in order of importance, although designated market makers of course have the obligation to facilitate orderly trading activities and keeping spreads reasonably tight is a big part of maintaining order.   This means that market makers effectively can keep a spread as tight as they wish (up to one penny) although large orders or extreme volatility (such as in the flash crash) may overwhelm even the market makers.

Generally speaking as a stock price rises, the spread will widen.  This is intuitive since the higher price may effectively cancel out the spread widening on a percentage basis.  IE if a $10 stock has a 1 penny spread the spread is the same on a percentage basis as a $100 stock with a 10 penny spread.  Also because the stock is more expensive per share, there is generally less shares posted on the books than a lower priced security.

Volume will affect the spread in the same way.  If there are fewer shares transacting, there is a higher likelihood that there will not be shares posted on each penny increment on the books and wider spreads are generally seen.

Higher volatility can create wider spreads.  If a stock is very volatile, its fair value at any one point in time is generally less agreed on by the market as a whole.  This means that all of the buy/sell interest will not be tightly centered around the last transaction price, and wider spreads are seen.

Spreads are very pertinent to high frequency traders, especially algorithmic traders.  This is because often times their entire profit goal is simply the spread.  A higher spread may generate higher profits per round lot traded for them, but it also may imply greater risk that they will not be able to exit their positions at their desired price.  It should be noted that with the rise of high frequency traders, spreads have generally become tighter as they seek to profit from smaller and smaller inefficiencies as well as add volume to the system.

All traders must be concerned with what a spread implies about the liquidity of a security.  If a trader purchases a position at the ask, which is $1 higher than the bid, the only way the trader could exit the position instantly is by selling to the bid, and assuming the loss.  In especially illiquid securities, a trader should never assume that they will be able to exit the position with a limit order at the bid or ask.  A high spread could imply the possibility of difficulty exiting the position at the desired price.

Hand traders who are scalpers are especially concerned with spreads since a wide spread may make scalping very difficult, especially during volatile trading times.

All traders should be aware though of factors that are influencing spreads, and if a trader spots a changing spread it may be useful to ask why the spread is changing and what it may mean for their trade.

 

Women Day Traders are on the Rise

A 17 year old actress, a stay at home Mom, and a young female graduate, what do these women have in common? If your first thought was that they are all scared of the stock market, guess again. Long dominated by the most machismo and, at least according to one recent study even sociopathic males, a wave of women have recently decided that they too are capable of making day trading a viable career.

Women’s Interest Surging

Our data indicates a recent surge of interest from women exploring the possibility of day trading, at least as a hobby. According to HowWeTrade usage data, 34% of new trader inquiries are now made by women! This is in stark contrast to historical data, which suggests that women strongly shy away from the trading world. According to Reuters, as of 2012, women at most represented a mere 5% of professional traders.womentrader2

While this is hardly social parity, it is at least a big step in the right direction, especially for a profession that has long propagated predictions of impending failure for any woman who has thoughts of joining the exclusive ranks of male traders. What we are seeing is an influx of women from varying ages and backgrounds, and we view it as a definite positive for the industry.

Past Research

Often citing what was proclaimed to be a landmark study by the University of Cambridge which correlated profits of high-frequency London traders to their finger-digit length ratio and testosterone levels (which are partly influenced by gender), some claimed to have scientific proof that women simply were not biologically cut out to be successful traders.

Women Beating Men Today

Given the pervading perceptions, many may be surprised to learn that women are not only making up a growing percentage of day traders, but that they are also doing quite well at it.

For proof look no further than Rachael Fox, a 17 year old actress/day trader that has been featured on a number of interviews on CNBC and other popular networks. Somehow between appearing in movies with Daniel Craig and acting on Desperate Housewives, she manages to run foxonstocks, a popular website dedicated to introducing people to day trading. Rachael also claims to have personally returned 30.4% through her own trading in 2012, a figure well above the average market return for the same time period.

Rachael is not alone though, and there might be a very good reason why. In 2001 Brad M. Barber of the University of California, Davis, and Terrance Odean, currently at the University of California, Berkeley, released a study entitled “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment” that showed based on empirical data from a large discount brokerage that men on average reduced stock gains by nearly 1% more than women did by trading too often. The reason cited: men are likely to be over-confident and act outside the scope of their competence, while women are more prone to study and understand a situation before making a judicious decision, or otherwise refrain from acting outside of their abilities.

women tradersAnother recent study by Vanguard found that in the financial crisis of 2008 men were 10% more likely to exit their positions while stocks were at lows than women. Generally experts recommend buying when stock prices are depressed since selling at lows usually reduces long term returns.

Why has it taken women so long to realize that they are at least as capable as men at trading? There are no clear answers. Guesses range from an aversion from women to risky behaviors like trading in general, to societal and group norms discouraging women from entering the profession.

Whatever the reasons, women are at last getting some long overdue support. Programs like the University of Tennessee’s Finance for the Future Initiative, which focuses on trading from the female perspective, are shifting beliefs about what female traders can accomplish. Finally women seem to be deciding that they too are capable of becoming traders and at How We Trade, we think that’s a good thing.

Stock Option Pricing Basics

While stock option pricing models can become extremely complex, the underlying factors they are taking into account to put a fair value estimate on the option contracts remain the same.

Stock options are generally priced based on 6 factors.

  1. The current share price of the stock.
  2. The strike price of the options contract.
  3. The amount of time remaining until the option contract expires.
  4. Any dividends that the stock may accrue during the option time frame.
  5. The expected volatility of the underlying stock.
  6. Current interest rates.

While this may seem complicated, it is all fairly intuitive when you think about it a little more closely. The position of the current stock price relative to the strike price of the option is likely the most influential factor in the price of every option contract. If you own a call option with a strike price of $20, and the underlying stock is currently trading at $10, there is no inherent value because the strike price is higher than the current price. A logical person would just purchase shares on the open market rather than exercise the option contract. If the reverse were true and a $10 strike price existed with the underlying stock trading at $20, there is $10 of inherent value to each share.

The expected volatility of the option and time remaining until the contract expires also play important roles in the pricing. If an underlying security has higher volatility, there is a greater chance for the value of the option to be higher at expiration. Similarly, the more time that remains until the option contract expires, the more opportunity there is for the option contract to be worth more at expiration. This is a risk for the seller of the option contract, and they expect to be compensated for this risk. Generally speaking the higher the volatility and the more time remaining until the contract expires, the more the option contract will be worth (all else being equal).

Dividends have a very obvious effect on options pricing. When a stock pays a dividend, it can be expected that the price of the stock will fall on the ex dividend date proportionately to value of the dividend paid per share. Since a dividend is expected to lower a stock’s price, this has a negative effect on call options price and a positive effect on put options price (positive meaning higher contract value). Because sellers of option contracts understand this effect and are aware of ex-dividend dates, the market will price this into the option contract value if the underlying stock is affected by dividend payments during the option contract’s life.

Perhaps the most difficult concept to understand is the effect of interest rates on option prices. American stock options are unlike their European counterparts in that the owner can choose to exercise the contract at any point before the expiration date, whereas in Europe the contract can only be exercised upon expiration. This means that each trader hypothetically has an opportunity cost of not being invested elsewhere, the opportunity cost generally given to be the current risk free rate of return.

This means that if a trader purchases the underlying security rather than the options, he will have greater capital tied up in the position, and therefore a greater opportunity cost than if he purchased the less expensive options contracts. If interest rates rise, this means that call options become more expensive to account for this increased opportunity cost in owning the position. Put another way, a buyer is willing to pay more for option contracts because of the higher opportunity cost of actually owning the position. The opposite is true for put options. Since a short seller takes possession of the capital from the sale of securities, if interest rates rise the trader can now expect a higher rate of return on the short proceeds. This makes buying put options comparatively less attractive as it ties up capital that would elsewhere be earning interest.

These are the general factors that go into creating pricing models, but the actual pricing models can become extremely complex. It is important to first have a solid grasp intuitively on how different factors affect pricing before one gets caught up in the quantitative application.