Day Trading

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.

A moving average is a statistical measurement commonly used as an indicator in trading.  Moving averages measure an average price over a set period of time, commonly 10, 15, 20, 50, or 200 previous periods.  When plotted over time, a moving average can give an indicator of price trend in a security.  Multiple moving averages are often compared simultaneously, and the relationship of different time period moving averages to each other is believed by many traders to provide an indication of likely future price movement.

Often times moving averages are treated as areas of support or resistance.  When these levels break, there is sometimes a large fast push in price movement.  Generally the longer term the moving average, the larger the push created.  Sometimes traders will look for a bounce off of a moving averages as well depending on strategy and if they believe the overall trend is in tact.

Some traders use moving averages in more complex ways as technical price indicators.  An example is a moving average cross.  This occurs when two moving averages of different time periods cross each other.  Sometimes when this happens there is a large push in price movement in the direction of a cross.  A common cross seen as significant to traders is the 50 time period crossing the 200.  Some traders may find significance in different time periods however.

Another more complex use of moving averages is the MACD indicator.  This indicator uses convergence or divergence of moving averages in an attempt to predict future price direction.

Moving averages may be simple or exponential, which applies weighting factors that decrease exponentially.

Whether you are a technical trader or not, it behooves most traders to at least be aware of moving averages as many market participants believe in their ability to provide a level of support or resistance.

The advantage of entering passive orders is that the trader is not giving up the spread in price.  Over time, or with large enough shares, saving the spread can lead to a huge difference in net profits for a trader.

The drawback of entering passive orders is the lower likelihood of having the order actually filled.  This is true on both LIT and dark markets.  If you use an aggressive order to enter a position, meaning you remove liquidity posted to the order book or in the dark pools, you are guaranteed that your order will transact.  If you are putting an order in passively there is no guarantee that even part of your order will be filled.

There is also a high probability in most cases that if the order is actually filled, most likely the price will move and the order could be transacted at a better price anyway in the near future. 

This is known as the adverse selection of fills.  This is also true on both dark and LIT markets.  There are ways that a trader can avoid this to some extent, and it is understanding the nature of how different ECN and dark markets fill during different situations.

For instance, a stock may have a very thick ECN book with lots of share size on both the bid and the offer.  Sometimes an institution may be buying or selling a large quantity of shares, and may be willing to give up the spread, but does not want to move the share price. 

An alert trader may be watching the tape print, and the markets that offer traders rebates to remove liquidity may be transacting very quickly on the bid or offer, as the institution seeks to slowly enter or exit their position.  At the same time the more expensive markets may not be printing at all, and the trader can be reasonably confident that the price is not about to move in the near future. 

The trader can enter the position passively and be reasonably assured that they have a good price.

The Dark Pools

Understanding how different dark pools transact can also be critical to a trader’s ability to have the highest probability of seeking the best priced liquidity.  There are dozens of dark pools in which traders can execute orders, and each one fills differently. 

Some are managed routes, meaning the dark pool maintains their own inventory of shares, and as they balance their share holding quantity their traders or algorithm may be willing to execute a trader passively, even if the LIT markets would not offer the same fill. 

Other dark pools indicate a large buyer or seller may be moving the share price in the near future, and a passive fill will typically be a strong sign that the price is about to move against the trader.

With large enough size understanding how to be filled passively can be a huge advantage for a trader.  Even taking a one penny spread with 10,000 shares is a $100 profit for a trader.  For this reason a trader must always watch how different ECN markets and dark pool markets are filling.

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