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.

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

Rank Broker Min. Deposit Max Returns Features Review
1
review $250 88% + 1 RISK FREE TRADE
TRADE NOW
3
review $250 91% + 3 PROTECTED TRADES
TRADE NOW

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.

Stock Market Terminology

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:

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.

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.

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.

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 Definition

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.

What is the Stock Market

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.

 

Do Day Traders Make Money Everyday

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 in Trading

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.