Being disciplined

Successful day traders have an innate sense of discipline. They know when to commit more money to a trade and when to cut their losses and close shop for the day.

Unfortunately, a lot of long-term investors can get sloppy. They have done so much research and committed so much time waiting for a position to work that they often forget the cardinal rule of the trader: The market doesn’t know that you’re in it. The stock doesn’t know you own it, so it’s not going to reward your loyalty. Securities go up and down every day for no good reason, and sometimes you are going to make a mistake and will have to cut your losses. There’s no shame in that, as long as you take something away from it.

Now, how can you get that discipline? By doing these things:

• Develop an investment and trading plan, covered in Chapter 7. Although investing is probably not your primary occupation, you do want to have in writing what your objectives are and how you plan to meet them given other constraints: time, tax considerations, and risk tolerance.
• Carefully evaluate your performance (covered in Chapter 13). Keep a trading diary so that you know what you’re trading and why. Can you find ways to improve? Are you making mistakes that can be avoided?

• Set up a sell rule. A quick way for an investor to improve her trading discipline is to set up a sell rule, a rule that tells her when to cut her losses and move on. For example, if a stock is down 20 percent from where it was purchased or where it traded at the beginning of the year, it may be time to sell, regardless of what you hope it will do.

Traders have to go through these exercises to survive. Investors often skip these steps, but they shouldn’t.

Dealing with breaking news and breaking markets

One reason that the markets are so volatile is that they respond to news events. Prices reflect information, changing when any little bit of information comes into the market — even if the info is just that someone wants to buy and someone wants to sell right now. The problem is that sometimes the market participants don’t react in proportion to the news they receive. Good traders have an almost innate ability to discern news that creates a buy from news that creates a sell. (You can find out more about market indicators and strategies in Chapter 9.) Sometimes traders want to go with the market, and sometimes they want to go against it.

When your investment idea has been affected by a news announcement, you need to consider how your position — and you — will react. After all, no matter how long your time horizon and how careful your research, things happen to companies: CEOs have heart attacks, major products are found to be defective, financial statements turn out to be fraudulent, and so on. How are you going to respond?

The first point is that you have to respond. The market doesn’t know your position, and the market doesn’t care. (Have I mentioned that already?) You need to assess the situation and decide what to do. Given the information, is it time to buy, sell, or stay put? Holding your long-term position in the face of long-term news is often okay, but that decision should be an active one, not a fallback. The trick is to be objective, which isn’t easy when real dollars are at stake.

Successful day traders are able to keep their emotions under control and keep the market separate from the rest of their lives. Good investors should be able to do the same.

When evaluating news, day traders look at how the news is different from expectations. Investors can also consider how the news is different relative to the known facts about the company to date. For example, suppose that the Timely Timer Company is expected to report earnings of $0.10 per share. Instead, the news hits the tape saying that earnings will be only $0.05 because of accounting charges. The trader may see that the earnings are below expectations and short the shares to play on the bad news. The investor may know that the accounting charges were expected and quickly buy more shares while the price is depressed. The fact that there is a way for a buyer and a seller to match their differing needs is the whole reason that the financial markets exist!

To a day trader, perception is reality. To a keen-eyed investor, the difference between perception and reality may be an opportunity to make money.

Day traders have to think about the psychology of the market because everything moves so quickly. Investors sometimes forget about psychology because they can wait for logic to prevail. When it comes time to place a buy or sell order, however, understanding the psychological climate that day can give the investor a price advantage, and every bit of profit improvement goes straight to the bottom line.

Day traders keep their sanity by closing out positions at the end of the day so that they can get on with their lives until the next market opens. Investors, on the other hand, may want to know what’s happening to their positions at other times. Many brokerage firms offer mobile-phone alert services, which I think are a terrible idea for a day trader but may not be a bad idea for an investor.

Setting targets and limits

Good day traders set limits. They often place stop and limit orders to automatically close out their positions when they reach a certain price level. They have profit targets in mind and know how much they’re willing to risk in the pursuit of those gains.

Good investors should set similar limits. It can be harder for them, because they have often done so much research that they feel almost clairvoyant. Why worry about the downside when the research shows that the stock has to go up?

Well, the research may overlook certain realities. And even with thorough analysis, things change. That’s why even the most ardent fundamentalist needs to have a downside risk limit. In most cases, stop and limit orders are bad ideas for a long-term investor because they force the sale of a security during a short-term market fluctuation and force the sale when it’s really a good time to buy more. Investors have a different risk profile than day traders, so they need to manage risk differently — but they do still need to manage it.

With a stop order, the broker buys or sells the security as soon as a pre-determined price is met, even if the price quickly moves back to where it was before the order took effect. A limit order is only executed if the security hits the predetermined level, and it stays in effect only if the price is at that level or lower (for a buy limit order) or at that level or higher (for a sell limit order).

Day traders close out their positions at the end of each day, so they rarely review their limits. A swing trader or an investor, on the other hand, who holds for a longer period of time, needs to review those limits frequently. How much should a position move each month, quarter, or year before it’s time to cover losses or cash out with a profit? How has the security changed over time, and do the limits need to change with it?

When the position is working, an investor thinks of letting it ride forever. But, alas, few investments work that long into the future, so the investor also needs to think in term of relative performance. Has the time come to sell and put the money into something else with greater potential?

When managing money, day traders usually think about maximizing return while minimizing the risk of ruin. For an investor, the goal is maximizing return relative to a list of long-term objectives, including a target for risk. But because long-term objectives change, the portfolio has to as well. That means that a position that has been working out fine may have to be changed in order to meet the new portfolio goals. The discussion is starting to get beyond the scope of this book, but the point remains: Like successful day traders, successful investors have a plan for how they will allocate their money among different investments, and they adjust it as necessary.

Although investing is a long-term proposition and lacks the frenzy of trading, it is still an active endeavor. Instead of putting energy into buying and selling, the investor puts it into monitoring.

Judging execution quality

Day traders rely on outstanding trade execution from their brokers. They need to keep costs as low as possible in order to clear a profit from their trading, especially because their profits are relatively small.

Investors may have a greater likelihood of making a profit, given that they are waiting for a position to work out rather than closing it out every night. Even then, better execution leads to better profits. The magnitude of the few extra cents may be smaller relative to the entire profit, but it still counts.

Earnings momentum

Earnings momentum is the province of the investor, not the trader. The investor is looking at the earnings that a company reports every quarter to see whether the earnings are going up at a faster rate, say from a steady rate of 10 percent a year to 12, 13, or more. Such an increase often happens because of a new technology or product that turns a decent company into a hot property in the stock and options markets. If the earning growth rate is accelerating, then the underlying price should go up at an accelerating rate, too.

Day traders don’t look for earnings momentum, but they do look for price momentum. The two are usually related.

Price momentum

When a security goes up in price, especially at a fast clip with strong demand underneath it, it is said to have price momentum. Most day traders are looking for price momentum in order to make a swift profit. Many long-term investors should look for price momentum, too, in order to avoid being stuck with a position for months before it starts to move. After all, patience pays, but it pays even better if your money is working for you while you wait.

Many momentum traders don’t care why something is going up in price; they only know that it is going up and that they can profit by being there for even part of the ride. Following are some of the different indicators that these traders look at:

• Relative strength: You can calculate relative strength in different ways, discussed in Chapter 8, but the basic idea is that a security that’s going up faster than the market as a whole is showing momentum and may be a buy.
• Moving average convergence/divergence (MACD): This indicator looks at how the average price of the security is changing over time. Is the indicator staying relatively level, meaning that the price is moving slowly back and forth, or is the indicator gradually going up, meaning that the price is gradually going up, too? If you plot the moving average against the actual price levels, a wide gap means that the security is moving up or down faster than the average, and if it’s moving up, you’d probably want to buy it. (Otherwise, consider shorting the security; you can read more about that in Chapter 5.)
• Stochastics index: This index is the difference between the high and the low price for a security over a given time period. Some analysts look at days, some at weeks. The idea is that, if the difference is getting bigger, it may be because the security is moving up or down in price at a faster than normal rate, creating an opportunity for a momentum buyer.

At an extreme, momentum investing leads to bubbles, like the infamous dot-com bubble in the late 1990s. People were buying the stocks because they were going up, not because they necessarily thought that the businesses were worth much. This run was fun while it lasted, but a lot of people lost a lot of money when reality set in during March and April 2000. The same thing happened in the real estate market. People were playing momentum when they were flipping condominiums in Las Vegas in the first decade of the 21st century, but prices couldn’t go up forever — and they didn’t. What’s the next bubble? I have a few ideas, and you probably do, too.

For investors only: Momentum-research systems

Many day traders rely on different research systems to help them identify buy and sell opportunities in the course of a trading day. These systems usually don’t work for an investor, simply because investors are less concerned about short-term movements. They wouldn’t see the value in systems that scan the market and identify short-term price discrepancies, for example.

However, many investors use their own research services to help identify good buy and sell opportunities. Two of the more popular ones are Value Line and the William O’Neil charts.

The idea has a short shelf life

Certain circumstances turn every long-term investor into a trader once or twice: He buys a security intending to hold it forever, and within a few days or weeks, some really bad news comes out. Or he buys only to see two days later that the company is being sold. That great long-term buy-and-hold idea no longer fits the original parameters, so it’s time to sell. Despite the goal of holding forever, the investor decides to get out and move on, even if it’s only a day later.

Your research shows you some trading opportunities

Good investors monitor their holdings, and some become intimate with the nuances of a security’s short-term price movements even though the objective is to hold the position for the long term. An investor who gets a feel for the trading patterns of a specific holding may want to turn that into swing-trading and day trading opportunities. Yes, doing so adds risk to the portfolio (and the risks of day trading are covered extensively throughout this book), but it can also increase return.

For example, suppose that an investor who is fascinated with technology stocks notices that the stocks always rise in price right before big industry conferences and then fall when the conference is over. She may not want to change any of her portfolio holdings based on this observation, but she may want a way to profit. So she buys call options on big technology companies before the conference and then sells them on the meeting’s first day. That short-term trade allows her to capture benefits of the price run-up without affecting her portfolio position.

You see some great short opportunities

Short selling allows a trader to profit from a decline in the price of a security. The trader enters the order, which automatically arranges the loan of a security from the broker followed by a sale in the market. The trader then waits in hopes that the price will go down. When it does, the trader buys the security back at the lower price and repays the loan, keeping the difference between the purchase price and the sale price.

Because the broker charges interest on the loaned securities, short selling can get expensive. Traders who sell short are usually looking for a relatively short-term profit, not necessarily over a single day but over months rather than years.

In addition to the interest, short selling faces another risk, which is that the security can go up in price while the trader is waiting for it to go down. To reduce that risk, most short sellers do careful research, especially about accounting practices, to back up their choices. And who else does careful research? Many long-term investors.

For the investor who loves to do research and has some appetite for risk, short selling is a way to make money from securities that would make terrible long-term holdings because it seems obvious that they aren’t going to do well. When these investors come across securities that are headed for trouble, they can short them in the hope of making a nice short-term profit.