Supply and demand

In a free market, supply and demand meet at a price where the buyer receives good value for the price paid and the seller makes enough of a profit to stay in business. The supply for a given price is the number of goods that sellers are willing to sell at a given price, and the demand is the price that buyers are willing to pay for a given number of goods. If demand increases, then sellers are able to raise prices. If demand falls, sellers lower prices. Likewise, if the supply increases, sellers will cut prices to move inventory. If the supply falls, sellers will raise prices.

Consider what happens if supply and demand are out of whack. Say you want a pair of new shoes and have a budget of $50. You go shopping and find that the shoes you want cost $75, so you walk out empty handed. It’s possible someone else would find the $75 price fair, but you don’t. And in this example, not enough people do, so the shoe store runs a huge sale on its unsold inventory. Everything is two-thirds off! The shoes that were two expensive at $75? They are now $25 a pair, so you leave with two of them.

But at $25 a pair, the shoe store can’t make any money and goes out of business. You’re better off, but the seller is worse off — nothing’s magical about that.

In this example, if the people running the shoe store had been paying more attention, they would have figured out that at $50, they could sell shoes and still make money. In the real world, business owners talk to customers and track what competitors are doing so that they can figure out where to price their products. They also pay close attention to their costs to make sure that they are able to keep customers happy and stay in business.

And this is what happens in the financial markets. Every day, people go shopping for what they want to buy, whether it be shares of stock, an ETF (exchange-traded fund), commodity option, or foreign currency. Some of these buyers have to make a purchase to cover a loan. Others have done research to figure out how much something seems to be worth. And still others are placing their orders based on hunches. The buyers are determining the amount of demand in the market.

At the same time, people are looking to sell the same set of assets. Some of these sellers have mundane interests. Maybe the assets belonged to someone who died, and so they have to be sold so that the cash can be divided among the heirs. Maybe they’re looking to hedge a risk but no longer need to do it. Maybe they’ve done research to show that the item in question is overpriced, or maybe they’re acting on pure emotion. These sellers determine the amount of supply in the market.

And, of course, if the price gets high enough, a lot more people will be interested in selling than in buying, and if it gets low enough, traders will be looking to scoop up bargains. Sometimes traders quip that a stock is up in price because there are more buyers than sellers. That’s not quite true — someone has to be on each side of the trade — but motivated buyers will have to raise the price they’re willing to pay in order to entice the sellers to part with their shares, bitcoins, or futures contracts.

Exchanges versus over the counter

The people who actually place your order to buy or sell securities are known as brokers. Brokers are members or shareholders of the exchanges. The exchanges, in turn, are organizations designed to bring together groups of brokers representing a number of buyers and sellers. Having a central place to meet, whether in real life or virtually, increases the number of trades taking place and increases the likelihood that the transaction price will match the true value of the asset in question.

Once upon a time, brokers met physically on the floor of the exchange building. Nowadays, of course, most trading happens electronically, and the exchange buildings are often giant server farms. You won’t see that when you watch the opening bell on TV, because the servers are hidden in high-security, temperature-controlled rooms.

Some financial assets trade over the counter rather than on the exchange. Instead, they trade through networks of brokers or banks. Years ago, these items traded at special desks at banks and brokerage firms or on the street outside the exchange buildings. That’s why sometimes market pundits refer to these markets as the curb.

For most traders, there is no real difference in the execution of an order placed in an exchange market or an over-the-counter market. Both are now executed on electronic networks. Some markets, like currency, take place almost entirely over the counter. You still need an account with a broker to access over the counter listings.

After all, the broker’s reason for being is to guarantee that customers have the items that they want to sell or the cash to pay for the things they want to buy, which ensures that the market works as intended.

Commissions, fees, and spreads

The broker’s service isn’t free. After all, brokerage firms are run by capitalists subject to their own sets of supply and demand forces. The prices you pay come in three forms: commissions, fees, and spreads.

Understanding zero-sum games

The first thing to know about game theory is that, despite the name, it isn’t about why people have fun. The second thing to know is that it classifies different activities based on how much total value is added or created for the people involved. Game theory is often used to describe financial markets, so the three main categories matter:

• In a zero-sum game, each gain is someone else’s loss. For every winner, there is a loser. Sometimes the losers are okay with the loss. Maybe they were willing to accept a small loss in order to prevent a bigger loss, for example. The total value is rearranged but doesn’t change.
• In a positive-sum game, most participants are better off. Some may lose money, but the total gains exceed the total losses. Total value increases.
• In a negative-sum game, most participants end up losing money. Some value is destroyed.

Day trading is a zero-sum game. Your gain is someone else’s loss, and vice-versa. To make this work, you have to determine who is willing to lose money.

This isn’t as horrible as it may seem. Remember that each of the people in the market has a different reason for being in it. Many people use options to manage risk, for example (as I explain in Chapter 4). They’re all right with paying a little bit of money now in order to prevent a big loss in the future.

Likewise, in currency markets, some people are trading because they need one particular currency in order to make a transaction. Sure, they may get a better rate if they could wait a little bit, but they can’t wait. That’s the point.

One reason why it’s difficult to make money day trading is because day trading is a zero-sum game. A lot of day traders who lose money aren’t prepared and don’t manage their risks. If you take the time to trade right, you can increase your odds of making money.

Opening a brokerage account

After you find a broker (see Chapter 15 for ideas), you go to its website, fill out a bunch of forms, and then set up a transfer from your bank account to your new brokerage account. This transfer will be your initial trading capital.

There are no shortcuts here, by the way. The broker is required by a range of international laws to verify who you are and where your money comes from. A compliance officer isn’t willing to go to prison because you don’t want to share your personal information in exquisite detail.

Placing your initial order

To place an order, log in to your account and fill out the form to place an order. It’s almost like online shopping! You tell the broker what you want and how much of it, and then you enter the other details such as whether the trade is long (that is, you’re buying) or short (if you’re selling) (see Chapter 3). You can pay for it either with the money in your account or by borrowing money from the broker, known as a trade on margin. Press enter, and away it goes for the broker to handle.

Closing out your order

If your initial order was a buy, now you need to sell your position. And, once again, it’s almost like online shopping. This time, you’re doing a return. You log in and place the order, again specifying what and how much. When the broker completes the transaction, the money will be used to pay off any margin and then go into your account.

Taking your cash

If your brokerage account grows beyond the amount you want to risk, transfer some money back into your bank account. It’s simple and easy – and is the way you take your trading profits and apply them to everything else in your life.

Working with a small number of assets

Most day traders pick one or two markets and concentrate on those to the exclusion of all others. That way they can figure out how the markets trade, how news affects prices, and how the other participants react to new information. Also, concentrating on just one or two markets helps them maintain focus.

And what do day traders trade? Chapters 3 and 4 have information on all of the different markets and how they work. Here’s a quick recap, in no particular order, of the most popular assets with day traders right now if you’re overeager:

• Financial futures: Futures contracts allow traders to profit from price changes in such market indexes as the S&P 500 or the Dow Jones Industrial Average. They give traders exposure to the prices at a much lower cost than buying all the stocks in the index individually. Of course, they tend to be more volatile than the indexes they track because they’re based on expectations.
• Options: An option gives the holder the right, but not the obligation, to buy or sell something in the future at a price agreed to today. Options are similar to futures. They allow people to take larger positions for less money up front, but doing so increases the amount of risk involved.
• Forex: Forex, short for foreign exchange, involves trading in currencies all over the world to profit from changes in exchange rates. Forex is the largest and most liquid market there is, and it’s open for trading all day, every day. Traders like the huge number of opportunities. Because most price changes are small, forex traders have to use leverage (borrowed money) to make a profit. The borrowings have to be repaid no matter what happens to the trade, which adds to the risk of forex. Cryptocurrency, a relatively new asset class, has characteristics similar to foreign exchange.
• Common stock and exchange-traded funds: The entire business of day trading began in the stock market, and the stock market continues to be popular with day traders. These day traders look for news on company performance and investor perception that affect stock prices, and they look to make money from those price changes. A similar asset is the exchange-traded fund, which trades like a stock but is based on a market index or strategy. The big drawback? Stock and ETF traders can get killed at tax time if they aren’t careful. See Chapter 17 for more information.

Day traders can, and sometimes do, trade bonds and commodities. Usually, they do so through financial futures or exchange-traded funds.

Managing your positions

A key to successful trading is knowing how much you’re going to trade and when you’re going to get out of your position. Sure, day traders are always going to close out at the end of the day — or they wouldn’t be day traders — but they also need to cut their losses and take their profits as they occur during the day. Specifically, they need to determine the size of the trade and the maximum profit or loss:

• Determining what portion of their money they risk for any particular trade: Traders rarely place all their money on one trade. That’s a good way to lose it! Instead, they trade just some of their money, keeping the rest to make other trades as new opportunities in the market present themselves. If any one trade fails, the trader still has money to place new trades. Some traders divide their money into fixed proportions, and others determine how much money to trade based on the expected risk and expected return of the security they’re trading. Careful money management helps a trader stay in the game longer, and the longer a trader stays in, the better the chance of making good money. Chapter 6 has more information on money-management strategies.
• Protecting their funds by using stop and limit orders: Stop and limit orders are placed with the brokerage firm and kick in whenever the security reaches a predetermined price level. If the security starts to fall in price more than the trader likes — bam! — it’s sold, and no more losses will occur on that trade. The trader doesn’t agonize over the decision or second-guess herself. Instead, she just moves on to the next trade, putting her money to work on a trade that’s likely to be better.

Day traders make a lot of trades, and a lot of those trades are going to be losers. The key is to have more winners than losers. By limiting the amount of losses, you as the trader make it easier for the gains to be big enough to generate more than enough money to make up for the losers.

Focusing your attention

Day traders are often undone by stress and emotion. Keeping a steady eye on what’s happening in the market is hard when you’re looking at screens all day and working alone. But as a trader, you have to be able to concentrate on the market and stick to your trading system, staying as calm and rational as possible.

Day traders who do well have support systems in place. They’re able to close their positions and spend the rest of the day on other activities. They do something to get rid of their excess energy and clear their minds, such as running or yoga or meditation. They understand that their ability to maintain a clear mind when the market is open is crucial.

Traders sometimes think of the market itself, or everyone else who is trading, as the enemy. The real enemies are emotions: doubt, fear, greed, and hope. Those four feelings keep traders from concentrating on the market and sticking to their systems.

One of the frustrations of trading is that some days offer more opportunities to trade than you have time or money to trade. On these days, good trades get away from you because you simply don’t have the resources to take advantage of every opportunity you see. That’s why having a plan and concentrating on what works for you are so important.

Recognizing what risk is

Risk is the measurable likelihood of loss. The riskier something is, the more frequently a loss will occur, and the larger that loss is likely to be. Playing in traffic is riskier than driving in traffic, and skydiving is riskier than gardening. This doesn’t mean that you can’t have losses in a low-risk activity or big gains in a high-risk one. It just means that with the low-risk game, losses are less likely to happen, and when they do, they’re likely to be small.

What’s the difference between risk and uncertainty? Risk involves the known likelihood of something good or bad happening so that it can be priced. What’s the likelihood of your living to be 100? Or of getting into a car accident tonight? Your insurance company knows, and it figures your rates accordingly. What’s the likelihood of aliens from outer space arriving and taking over Earth? Who knows! It could happen, but that event is uncertain, not risky — at least until it happens.

The ability to measure risk makes modern business possible. Until mathematicians were able to use statistics to quantify human activities, people assumed that bad things were simply the result of bad luck or the wrath of the gods. But when people understand probability, they can apply and use that to assess the likelihood of an event happening and determine the commensurate compensation for taking the risk. If a sailor agreed to join a voyage of exploration, what was the probability that he would return home alive? And what would be fair compensation to him for that risk? What was the probability of a silo of grain going up in flames? And how much should the farmer charge the grain buyers for the risk that he was taking, and how much should someone else charge to insure the farmer against that fire?

Getting rewarded for the risk you take

When you take risk, you expect to get a return. That’s fair enough, right? That return comes in a few different forms related to the risk taken. Although you may not really care how you get your return as long as you get it, thinking about the breakdown of returns can help you think about your trading strategy and how it works for you.

Market efficiency in the real world

The reason a balance exists between risk and reward is that markets are reasonably efficient. This efficiency means that prices reflect all known information about the companies and the economy and that all participants understand the relative tradeoffs available to them. Otherwise, you’d have opportunities to make a riskless profit, and that just won’t do, according to the average economist. “You can’t pluck nickels out of thin air,” they like to say. In an efficient market, if an opportunity exists to make money without risk, someone would have taken advantage of it already.

Here’s how market efficiency works: You have information that says that Company A is going to announce good earnings tomorrow, so you buy the stock. Your increased demand causes the price to go up, and pretty soon, the stock price is where it should be, given that the company is doing well. The information advantage is rapidly eliminated. In most cases, everyone gets the news — or hears the rumor — of the good earnings at the same time, so the price adjustment happens quickly.

Wouldn’t it be great to get the news of a good earnings report before everyone else and make a quick trading profit? Yep. At least until the Feds show up and haul you off to prison — talk about your opportunity costs. Trading on material inside information (information that is not generally known that would affect the price of the security) is illegal. And yes, the Securities and Exchange Commission and the exchanges monitor trading to see whether trading patterns suggest illegal trading based on inside information because they want all investors and traders to feel confident that the investment business is fair. Be very wary of tips that seem too good to be true.

The markets may be more or less efficient, but that doesn’t mean they work by magic. Price changes happen because people act on news, and the people who act the fastest are day traders. In the example, notice that it was the activity of traders that caused the price of Company A stock to go up to reflect the expected good earnings report.

In economic terms, arbitrage is a riskless profit. A hard-core believer in academic theory would say that arbitrage opportunities don’t exist. In practice, though, they do. Here’s how arbitrage works: Although Company A is expected to have a good earnings announcement tomorrow, you notice that the stock price has gone up faster than the price of a call option on Company A, even though premium should reflect the stock price. So you sell Company A (borrowing shares and selling it short if you have to) and then use the proceeds to buy the option. When the option price goes up to reflect the stock price, you can sell the option (that is, close out your short position) and lock in a riskless profit — at least, before your trading costs are considered. Chapter 10 discusses arbitrage in more detail.

Market efficiency isn’t perfect. It can take a while for people to make a logical decision about what an asset is worth, and until that happens, trading can be irrational and inefficient. Whether it’s Japanese stocks, Internet stocks, condominiums in Florida, or gold, the markets have pockets of craziness that defy rhyme and reason. In the short term, a wave of panic or euphoria can overtake the market during a single trading day, pushing prices into inefficient territory. On days like that, your ability to keep calm and steer into the trend, rather than getting swept up into an uncontrollable craze, will help you have more winning trades.

Bubbles and panics happen, and they happen more often than academic economists like to admit. However, most days, trading is efficient. Your edge comes from knowing the markets, having good risk management, and being able to walk away. Don’t count on crazy price action every day.

Investing is slow and steady

Investing is the process of putting money at risk in order to get a return. It’s the raw material of capitalism. It’s the way that businesses get started, roads get built, and explorations get financed. It’s how our economy matches people who have more money than they need, at least during part of their lives, with people who need it in order to grow society’s capabilities.

Investing is heady stuff. And it’s very much focused on the long term. Good investors do a lot of research before committing their money because they know that it will take a long time to see a payoff. That’s okay with them. Investors often invest in things that are out of favor, because they know that, with time, others will recognize the value and respond in kind. In the long run, investing is a positive-sum game; on average, investors will make money, the only question is how much.

One of the best investors of all time is Warren Buffett, chief executive officer of Berkshire Hathaway. His annual letters to shareholders offer great insight and are a great introduction to the work that goes into choosing and managing investments. You can read them at www.berkshirehathaway.com/letters/letters.html.

What’s the difference between investing and saving? When you save, you take no risk. Your compensation is low; it’s just enough to cover the time value of money. Generally, the return on savings equals inflation and no more. In fact, a lot of banks pay a lot less than the inflation rate on a federally insured savings account, meaning that you’re paying the bank to use your money.

In contrast to investing, day trading moves fast. Day traders react only to what’s on the screen. There’s no time to do research, and the market is always right when you’re day trading. You don’t have two months or two years to wait for the fundamentals to work out and the rest of Wall Street to see how smart you were. You have today. And if you can’t live with that, you shouldn’t be day trading.

Trading works fast

Trading is the act of buying and selling securities. All investors trade, because they need to buy and sell their investments. But to investors, trading is a rare transaction, and they get more value from finding a good opportunity, buying it cheap, and selling it at a much higher price sometime in the future. But traders are not investors.

Traders look to take advantage of short-term price discrepancies in the market. In general, they don’t take a lot of risk on each trade, so they don’t get a lot of return on each trade, either. Traders act quickly. They look at what the market is telling them and then respond. They know that many of their trades won’t work out, but as long as they measure proper risk versus reward, they’ll be okay. They don’t do a lot of in-depth research on the securities they trade, but they know the normal price and volume patterns well enough that they can recognize potential profit opportunities.

Trading keeps markets efficient because it creates the short-term supply and demand that eliminates small price discrepancies. It also creates a lot of stress for traders, who must react in the here and now. Traders give up the luxury of time in exchange for a quick profit.

Speculation is related to trading in that it often involves short-term transactions. Speculators take risks, assuming a much greater return than may be expected, and a lot of what-ifs may have to be satisfied for the transaction to pay off. Many speculators hedge their risks with other securities, such as options or futures.

Gambling is nothing more than luck

A gambler puts up money in the hopes of a payoff if a random event occurs. The odds are always against the gambler and in favor of the house, but people like to gamble because they like to hope that, if they hit it lucky, their return will be as large as their loss is likely. It’s a zero-sum game with one big winner – the house – and a whole bunch of losers.

Some gamblers believe that the odds can be beaten, but they are wrong. (Certain card games are more games of skill than gambling, assuming you can find a casino that plays under standard rules. Yeah, you can count cards when playing blackjack with your friends, but doing so is a lot harder in a professionally run casino.) They get excited about the potential for a big win and get caught up in the glamour of the casino, and soon the odds go to work and drain away their stakes.

There is some evidence that day traders are gamblers. For example, in 2016, some researchers at the University of Adelaide published the paper “Day Traders in South Australia: Similarities and Differences with Traditional Gamblers.” They found that almost 91% of the day traders in their survey were also gamblers, and that 7.6% of those also had a problem with gambling, significantly higher than among people who were not day traders. The authors concluded that many day traders are actually gamblers who have added the financial markets to the games that they play.

Trading is not gambling, but traders who aren’t paying attention to their strategy and its performance can cross over into gambling. They can view the blips on their computer screen as a game. They can start making trades without any regard for the risk and return characteristics. They can start believing that how they do things affects the trade. And pretty soon, they’re using the securities market as a giant casino, using trading techniques that have odds as bad as any slot machine.

If you lose money day trading, you won’t get free drinks or comped tickets to the Celine Dion show in Vegas.

It’s your business

Business risk is the uncertainty of the timing of your cash flow. Not every month of trading is going to be great, but your bills will come due no matter what. You’ll have to pay for subscriptions while keeping the lights turned on and the computer connected to the Internet. Taxes come due four times a year, and keyboards hold a mysterious attraction for carbonated beverages, causing them to short out at the most inopportune times.

Keep track of your business expenses and keep them as low as is reasonable. You should invest in your business, obviously, but only to the extent that you can pay your bills even if you have an off month in the market.

Regardless of what happens to your trading account, you need cash on hand to pay your bills or you’ll be out of business. The best way to protect yourself is to start out with a cash cushion just for covering your operating expenses. Keep this cushion separate from your trading funds. Replenish it during good months. Walk away from trading if it goes down to zero.

It’s your life

The personal risk of trading is that it becomes an obsession that crowds out everything else in your life. Trading is a stressful business, and the difference between those who succeed and those who fail is often psychological. You need to be on when you are trading and then, at the end of the trading day, close out the emotions the same way that you close out your positions. It’s not easy, so you need to have ways to manage your mood. Figure those out before you start trading, and you’ll be ahead of the game.

In fact, the personal risk is so great that I devote an entire chapter to managing it — Chapter 14. Go there if anything you have read in this chapter alarms you.