Speculating, not hedging

Professional traders fall into two categories: speculators and hedgers. Speculators look to make a profit from price changes. Hedgers look to protect against a price change. They make their buy and sell choices as insurance, not as a way to make a profit, so they choose positions that offset their exposure in another market.

As examples of hedging, consider a food-processing company and the farmer who raises or grows the ingredients the company needs. The company may look to hedge against the risks of price increases of key ingredients — like corn, cooking oil, or meat — by buying futures contracts on those ingredients. That way, if prices do go up, the company’s profits on the contracts help fund the higher prices it has to pay for those ingredients. If the prices stay the same or go down, the company loses only the price of the contract, which may be a fair tradeoff to the company. The farmer raising corn, soybeans, or cattle, on the other hand, benefits if prices go up and suffers if they go down. To protect against a price decline, the farmer would sell futures on those commodities. His futures position would make money if the price went down, offsetting the decline on his products. And if the prices went up, he’d lose money on the contracts, but that loss would be offset by his gain on his harvest.

The commodity markets were intended to help agricultural producers manage risk and find buyers for their products. The stock and bond markets were intended to create an incentive for investors to finance companies. Speculation emerged in all of these markets almost immediately, but it was not their primary purpose.

Day traders are all speculators. They look to make money from the market as they see it now. They manage their risks by carefully allocating their money, using stop and limit orders (which close out positions as soon as predetermined price levels are reached), and closing out at the end of the night. Day traders don’t manage risk with offsetting positions the way a hedger does. They use other techniques to limit losses, like careful money management and stop and limit orders (which you can read about in Chapter 2).

Markets have both hedgers and speculators in them. Knowing that different participants have different profit and loss expectations can help you navigate the turmoil of each day’s trading. And that’s important, because to make money in a zero-sum market, you only make money if someone else loses.

Understanding zero-sum markets

A zero-sum game, discussed in Chapter 2, has exactly as many winners as losers. And options and futures markets, which are popular with day traders, are zero-sum markets. If the person who holds an option makes a profit, then the person who wrote (which is option-speak for sold) that option loses the same amount. There’s no net gain or net loss in the market as a whole.

Now some of those people buying and selling in zero-sum markets are hedgers who are content to take small losses in order to prevent big ones. Speculators may have the profit advantage in certain market conditions, but they can’t count on having that advantage all the time.

So who wins and who loses in a zero-sum market? Some days, whether you win or lose all depends on luck, but over the long run, the winners are the people who are the most disciplined: They have a trading plan, set limits and stick to them, and can trade based on the data on the screen rather than on emotions like hope, fear, and greed.

Unlike the options and futures markets, the stock market is not a zero-sum game. As long as the economy grows, company profits grow, which in turn lead to growing stock prices. The stock market really has more winners than losers over the long run. That doesn’t mean that any given day will have more winners than losers, however. In the short run, the stock market should be treated like a zero-sum market.

If you understand how profits are divided in the markets that you choose to trade, you have a better awareness of the risks that you face as well as the risks that the other participants are taking. People do make money in zero-sum markets, but you don’t want those winners to be making a profit off you.

Some traders make money — lots of money — doing what they like. Trading is all about risk and reward. The traders who are rewarded risked the 90 percent washout rate. Knowing that, do you want to take the plunge? If so, read on and check out Chapter 5 where I discuss risk and reward in greater detail. And if not, read on anyway, because you may get some ideas that can help you manage your other investments.

Being disciplined: Closing out each night

Day traders start each day fresh and finish each day with a clean slate. This daily regimen reduces some of the risk, and it forces discipline. You can’t keep your losers longer than a day, and you have to take your profits at the end of the day before those winning positions turn into losers.

That discipline is important for day traders. When you day trade, you face a market that doesn’t know and doesn’t care who you are, what you’re doing, or what your personal or financial goals are. There’s no kindly boss who may cut you a little slack today, no friendly coworker to help you through a jam, no great client dropping you a little hint about her spending plans for the next fiscal year. Unless you have rules in place to guide your trading decisions, you’ll fall prey to hope, fear, doubt, and greed — the Four Horsemen of trading ruin.

So how do you start? First you develop a business plan and a trading plan that reflect your goals and your personality. Then you set your working days and hours, and you accept that you’ll close out every night.

In other words, you prepare and have a plan. That’s a basic strategy for any endeavor, whether you’re running a marathon, building a new garage, or taking up day trading.

Trading part-time: An okay idea if done right

Can you make money trading part-time? You can, and some people do. Successful part-time day traders approach trading as a part-time job, not as a little game to play when they have nothing else going on. A part-time trader may commit to trading three days a week or to closing out at noon instead of at the close of the market. A successful part-time trader still has a business plan, still sets limits, and still acts like any professional trader would, just for a smaller part of the day.

Part-time trading works best when you can set and maintain fixed business hours. Working on a fixed schedule helps your brain know when to go to work and concentrate on the market, because the habit is ingrained. The successful part-timer operates as a professional with fixed hours. Think of it this way: My son is a patient in a group pediatric practice that has some part-time doctors. These part-time doctors keep set hours and behave like the other doctors in the practice; the only difference is that they work fewer hours each week. They commit their attention to medicine when they are on the job, and patients only know about their part-time hours when it comes time to make an appointment. These doctors don’t pop into the office and start giving shots during their lunch break from their “real” job, sneaking around so that their real boss doesn’t find out.

If you want to be a part-time day trader, approach it the same way that a part-time doctor, part-time lawyer, or part-time accountant would approach work. Find hours that fit your schedule and commit to trading during them. Have a dedicated office space with high-speed Internet access and a computer that you use just for trading. If you have children at home, you may need to have childcare during your trading hours. And if you have another job, set your trading hours away from your work time. Trading via cellphone during your morning commute is a really good way to lose a lot of money (not to mention your life if you try it while driving).

Trading as a hobby: A bad idea

Because of the excitement of day trading and the supposed ease of doing it, you may think that day trading makes a great hobby. On a boring Saturday afternoon, you could just spend a few hours trading in the forex market (foreign exchange) to make more money than if you spent those few hours playing video games! Right?

Uh, no.

Trading without a plan and without committing the time and energy to do it right is a route to losses. Professional traders are betting that plenty of suckers are out there, trading in just such a random way because that creates the losers that allow them to take profits in a zero-sum market.

The biggest mistake amateur traders make? Making a lot of money the first time trading and then assuming that all such successes will come as easily. That first success was almost definitely due to luck, and that luck can turn against a trader on a dime. If you make money your first time out, take a step back and see whether you can figure out why. Then test your strategy, using Chapter 13 as a guide, to see whether your strategy is a good one that you can use often.

Yes, I have two warnings in this section, and for good reason: Successful day traders commit to their business. Even then, most day traders fail in their first year. Brokerage firms, training services, and other traders have a vested interest in making trading seem like an easy activity that you can work into your life. But it’s a job — a job that some people love, but a job nonetheless.

If you really love the excitement of the markets, you can find ways to invest on a hobbyist’s schedule: You can spend your time doing fundamental research to find long-term investments, look into alternative investments to help diversify your portfolio, and trade with play money, either in demo accounts or in trading contests, to try trading without committing real money.

By all means, replace your Saturday video game habit with forex trading if you have the money and the inclination. Just make sure to set regular hours so that you find out how the markets normally trade during that time. Track your trades. Figure out what works right and what can go wrong. That’s the only way you will level up in the trading game.

Independence

For the most part, day traders work by themselves. Computers and monitors are relatively inexpensive, high-speed Internet connectivity is easier to get, and many brokerage firms cater to the needs of traders who are working by themselves — all of which leaves the day trader at home, alone, stuck in a room with nothing but the computer screen for company. Being alone all day may be boring and make it hard to concentrate. Some people can’t handle it.

But other traders thrive on being alone all day, because it brings out their best qualities. They know that their trading depends on them alone, not on anyone else. The trader has sole responsibility when something goes wrong, but he also gets to keep all the spoils. He can make his own decisions about what works and what doesn’t, with no pesky boss or annoying corporate drone telling him what he needs to do today.

If the idea of being in charge of your own business and your own trading account is exciting, then day trading may be a good career option for you.

What if you want to trade but don’t want to work by yourself? Consider going to work for a brokerage firm, a hedge fund, a mutual fund, or a commodities company. These businesses need traders to manage their own money, and they usually have large numbers of people working together on their trading desks to share ideas, cheer each other on, and give each other support when things go wrong.

No matter how independent you are, your trading will benefit if you have friends and family to offer you support and encouragement. That network can help you better manage the emotional aspects of trading. Besides, celebrating your success is more fun with someone else!

Quick-wittedness

Day trading is a game of minutes. An hour may as well be a decade when the markets are moving fast. And that means a day trader can’t be deliberative or panicky. When it’s time to buy or sell, it’s time to buy or sell, period.

Many investors prefer to spend hours doing a careful study of a security and markets before committing money. Some of these people are enormously successful. Warren Buffett, the CEO of Berkshire Hathaway, amassed $54 billion from his careful investing style, money that he is giving to charity. But Buffett and people like him aren’t day traders.

Traders have to have enough trust in their system and enough experience in the markets to act quickly when they see a buy or sell opportunity. Many brokerage firms offer their clients demonstration accounts or backtesting services that enable traders to work with their system before committing actual dollars, helping them learn to recognize market patterns that signal potential profits.

A trader with a great system who isn’t quick on the mouse button has another option: automating trades. Many brokerage firms offer software that executes trades automatically whenever certain market conditions occur. For many traders, automatic trades are a perfect way to take the emotion out of a trading strategy. Others dislike this type of trading, because it takes some of the fun out of the job. And let’s face it, successful traders find the whole process to be a good time.

Decisiveness

Day traders have to move quickly, so they also have to be able to make decisions quickly. You can’t wait until tomorrow to see how the charts play out before committing capital. If you see an opportunity, you have to go with it. Now.

But what if the decision is a bad one? Well, of course some decisions are going to be bad. That’s the risk of making any kind of an investment, and without risk, there is no return. Anyone playing around in the markets has to accept that.

But two good day trading practices help limit the effects of making a bad decision. The first is the use of stop and limit orders, which automatically close out losing positions. The second is closing out all positions at the end of every day, which lets you start fresh the next day.

If you have some downside protection in place, you’re more psychologically prepared to make the decisions you need to make in order to earn a profit. And if you’re one of those people who has a hard time making a decision, day trading probably isn’t right for you.

It’s not investing

While swing traders hold positions for a few days, maybe even a few weeks, and investors hold their stakes for the long term, with some looking to hang onto their securities for decades and maybe even hand them down to their children, day traders never hold a position for more than a day.

Day trading is most definitely not investing. Day traders perform an important function to the capital markets because they force the price changes that bring the supply and demand of the market into balance. Day trading, however, doesn’t create new sources of funding for companies and governments. It doesn’t generate long-term growth.

Just because day trading isn’t investing doesn’t mean day traders don’t have investments elsewhere. Many day traders withdraw their trading capital on a regular basis to put into investments, helping them build a long-term portfolio for their retirement or for other ventures they may want to take on. Still, because investing and trading have different mindsets, chances are the trader will have someone else manage this money.

It’s not gambling

One of the biggest knocks on day trading is that it’s just another form of gambling. And as everyone knows, or should know, in gambling, the odds always favor the house. That’s not the case with day trading, however. Consider these points:

• In day trading, the odds are even in many markets. The options and futures markets, for example, are zero-sum markets with as many winners as losers, but those markets also include people looking to hedge risk and who thus have lower profit expectations than do day traders.
• The stock market has the potential for more winning trades than losing trades, especially over the long run. For this reason, the stock market isn’t a zero-sum market, like options and futures markets. In the stock market, the odds are ever so slightly in the trader’s favor.

In all markets, the prepared and disciplined trader can do better than the frantic, naïve trader. That’s not the case when gambling, because no matter how prepared the gambler is, the casino has the upper hand.

People with gambling problems sometimes turn to day trading as a socially acceptable way to feed their addiction. If you know you have a gambling problem or suspect you are at risk, taking up day trading is probably not a good idea for you. Day traders who are closet gamblers tend to make bad trades and have trouble setting limits and closing out at the end of the day. They turn the odds against themselves. Chapter 4 has some information on the line between day trading and gambling.

It’s not dangerous — if you use risk capital

A lot of day traders lose money, and some lose everything that they start with. Others don’t lose all of their trading capital; they just decide that there are better uses of their time and better ways to make money.

A responsible trader works with risk capital, which is money that she can afford to lose. She uses stop and limit orders to minimize her losses, and she always closes out at the end of the day. She understands the risks and rewards of trading, and that keeps her sane.

Many day trading strategies rely on leverage, which is the use of borrowed money to increase potential returns. Leverage carries the risk of the trader losing more money than is in his account. However, brokerage firms, which don’t want that to happen, will probably close a leveraged account that’s in danger of going under. That’s good, because it limits your potential loss. See Chapter 5 for a detailed discussion of leverage.

It’s not easy

Along with the relatively low rate of success, day trading is really stressful. Concentrating on the markets and knowing that real money is at stake takes a lot of energy. The profit amounts on any one trade are likely to be small, which means you have to be persistent and keep placing trades until the end of the day.

Some traders can’t handle the stress. Some get bored. Some get frustrated. And some can’t believe that they can make a living doing something that they love.

Day trading is difficult, but it’s not impossible. You can improve your chances of success by taking the time to prepare and by having enough money to fund your initial trading account. During the first year, you’ll want to handle trading losses and still be able to pay your rent and buy your groceries. Knowing that you can cover your basic expenses will give you more confidence, and that can help your performance.

Although day trading is tough, many day traders can’t imagine doing anything else. The simple fact is that a lot of occupations are difficult ways to make a living, and yet they are right for some people. Every career has its advantages and disadvantages, and day trading is no different.

When you finish this book, you should have a good sense of whether or not day trading is right for you. If you realize that it’s the career you have been searching for, you can find lots of good ideas in the coming chapters for how to set up your day trading business and plenty of advice on how to increase your chances of success.

If you find that maybe day trading isn’t right for you, I hope you get some ideas that can help you manage your long-term investments better. After all, the attention to price movements, timing, and risk that is critical to a day trader’s success can help any investor improve his returns. What’s not to like about that?