What do you want to trade?

The first step in your trading plan should also be addressed in your business plan: What do you want to trade? Many traders work in more than one market, and each market is a little different. Some trade different products simultaneously, whereas others choose one for the day and work only on that.

Chapters 3 and 4 cover the different assets that day traders can work with in great detail. You can refer to them if you’re just starting out. What assets fit your style, your expertise, and your risk levels? For example, many farmers trade commodities futures both to manage their own risk and to apply their knowledge of agriculture to short-term profits. If your expertise is technology, commodities may not be as good a fit for you. Everything flows from your asset choices.

You need to figure out which markets give you the best chance of getting a profit that day, and this changes regularly. Some days, no trades will be good for you in one market, and you’ll be better off sitting out. If you’re too antsy to sit out, then find another market to keep you busy so that you don’t trade just to stay awake. (Of course, many traders report that the big money opportunities are in the slower, less glamorous markets.)

As a day trader, you’re self-employed. You don’t answer to a boss, and you don’t have to trade on any particular day if you don’t want to. So if you have a headache, if no good trades are available to you, or if recent losses have gotten you down, take the day off and do something fun.

When will you be trading?

You want to find assets that are trading when you are. That sounds obvious, right? Well, it’s so obvious that it should be in your plan.

Although global markets seem to be operating 24 hours a day these days, they really don’t. Breaks in trading sessions occur, and market holidays in different countries close markets. Even assets that trade well in overnight markets trade differently in them because the participants in them are different. For instance, the interests of currency traders in Asia are somewhat different from those of currency traders in Europe if only because their profit accounting will take place in different currencies, which means that currency trading will be different during the Asian business day than during the European business day.

Hence, you need to consider what is happening when you’ll be trading. It’s particularly important if you don’t trade at the same time every day or if you trade something like currency where one region’s business day may be ending and another day beginning while you’re trading.

And so, determine if this asset is one you want to trade today, and if you want to work with it all day or for only part of the day.

How do you want to trade?

Figuring out how to trade an asset involves a lot of considerations: What is your mood today? What will other traders be reacting to today? How much risk do you want to take? How much money do you want to commit? These considerations represent the nitty-gritty stage of trade planning that can help you manage your market day better.

Figuring out when to buy and when to sell

After you get insight into what the day may be like and how much money you want to allocate to the markets, your next step is to figure out when you’ll buy and when you’ll sell. Ah, but if deciding when to buy and sell were easy, do you think I’d be revising a book on day trading? No. I’d be too busy taking private surfing lessons in front of my beachfront mansion on Maui.

The very best traders aren’t selling trading advice, because they’re already retired. Everyone else is figuring it out as they go along, with varying degrees of success.

Many traders rely on technical analysis, which involves looking at patterns in charts of the price and volume changes (I discuss technical analysis in Chapter 8). Other traders look at news and price information as the market changes rather than looking at price patterns (you can find a discussion of this in Chapter 9). Still others care only about very short-term price discrepancies (covered in Chapter 10). But the most important thing, no matter what approach you prefer, is that you backtest and simulate your trading before you commit real dollars. That way, you have a better sense of how you’ll react in real market conditions. You can find information about Backtesting in Chapter 13.

Setting profit goals

When you trade, you want to have a realistic idea how much money you can make. What’s a fair profit? Do you want to ride a winning position until the end of the day, or do you want to get out quickly after you make enough money to compensate for your risk? This question has no one single answer because so much depends on market conditions and your trading style. In this section are some guidelines that can help you determine what’s best for you.

Your profit goals can be sliced and diced a few different ways. The first is the gain per trade on both a percentage basis and an absolute basis. The second is the gain per day on both a percentage basis and an absolute basis. What do you have to do to reach these goals? How many successful trades will you have to make? Do you have the capital to do that? And what is right for the trade you are making right now, regardless of what your longer-term goals are?

No one ever lost money taking a profit, as the cliché goes. (The trading business is rife with clichés, if you haven’t noticed.) The newer you are to day trading, the more sense it makes to be conservative. Close your positions and end your day when you reach a target profit and then make note of what happens afterward. Can you afford to hold on to your positions longer to make a greater profit?

Setting limits on your trades

Setting a loss limit along with a profit goal is a good idea. For example, many futures traders have a rule to risk two ticks in pursuit of three ticks. That means that they’ll sell a position as soon as it loses two ticks in value and as soon as it gains three ticks in value. And for anything in between? Well, they close out their positions at the end of the days the result is profit even smaller than three ticks or a loss smaller than two. It’s a boring strategy that usually has small profits, but a small profit is better than a negative one.

Even traders who don’t have a rule as specific as losing two ticks in pursuit of three often set a limit on how much they’ll lose per trade. They know that there is no shame in a loss, only in wishing and hoping that it would magically reverse. Other traders use computer programs to guide their buys and their sells, so they sell their positions automatically. Brokers make setting limits easy by giving customers the choice of a stop order or a limit order to protect their positions.

You want to limit your loss per trade as well as your loss per day. If today is not a good one, close up shop, take a break, and come back fresh tomorrow.

What if the trade goes wrong?

No matter how in tune you feel with the market, no matter how good your track record, and no matter how disciplined you are with setting stops, stuff is going to happen. Just as you can make more money than you plan to, you can also lose a lot more. If you day trade, you have to accept that you’re going to have some really bad days.

So what do you do? You suck it up, take the loss, and get on with your life. Yes, the market may have blown past your stops. That happens sometimes, and it’s hard to watch real dollars disappear into someone else’s account, someone you will never know. Still, close your position and just remember that tomorrow is another day with another chance to do better.

Don’t hold in hopes of making up a loss. The market doesn’t know what you own and will not reward your loyalty and best hopes.

After you take the loss and clear your head, see whether you can learn something for next time. Sometimes a loss can teach you valuable lessons that make you a smarter, more disciplined trader in the long run.

Swing trading: Holding for days

Swing trading involves holding a position for several days. Some swing traders hold overnight, while others hold for days or even months. The longer time period gives more time for a position to work out, which is especially important if the position is based on news events or if it requires taking a position contrary to the current market sentiment. Although swing trading gives traders more options for making a profit, it carries some risks because the position can turn against you while you are away from the markets.

A tradeoff always exists between risk and return. When you take more risk, you do so in the hopes of getting a greater return. But when you look for a way to increase return, remember that you have to take on more risk to do it.

Swing trading requires paying attention to some basic fundamentals and news flow. (Fundamental research is discussed in Chapter 8.) It’s also a good choice for people who have the discipline to go to bed at night instead of waiting up and watching their position in hopes that nothing goes wrong.

Position trading: Holding for weeks

A position trader holds a stake in a stock or a commodity for several weeks and possibly even for months. This person is attracted to the short-term price opportunities, but he also believes that he can make more money holding the stake for a long enough period of time to see business fundamentals play out. Position trading increases the risk and the potential return because a lot more can happen over months than minutes.

Investing: Holding for months or years

An investor is not a trader. Investors do careful research and buy a stake in an asset in the hopes of building a profit over the long term. It’s not unusual for investors to hold assets for decades, although good ones sell quickly if they realize that they’ve made a mistake or if the story changes. (They want to cut their losses early, just as any good trader should.)

Investors are concerned about the prospects of the underlying business. Will it make money? Will it pay off its debts? Will it hold its value? They view short-term price fluctuations as noise rather than as profit opportunities.

Many traders pull out some of their profits to invest for the long term (or to give to someone else, such as a mutual-fund manager or hedge fund, to invest). Doing so is a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account.

Pigs get fat, hogs get slaughtered

Trading is pure capitalism, and people do it for one primary reason: to make money. Sure, a ton of economic benefits come from having well-functioning capital markets, such as better price prediction, risk management, and capital formation. But a day trader just wants to make money.

Get too greedy, however, and you’re likely to get stupid. You start taking too much risk, deviating too much from your strategy, and getting careless about dealing with your losses. Good traders know when it’s time to take a profit and move on to the next trade.

This maxim is one of those obvious but tough-to-follow ones. After all, when do you cross the line from being a happy little piggy to a big fat greedy hog that’s about to be turned into a pork belly? Just know that if you’re deviating from your trading plan because things are going so great, you may be headed for some trouble.

Here’s a cliché that’s related to “Pigs get fat, hogs get slaughtered”: “Bears get fat, bulls get fat, and hogs get slaughtered.” In other words, a savvy trader can make money whether the market is up or down, but a greedy trader runs into trouble.

In a bear market, the money returns to its rightful owners

A bull market is one that charges ahead; a bear market is one that does poorly. Many people erroneously think of themselves as trading geniuses because they make money when the entire market is going up. Making money by day trading was easy with Internet stocks in 1999, but it wasn’t so easy in 2000 when the bubble burst. And when the markets turn negative, those people who really understand trading and who know how to manage risk are able to stay in until things get better, possibly even making nice profits along the way.

The corollary cliché for “In a bear market, the money returns to its rightful owners,” is “Don’t confuse brains with a bull market.” When things are going well, watch out for overconfidence. It may be time to update your business and trading plans, but it’s not to time cast them aside.

The trend is your friend

When you day trade, you need to make money fast. You do not have the luxury of waiting for your unique, contrary theory to play out. An investor may be buying a stock in the hopes of holding it for decades, but a trader needs things to work now.

Given the short-term nature of the market, short-term sentiment is going to trump long-term fundamentals. People trading today may be wrong about the direction of foreign exchange, interest rates, or stock prices, but if you are closing out your positions tonight, you need to work with the information in the market today. In the short run, traders who fight the market lose money.

There are two problems with the maxim “The trend is your friend.” The first is that by the time you identify a trend, it may be over. Second, sometimes, going against the herd makes sense because you can collect when everyone else realizes their mistake. In such a situation, the psychology of trading comes into play. Are you a good enough judge of human behavior to know when the trend is right and when it’s not?

Buy the rumor, sell the news

Markets react to information. That’s ultimately what drives supply and demand. Although the market tends to react quickly to information, it can overreact, too. Lots of gossip gets traded in the markets as everyone looks to get the information they need to gain an advantage. And despite such things as confidentiality agreements and insider-trading laws, many rumors turn out to be true.

These rumors are often attached to such news events as corporate earnings. For whatever reason — good news, analyst research, a popular product — traders may believe, for example, that the company will report good quarterly earnings per share. That’s the rumor. If you buy on the rumor, you can take advantage of the price appreciation as the story gets more play. When the earnings are actually announced, one of two things will happen:

• The earnings will be as good as or better than rumored, and the price will go up. The trader can sell into that and make a profit.
• The earnings will be worse than rumored, everyone will sell on the bad news, and the trader will want to sell to get out of the loss.

Of course, if the rumor is bad, you want to do the opposite: sell on the rumor and buy on the news. For more information on short selling — selling securities in hopes that they fall in price — turn to Chapter 9.

The problem with “Buy the rumor, sell the news” is that rumors are often wrong, and there may be more opportunities to buy on bad news when other traders are panicking, thus driving prices down for a few minutes before sanity sets in. But this rule is one of those that everyone talks about, whether or not they actually follow it.

Cut your losses and ride your winners

I mention earlier in this chapter that you need to cut your losses before they drag you down. No matter how much it hurts and no matter how much you believe that you’re right, you need to close out a losing position and move on.

But the opposite — that you should ride your winners — is not necessarily true. Although good traders tend to be disciplined about selling winning positions, they don’t use stops and limits as rigorously on the upside as they may on the downside. They’re likely to stick with a profit and see how high it goes before closing out a position.

Note that this conflicts a little with the “Pigs get fat, hogs get slaughtered” maxim. (Trading maxims can be so contradictory!) To prevent overconfidence and sloppiness from greed, ride your winners within reason. If your general discipline is to risk three ticks on a futures contract to make five, and a contract goes up six ticks before you can close it out, you may want to stick with it. But if you also close out at the end of every day, don’t give in to the temptation of keeping that position open just because it’s still going up. Keep to your overall discipline.

You’re only as good as your last trade

The markets churn on every day with little regard for why everyone trading right now is there. Prices go up and down to match the supply and the demand at any given moment, which may have nothing to do with the actual long-term worth of an item being traded. And it certainly has nothing to do with how much you really, really want the trade to work out.

One of the biggest enemies of good traders is overconfidence. Especially after a nice run of winning trades, a trader can get caught up in the euphoria and believe that he finally has the secret to successful trading under control. While he’s checking the real estate listings for that beachfront estate in Maui, BAM! The next trade is a disaster. Does that mean that the trader is a disaster, too? No, it just means that the markets won this time around.

Most day traders work in zero-sum markets, where for every winner, there’s a loser. Hence, not everyone can make money every day. The challenge is to maintain an even keel so as not to be distracted by confidence when the trading is going well or by fear when the trading is going poorly. The next trade is a new trade.

If you don’t know who you are, Wall Street is an expensive place to find out

The best traders know their limits. They know what gets them excited, what gets them angry, and what they need to watch out for. They haven’t necessarily figured it out in front of a screen, either. Instead, they’ve looked back on their lives and realized how to apply their strengths and weaknesses to trading.

If you are new to trading, consider your own capabilities when designing a trading plan and think carefully about the things that are likely to trip you up. By thinking about those things, you can pay attention and act accordingly.

If you wait to trade with real money to find out your tolerances for risk and stress, you’re going to lose a lot of real money first.

There are old traders and bold traders, but no old, bold traders

Trading has a huge survival bias, meaning that the most experienced traders are also the best traders because the worst traders got washed out early on. The sure-fire route to losing your trading capital is to make a few big bets. The older traders know that they have to watch what they do. They have to plan for the risks they want to take and understand when to close out their risks. After all, if you want excitement, go to Vegas,

If you want to make the ranks of the old traders, plan your traders and trade your plan.