Setting your goals

The first thing you need in your plan is a list of your goals, both short term and long term. Here is a sample list to get you started:

• Where do you want to be in the next three months, six months, nine months, a year, three years, five years, and ten years?
• How many days a year do you want to trade?
• What do you need to know to trade better?
• How much do you want to make?
• What will you do with your profits?
• How will you reward yourself when you hit your goals?

Be as specific as possible when you think about what you want to do with your trading business, and don’t worry if your business goals overlap with your personal goals. When you’re in business for yourself, the two often mix.

You might be tempted to say, “I want to make as much money as I possibly can,” and forget the rest, but that’s not a goal that’s quantifiable. If you don’t know that you’ve reached your goal, how can you go on to set new ones? And if you don’t meet your goal, how will you know how to make changes?

Picking the markets

There are so many different securities and derivatives that you can day trade! Sure, you want to trade anything that makes money for you, but what on earth is that? Each market has its own nuances, so if you flit from futures to forex (foreign exchange), you might be courting disaster. That’s another reason why you need a plan. If you know what markets you want to trade, you’ll have a better sense of what research services you’ll need, what ongoing training you might want to consider, and how to evaluate your performance.

Chapter 3 in Book 5 covers different asset classes and how day traders might use them in great detail. For now, Table 2-1 gives a little cheat sheet that covers those that are most popular with day traders. Think about your chosen markets in the same way: What do you want to trade, where will you trade it, what is the risk and return, and what are some of the characteristics that make this market attractive to you?

And what do zero sum, leverage, and upward bias mean?

• Well, zero sum means that for every winner, there is a loser. No net gain exists in the market.
• Leverage is the use of borrowed money, which increases potential return and also increases risk.
• Upward bias means that in the long run, the market is expected to increase in price, but that doesn’t mean it will go up on any given day that you are trading.

The characteristics of the different markets and assets will affect both your business plan and your trading plan. The business plan should include information on what you will trade and why, as well as on what you hope to learn to trade in the future. The trading plan looks at what you want to trade each day and why, so that you can channel your efforts.

Many day traders work in a few different markets, depending on their temperament and trading conditions, but successful traders have narrowed down the few markets where they want to concentrate their efforts. Start slowly, working just one or two different securities, but consider adding new markets as your experience and trading capital grows.

Fixing hours, vacation, and sick leave

The markets are open more or less continuously. Although many exchanges have set trading hours, there are traders working after hours who are willing to sell if you want to buy. Some markets, such as foreign exchange, take only the briefest of breaks over the course of a week. This gives day traders incredible flexibility — no matter what hours and what days are best for you to trade, you can find something that works for you. If you are sharpest in the evenings, you might be better off trading Asian currencies, because those markets are active when you are. Of course, this can be a disadvantage, because no one is setting limits for you. Few markets are great places to trade every hour of every day.

If you want to, you can trade almost all the time. But you probably don’t want to. To keep your sanity, maintain your perspective, and have a life outside of your trading, you should set regular hours and stick to them. In your business plan, determine when you’re going to trade, how often you’re going to take a vacation, how many sick days you’ll give yourself, and how you’ll know to take a day off. One of the joys of self-employment is that you can take time off when you need to, so give yourself that little perk in your business plan.

Trading is a stressful business. You need to take time off to clear your head, and you’ll probably find that working while sick is a sure-fire route to losses. Build in some sick and vacation time.

Getting yourself set up

Part of your business plan should cover where you work and what equipment you need. What can you afford now, and what is on your wish list? Do you have enough computing equipment, the right Internet connection, and a working filing system? This is part of your plan for getting your business underway, so put some thought into your infrastructure.

And yes, this is important. You don’t want to lose a day of trading because your computer has crashed, nor do you want to be stuck with an open position because your Internet service provider has a temporary outage. And you certainly don’t want to lose your concentration because you’re trying to work in the family room while other members of your household are playing video games.

Investing in your business

You won’t have the time and money to do everything you want to do in your trading business, so part of your business plan should include a list of things that you want to add over time. A key part of that is continuous improvement: No matter how good a trader you are now, you can always be better. Furthermore, the markets are always changing. New products come to market, new trading regulations are passed, and new technologies appear. You will always need to absorb new things, and part of your business plan should consider that.

Ask yourself the following questions:

• What percentage of your time and trade gains will go into expanding your knowledge of trading?
• Do you want to do that by taking seminars or by allocating the time to simulation testing?
• What upgrades will you make to your trading equipment?
• How are you going to set yourself up to stay in trading for the long haul?

It takes money to make money — another cliché. It doesn’t mean that you should spend money willy-nilly on any nifty gadget or fancy video seminar that comes your way. Instead, it means that an ongoing, thoughtful investment in your trading business will pay off in a greater likelihood of long-run success.

Evaluating and revising your plan

One component of your business plan should be a plan for revising it. Things are going to change. You may be more or less successful than you hope, market conditions may change on you, and you may simply find out more about how you trade best. That’s why you should set a plan for updating your business plan to reflect where you are and where you want to be as you go along. At least once a year, and more often if you feel the need for a change, go through your business plan and revise it to reflect where you are now. What are your new goals? What are your new investment plans? What are you doing right, and what needs to change?

Business plans are living documents. Use your plan to run your trading business; as your business runs, use the results to update your plan. You can keep the old ones around to show you how much progress you have made, if you’re so inclined.

What do you want to trade?

The first step in your trading plan should also be addressed in your business plan: What is it that 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. (See the earlier section “Picking the markets.”)

You need to figure out which markets give you the best chance of getting a profit that day. It’s going to be different. Some days, no trades will be good for you in one market. If you’re too antsy for that, 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 are self-employed. You don’t answer to a boss and don’t have to trade today if you don’t want to. So if you have a headache, or if no good trades are available to you, or if recent losses have gotten you down, take the day off and do something fun.

How do you want to trade it?

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? This is 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 might be like and how much money you want to allocate to the markets, your next step is to figure out when you will buy and when you will sell. Ah, but if that were easy, do you think we’d be writing a book on day trading? No.

The very best traders aren’t selling trading advice; 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. Other traders look at news and price information as the market changes, rather than looking at price patterns. Still others care only about very short-term price discrepancies. 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.

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 when you’ve made enough money to compensate for your risk? No one answer to this question exists, because so much depends on market conditions and your trading style. In this section you get some guidelines that can help you determine what’s best for you, and you find definitions for all the different terms for profits you might come across.

Setting limits on your trades

It’s a good idea to set a loss limit along with a profit goal.

For example, many futures traders have a rule to risk two ticks in pursuit of three ticks. That means they’ll sell a position as soon as it loses two ticks in value, and they’ll also sell a position 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 day, so whatever happens happens.

Even traders who do not have a rule like that often set a limit on how much they will lose per trade. Other traders use computer programs to guide their buys and their sells, so they need to sell their positions automatically. Brokers make this 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’re going to day trade, you have to accept that you’ll 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 it won’t reward your loyalty and best hopes.

After you take the loss and clear your head, see if 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, whereas 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 it 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 could turn against you while you’re away from the markets.

A trade-off 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 will have to take on more risk to do it.

Swing trading requires paying attention to some basic fundamentals and news flow. 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. This 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 have made a mistake. (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). It’s a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account. (Flip to Book 2 for more about stock investing and Book 3 for more about mutual fund investing.)

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.

However, get too greedy 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 is also a good example of an obvious but tough-to-follow maxim. When are you crossing 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 might be headed for some 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 think they’re trading geniuses because they make money when the entire market is going up. It was easy to make money day trading just about any stock in 2009, when the market recovered from near economic collapse, but it wasn’t so easy the year before when the frighteningly out-of-control financial crisis began. It’s when the markets turn negative that those people who really understand trading and who know how to manage risk will be able to stay in until things get better, possibly even making nice profits along the way.

The corollary cliché for this is “Don’t confuse brains with a bull market.” When things are going well, watch out for overconfidence. It might be time to update your business and trading plans, but it’s not to time to cast them aside.

The trend is your friend

When you day trade, you need to make money fast. You don’t 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, the 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 share prices, but if you’re 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.

Two problems exist with The trend is your friend. The first is that by the time you identify a trend, it may be over. Second, there are times when it makes sense to go against the herd, because you can collect when everyone else realizes their mistakes. This is where the psychology of trading comes into play. Are you a good enough judge of human behaviour to know when the trend is right and when it’s not?

Buy the rumour, 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 in order to gain an advantage in the markets. And despite such things as confidentiality agreements and insider-trading laws, many rumours turn out to be true.

These rumours are often attached to such news events as corporate earnings. For whatever reason — good news, analyst research, a popular product — traders might believe that the company will report good quarterly earnings per share. That’s the rumour. If you buy on the rumour, 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:

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

Of course, if the rumour is bad, you want to do the opposite: sell on the rumour, and buy on the news.

The problem with Buy the rumour, sell the news is that rumours 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 it’s one of those rules that everyone talks about, whether or not they actually follow it.

Cut your losses and ride your winners

A reminder: You need to cut your losses before they drag you down. No matter how much it hurts and no matter how much you believe you’re right, you need to close out a losing position and move on.

But the opposite 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 might 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 Pigs get fat, hogs get slaughtered. (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 in order to make five, and a contract goes up six ticks before you can close it out, you might 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 are working in zero-sum markets, which means that for every winner there is 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.