Chapter 3
Short-Term Trading: Day and Momentum Trading
In This Chapter
• Day traders dominate short-term trading
• The role of momentum traders
• Risks and opportunities of short-term trading
• Technological changes in short-term trading
Short-term trading, for the purposes of this book, refers to day traders and momentum traders. These two types of traders use essentially the same strategies. Many people who practice short-term trading still consider themselves day traders. Others (momentum traders) have expanded their view of short-term trading to include some longer holding periods of securities than day traders traditionally employ. Yet, most of what short-term traders do is day trading in every sense of the word.

Not Your Father’s Day Trading

The business of day trading suffered an unfortunate association with a number of get-rich-quick schemes during the wild bull market of the late 1990s. The Internet was still in its infancy and broadband connections were the rare exception. Companies sprang up all over the country offering training in day trading and work stations at their offices for traders to use (for a fee). Many of these companies often known as trading arcades were legitimate businesses, but some were not. They promised (or strongly hinted) that after completing their high-priced seminars and workshops, you would be ready to make millions day trading.
Although some day traders made a lot of money during the bull market, many did not.
Day trading was not the easy money some providers advertised (it still isn’t today). For awhile, a loophole in trading regulation gave an advantage to small traders with orders of 1,000 shares or less. This slight advantage in the priority in which orders were executed allowed day traders to make a small profit off their orders at the expense of larger traders. That advantage was eliminated in 2000.
Many of the day traders of that era chased high-tech companies and looked for much bigger profits than they were garnering with their small advantage. Unfortunately, many day traders that hooked up with the less reputable providers of market services found that fees took such a big bite from their gross that not much was left for them. Traders were encouraged to use excessive margin and to borrow against their homes or other assets if they needed to raise more cash.
Trading Tip
Day traders used to be shackled to the market by connections through workstations in the offices of brokers that specialized in this type of trading. Thanks to high-speed Internet access, short-term traders are now free to trade almost anywhere.
Margin Call
When the market was hot with technology stocks, it was also hot with urban legends of people quitting their jobs and becoming rich in three months by day trading. You don’t hear those stories anymore, and there’s a reason.
It’s hard to know how many day traders from that era lost all their investment capital (and perhaps more) or simply quit before losing it all. The ranks of day traders thinned considerably after the markets crashed in 2000 and have never regained those numbers. However, the numbers began growing, thanks to a bull market beginning in 2003. Fortunately, the short-term traders who survived and the new ones coming into the business have a more reasonable attitude about what to expect.

How Short-Term Trading Works

Short-term trading is a strategy of taking small profits on multiple trades during a single day of trading. When the short-term traders have a good day, they may make 80 to 100 trades. Many of the trades may only be open for minutes or seconds. Some trades may lose money or close out with no profit. However, short-term traders aim for more profitable trades than losing trades. The profit from good trades is very small, which is why short-term traders make so many in a single day. It is a difficult way to make a living; however, with a good trading plan and careful money management, short-term traders can do very well. Some days, there may not be many trades for short-term traders. Disciplined short-term traders will not force trades and will sit out a trading session rather than make bad trades.

The Bid-Ask Spread

Short-term traders look for certain signs that may indicate the price of a stock is going to change. It is important to understand that we are talking about live transaction prices scrolling across a screen, not conclusions drawn from hours of research. Short-term traders who want to profit from scalping are looking at the bid-ask spread of the stock they are following for small profits. These profits usually amount to pennies per share, which is why scalpers trade so often. To understand how short-term traders make money from such small profits, you first have to understand the bid-ask spread—what it is and how it informs the trader.
The bid-ask spread is the difference between what you can sell shares for and the price you pay when buying them. The bid price is what a broker will pay for a stock; the ask price is what she will sell for. The ask price is always higher. How much higher (the difference between the bid and ask prices) is the bid-ask spread. On wide-held and actively traded stocks, the bid-ask spread may be only one or two pennies.
Market Place
In 2001, stock prices switched from fractions to decimals. This changed the smallest price difference from 1 16 or $0.0625 to $0.01. This made it harder for short-term traders to make a profitable trade.
For other stocks, the spread may widen.
Traders watch the bid-ask spread (among other things) for a supply imbalance—a widening spread may indicate that the balance between buyers and sellers is shifting. Real-time market order data available through a direct access provider shows the trader all the pending orders. When an imbalance begins developing, traders may find an opportunity for a profit. We’ll dig into this deeper in Chapter 18.
Short-term traders make many trades and trade large blocks (1,000 plus) of stock if they are able. This way, very small profits per share can add up over the day. For example, a 1,000-share trade with a two-cent per share gross profit is only $20. Out of that must come brokerage fees and other transaction costs. If the trader is left with a $10 net profit, she will be lucky. This is why short-term traders may execute 100 or more trades per day. Not all will be profitable, so the trader must have a strategy to strictly limit losses on bad trades and to exit even on profitable trades.

Momentum Trading

A variation of day trading is momentum trading. Most momentum traders close out their positions at the end of each trading day, although there are some who do not. The idea with momentum trading is that once a stock price begins a trend in one direction (up or down) it tends to continue that way until it reaches a point of reversal. Momentum traders work to spot the beginning and end of trends. By riding the trend as long as possible, momentum traders earn the largest profit. Short-term traders should avoid stretching momentum positions over more than one trading day. However, those traders willing to take more risk for a larger profit may hold a momentum trade longer. The risk is that the price trend will reverse and any profit in the trade may be lost.
Margin Call
Spotting the beginning and end of very short trends is complicated and requires judgment and patience. The momentum trader relies on excellent timing to make a profit or avoid a loss.
In practice, many momentum trades last only a few hours before the trend ends or reverses. Traders look for technical signals and order activity that indicates a trend is beginning. The trick is to know when you are truly seeing a trend and not a quick blip that will bounce one way and then the other with no discernable direction. There are technical signals to watch for, but they aren’t foolproof. Momentum traders must be quick to jump on a trend, but even quicker to get out of a position if the trend proves false. It’s a risky way to make a living, but the rewards can be substantial for the patient and disciplined trader. We’ll look at momentum trading in more detail in Chapter 18.

A Typical Day of Short-Term Trading

The workday for short-term traders can be intense, exciting, boring, challenging, and/or dull—and you can experience all of that in the first hour. The pulse of the market drives the day for short-term traders. However, most successful short-term traders don’t let the market control their businesses. Traders can’t control how the market is running, but they can establish a trading strategy or plan that they test and update. By sticking to a plan, traders remain in control of their trading and avoid emotional decisions.
Short-term traders will likely spend most of their day in a home office connected to one or more direct access providers. The office has multiple ways to connect to the Internet, but the primary connection is a high-speed DSL or cable connection. The computer has a large amount of memory and is hooked to two (or more) large flat panel monitors. There may also be a television tuned to a financial news channel. From this nerve center, short-term traders can research and execute trades on multiple markets and multiple products—although most short-term traders follow one or two primary products.
Trading Tip
Short-term traders find ways to combat the isolation and intensity of their business. Exercise, yoga, or other physical and mental routines help reduce stress and clear the mind for a new day of trading.

The Risk Factor

Short-term trading can be risky—after all, you trade on price movements that are measured in minutes and seconds. This is one of the reasons many trades executed by short-term traders lose money—the high risk of predicting very short-term price movements. Finding a good strategy and gaining the experience to read technical signs and the markets takes time and can be expensive lessons. Many short-term traders never get beyond the learning stage because they run through all their investing capital before they gain enough knowledge to execute more winning than losing trades.
On the other hand, short-term traders close out their positions before the end of each trading day. There are no loose ends and no open positions that can turn into big losers overnight on some bit of bad news—and no big winners that will add to their gains, either. It takes discipline to close out all your positions each night, especially if you have a winning position that looks like it will continue to grow when the market opens tomorrow. But most short-term traders know the key to their survival is to start each day with a clean slate.
Margin Call
The market may appear to react emotionally to news, but it is the participants who are reacting. The market has no emotion or compassion for you or anyone else. It owes you nothing, so don’t expect anything from the market or you have quit trading and begun gambling.

Short-Term Trading Expectations

Short-term traders in today’s market frequently do it as a full-time business. The traders who are successful spend a lot of time learning their profession and try to add to that knowledge every day. The comparison to a business is appropriate because most small businesses don’t survive many years. Depending on the type of business, the failure rate can be as high as 90 percent in the first five years. It usually doesn’t take that long for short-term traders to either fail or admit this is not the business for them and give up before their capital does.
The short-term traders who are successful find emotional and intellectual satisfaction in the business as well as financial rewards. Short-term trading is difficult to do well day after day unless you develop a passion for the business. Fortunately, it can be very addictive in a positive way. Every day the market is different and the challenges change with the blink of an eye.
Market Place
Plan to spend as much (or more) time learning the short-term trading business as you would learning any other business. This is not something you can master with a brief amount of reading or practice.

Role of Short-Term Traders

Short-term trading is not the same as speculating in the sense that speculators often hope to influence the price of a security through their actions. Short-term traders try to capture profits from short-term price changes. They would rather their activities did not cause the price of the security to change, since that would tip their action to other short-term traders.
Short-term trading does provide liquidity and capital to the markets. The securities they buy and sell may or may not be from other traders. An investor entering a market order to sell a stock could be on the other side of a transaction from a short-term trader who wanted the stock at that price. There must always be a buyer and seller, so short-term traders add another level of liquidity to the market since their motives aren’t the same as buy-and-hold investors.
This is important because a factor that might cause a buy-and-hold investor to sell a stock may have no interest to a short-term trader who sees an opportunity to pick up the security on a price change that could be sold back in the same trading day for a small profit.

Short-Term Trading Regulations

Because of past excesses, the regulatory agencies that oversee the securities industry have some strict rules about who can be a short-term active trader and who can’t. The securities industry is highly regulated and is self-regulated in many areas. The primary agency charged with overseeing the securities industry is the Securities and Exchange Commission (SEC). The SEC has tremendous authority, but not complete authority, over the markets and industry professionals. Several self-regulatory organizations also monitor industry professionals. In addition, product-specific regulatory agencies and state agencies are involved.
Brokerage firms, securities exchanges, and other organizations belong to self-regulatory groups that monitor and mediate client disputes and license professionals. Although the consumer is the least represented in all the regulatory organizations, the customer needs the most protection.
For short-term traders, the regulations are designed to determine if you meet “suitability” standards. The rules require brokerages and others providing market access to determine if you are engaging in appropriate trading activities for your financial situation and understanding of the market. What that means is before you can open an account, you must sign a bunch of forms declaring that the money in your short-term account is risk capital, meaning you can lose it and not lose your house.
Trading Tip
Regulators and your broker will monitor trading patterns, and if you qualify, will put you in special class for regulatory consideration.
If you are deemed a “pattern day trader,” you must have at least $25,000 in your account. This is not something the broker can waive, but the rules. You can’t open an account with $5,000 and try to sneak in short-term trading. If you buy and sell the same security on the same day within a margin account, you are day trading as far as the regulators are concerned. Perform four or more of those trades within a week or five market days and you are a pattern day trader.

Be Prepared for Paperwork

Short-term trading accounts, by definition, involve at least $25,000 of cash to get started, more in some cases. Thanks to a number of rules to prevent money laundering, you will be required to prove you are not a member of organized crime or a known terrorist. Criminals have used legitimate businesses and investment accounts to launder ill-gotten cash for years. New rules that affect banks, investment companies, and other financial service organizations require them to report suspicious cash transactions (such as depositing large sums of cash in $100 bills).
Margin Call
Various laws enacted after the 9/11 attacks coupled with efforts to thwart organized drug trafficking make any major financial transaction complicated, often requiring multiple forms of identification.
It was discovered that the terrorists who carried out the attacks on September 11, 2001, were able to obtain large sums of cash from sources without triggering any alarms. As a result, most financial transactions or accounts require positive identification of various sorts before the firm will accept your business. This will include the usual identification information such as name, address, Social Security number, and additional identification, such as a passport and driver’s license.
For pattern day traders, you will be asked to provide financial statements to prove the money you are depositing is truly risk capital and not your kid’s college fund.

The Tax Bite

Short-term trading can be a tax nightmare if you don’t keep good records. Your broker will report your earnings to the IRS and you will get Form 1099 at the end of year. There is a special reporting consideration for full-time traders, but your records must be in order. We’ll cover the details in Chapter 21, but plan on setting up your trading business with tax reporting in mind.

Technology Helps, Hurts

Technology has made short-term trading possible from almost anywhere a high-speed Internet connection is available. Direct access providers and other vendors provide web-based applications that give traders access to domestic and international markets for just about any type of security you want to trade. Most short-term traders set up in their homes or an office to conduct their business full-time. However, with properly equipped laptop computers, short-term traders could take their businesses on the road. High-speed Internet access is available in many locations such as hotels, airports, and other locations. Trading from an airplane is just around the corner.
All this access and technology has put powerful tools in the hands of traders. While that has made the business of short-term trading more accessible, it is no substitute for experience and judgment. Technology will help you be a better trader, but it can’t be a substitute for market knowledge. You can tell technology to execute certain trades if conditions are met (the stock hits a certain price, for example). However, you must still tell the program what price point will activate the action and that requires your judgment. Too often traders confuse technology with judgment and rely too heavily on programs and charts for absolute answers.
The Least You Need to Know
• Short-term trading is the most aggressive of all active trading strategies.
• Scalpers take many small profits to make a profitable day.
• Momentum traders look for larger profits by riding price trends.
• Short-term trading is highly regulated.
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