Chapter 17
Short-Term Trading Strategies, Part 1: Day Trading
In This Chapter
• What you need to be a short-term trader
• Scalping as a trading strategy
• A closer look at shorting
• Fading as a short-term strategy
A combination of switching stock pricing from fractions to decimals and the bear market following the collapse of the dot.com bubble were thought by many to be the end of short-term active trading. Also known as day trading, this once robust part of the trading industry took a one-two punch. The conversion to decimals in pricing stocks reduced the spread between the bid and the ask, which was an important source of revenue for day traders. The bear market put an end to most of the big intraday gains that were the norm during the dot.com bull market.
However, the short-term active trader is still very much in the game and making money. Tough times weeded out many of the traders who were riding a bull market but lacked the experience to survive a more difficult trading environment. We have used the term short-term trader to distinguish the traders of today from the shoot-from-the-hip day traders of the dot.com boom. Today’s short-term traders must be smarter and more professional about their business if they want to succeed. Many of the techniques used by today’s successful short-term traders are the same as day traders have used for years with updates to include new products and new markets.
Market Place
Short-term traders, also known as day traders, don’t get the press they once did, but they are still active in the market.

The New Short-Term Trader

The one characteristic that has remained constant from the era of day traders is the rule that no trade carries over a trading day. This means traders close out all their positions at the end of the trading day. In this regard, short-term traders remain true to the day trader philosophy. While some view day trading as very risky (and there is risk involved), short-term traders feel holding positions open overnight is riskier.
The other characteristic that is common to short-term traders is a rigid trading system that defines entry and exit points for each trade. The short-term trader may make up to 100 trades per day, but each is organized with definite entry and exit strategies.
Finally, short-term traders use a high degree of leverage to accomplish their goals. When you are only making a small profit on a trade, it helps if that small profit is multiplied by 1,000 or more shares. Short-term traders must balance this need to make small profits with the expenses of multiple trades.

The Importance of Technical Analysis

Short-term traders may use technical and fundamental analysis to guide their trading. However, most use the charts provided by technical analysis to provide buy or sell signals. (We sampled a few of those in Chapter 16.) Thanks to advancements in electronic delivery of news and information, short-term traders have access to information that may change a stock’s price trend and can trade on that movement—or at least protect their positions.
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Trading Tip
Many short-term traders find most of their buy and sell signals in charts. However, watching the Level II quotes and additional indicators can yield buy and sell signals, too.
If you are going to succeed as a short-term trader, you will need to find a trading system—whether it is based on technical or fundamental analysis or both—that provides you with reliable buy and sell signals quickly and accurately. No system is perfect in all market conditions, but without a working system, it is difficult to survive as a short-term trader.

Be Flexible

While most short-term traders continue the pure day trading strategy, others have chosen to let profit opportunities drive whether the trade is closed at the end of the trading day or not. New short-term traders take a less rigid view of closing all trades at the end of the day and may shift into another strategy if they are holding a trade that has more profit to be made. In this scenario, day traders may become momentum traders (Chapter 18), swing traders (Chapter 19), or even position traders (Chapter 20).
To be certain, this can be a more risky strategy because your position is exposed for longer periods and you may not have done much, if any, fundamental research on the company. However, if you have strong indicators that there is more profit to be taken by holding on, the new short-term active trader is free to carry over trades from one trading day to another.

What You Need to Succeed

Short-term trading is not a get-rich-quick scheme, despite what you may have seen on the Internet. Most people who try it do not succeed. It is not the type of activity you can do when you feel like it or when there is nothing else to do. If you plan to make a living with short-term trading, you should plan to spend months learning the trading platform of your direct access provider (see Chapter 12). This exercise should include paper trading and using all of the platform’s features.
You will also need a significant amount of risk capital—that is, capital you can afford to lose without ruining your life. Regulations for day traders call for an account minimum of $25,000. Some brokers may require a higher minimum. You will lose money in the beginning, so it is important to have enough capital to see you through your learning process. Many advise a $50,000 minimum.
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Margin Call
You will lose money when you begin short-term trading. You must have discipline to keep your losses to a minimum while you are learning. If you can’t tolerate losing money, short-term trading is not for you.
With your investment capital, you will be using a high degree of leverage to make large trades. As we’ll see later in this chapter, small profits on large trades can add up over the course of a day, as can small losses. Leverage is a two-edged sword, but one we must use to be successful.
Later in the book, we’ll look at legal and tax issues as well as setting up your office, time management, and other issues directly related to active trading.

What You’re Looking For

Short-term traders look for a stock that has liquidity and volatility. Because most, if not all, trades will be closed out in a single day, the short-term trader wants a stock that trades in a broad intraday range. This means that the difference between the day’s high and low is significant enough to allow the trader to profit on up or down swings in the trading range. These swings may only be a point or less, but if the trader puts together a 500-share trade, the net could be impressive.
Say the trader made $0.50 per share on a trade within the intraday range. At 300 shares, that’s $150, minus commissions, fees, and so on of $50, for a net of $100 for the trade before taxes. If the trader could do that several times a day, always at a profit, it would be a good day. Unfortunately, not every trade will be for a profit—some will be losses. Not every trade will deliver this much profit. In fact, as we’ll see in the section on scalping, many profitable trades make much less.
The bottom line is the more trades you make, the better your chances are of ending the day with a profit—and the greater risk that you will lose more of your investment capital.
The liquidity requirement of good short-term trading candidates means there is an active and ready market for the security. This gives short-term traders good entry and exit points, which are important for capturing profits or cutting losses. With poor liquidity, it may be difficult for traders to get the price they want in a timely fashion. This is one reason most short-term traders stick with well-known actively traded stocks.
A stock with good liquidity will have narrow spreads, meaning there will be little difference between the bid and ask price. This is important because you are not giving up much to the market maker in the stock.
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Trading Tip
Stocks that are actively traded are said to be highly liquid. This will help keep the spread narrow, which means you are paying less for the product.

Using the Right Tools

The short-term trader needs the fastest, most reliable technology available. A direct connection to markets via a direct access broker and a trading platform that allows the trader to execute preprogrammed trades with a single click are essential. In addition, the short-term trader should have Level II prices, Time and Sales charts along with TotalView (see Chapter 14) to have a complete picture of the market. Charts beyond a one- to five-minute period are too old to see set-ups for the short-term trader.
Of all active traders, the short-term trader needs the best information technology to be successful. This is not an area to cut corners or save pennies. Buy adequate equipment, software, and services and learn how to use it all completely before you invest a dime in actual trades (we’ll discuss tools in detail in Chapter 22). There is nothing more frustrating than failing because you are stumped by a hardware or software question.

Scalping

The best-known trading strategy of short-term active traders is scalping—one that day traders have been using for years and perfected during the dot.com bull market. The essence of scalping is to grab small profits in trades that may last minutes or less. Scalping is the primary trading strategy for a number of short-term active traders. When done correctly, scalping is a moderately low-risk strategy because your exposure to the market for any one trade is so short.
On the other hand, scalping requires strict discipline and endurance. Short-term traders may have to enter many trades every day to make a decent profit, and one slip in discipline can wipe out a big piece of their profit.
The traditional scalping strategy is to buy on the bid and sell on the ask. These orders are entered simultaneously by the traders in mimicking the role of the market maker. This strategy works if there is enough of a spread between the bid and ask to produce a profit that will cover trading expenses.
def·i·ni·tion
Bid is the price a market maker is willing to pay for a security. Ask is the price a market maker is willing to sell the security. The ask price will always be slightly higher than the bid. The difference between the two prices is the market maker’s fee per share.
In this strategy, the trader buys and immediately sells at prices that guarantee a small profit. To make enough money to cover expenses, the trader may have to buy 2,000 or more shares. If the spread between the bid and ask prices is sufficient, the trader can do this repeatedly throughout the day and build up a nice daily profit. This strategy works best with stocks that don’t change price frequently during intraday trading.
The switch to quoting stock prices in decimals hurt scalpers. When prices were quoted in fractions, scalpers were almost always assured of at least a spread of one-sixteenth point, which meant a profit of $0.0625 per share. On a 1,000-share trade, this gave the trader $62.50 profit before expenses. With prices quoted in decimals, the spread may be down to $0.01 per share or $10 on the 1,000-share trade. This has made it more difficult to profit by playing market maker, although there are still stocks with larger spreads than $0.01.
Despite the increased risk, scalping remains a major source of income for many short-term active traders. By looking for larger spreads and increasing the size of their trades, active traders may compensate for the more difficult environment.
Although we’ve used stocks as our example, active traders can apply many of the same techniques to other securities including trading e-mini stock futures, the Forex, and so on. These nonequity markets may offer a different opportunity that you will find more attractive than pure stocks. For example, the Forex trades 6 days per week, 24 hours a day.
Market Place
Many short-term traders keep up on several different securities so if one market (stocks, for instance) seems bereft of opportunities, they can switch to another security (Forex or futures, for example).

Take a Large Position

Scalpers who have been frustrated by the small spreads in the decimalized stock market have taken another approach. They will take a large position in a stock and wait for a small movement in price before selling. Unlike traditional investors who let their profits run, the short-term trader will fix a profit target and exit when that goal is reached. They believe the longer you are in the market, the more danger you face. Still they are out of the trade quickly. A volatile stock will likely move enough during intraday trading for a scalper to grab a profit.
This strategy is much riskier than the market-maker tactic because you are counting on the price to move in the direction of your trade. You must have protective stops in place to prevent large losses. It is not unusual for a volatile stock to move 10 to 50 cents or more during a trading day. Scalpers set their profit goals that reflect the risk and sell when the price hits the target. This strategy may “leave money on the table” by selling out of a stock that is increasing in price beyond the trader’s profit target. However, the strategy assures a profit and reduces the risk that instead of continuing an upward climb, the price reverses and destroys your profits.
Scalpers use charts and Level II pricing to watch for price reversals and pressure building on the buy or sell side with pending orders. If they get good signals from their charts with confirmation from volume and Level II information, traders will buy near the low for the day (up to that point in the trading day) and sell when the price is close to the high for the day.
While it is tempting to let a winner run, it is also risky. Intraday prices on volatile stocks can change direction without warning, despite what charts may indicate.
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Margin Call
Trying to follow Level II quotes on a very volatile stock can be challenging as the numbers change faster than you can track them. If a stock is moving too fast, it may be time to back off and wait for the action to slow down. Don’t be caught in the excitement at the expense of common sense.
 
While this strategy may entail fewer trades than traditional scalping, you still need discipline to set entry and exit points. Many short-term traders fail because they do not stick to a disciplined exit plan. They will either get greedy and try for a few more cents per share profit on too many trades or will take high-risk trades in an attempt to compensate for losing trades. Either course of action (or a combination) of the two will lead to failure.

Playing the Down Side

Scalpers can make money in other ways besides the traditional “buy low, sell high” strategy. One of the more popular ways is to take the other side of a trade and short stocks that the trader believes will fall in price. Many of the technical tools and charts discussed in Chapter 16 point toward reversals of upward trends. This signal gives the trader the opportunity to short or sell the stock prior to the price fall. We discussed the mechanics and risks of shorting in Chapter 3.
Although the terms are slightly different for traders who close short positions in a matter of minutes or hours, the risks remain the same. Because short-term traders are highly leveraged, the risks of shorting are multiplied. If the stock’s price continues up, instead of dropping as anticipated, traders had better have a stop in place to close out their positions in a hurry.
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Trading Tip
Shorting is a popular and potentially profitable activity for short-term traders. Following a large run-up in price, some traders will short the stock, feeling acorrect, they profit. If not, they are forced to cover their positions and lick their wounds.
However, with short-term trades not open over trading days, the risks are usually much less than a normal shorting strategy that holds open a position overnight.
Traders may use charts to spot upcoming reversals and make their move based on those signals. Other traders may take a less analytical approach and short stocks that have a quick run-up in intraday price on the belief that toward the end of the trading day (or perhaps before), others will be taking profits and those sales will drive down the price.
On intraday trading, an eye on Level II orders will give the trader an idea when selling pressure is beginning to build. As profits are taken and the price drops, the trader should watch for buyers coming back into the market to pick up shares at a bargain off the day’s high. That is a good signal to cover the short position and take your profit. If you feel the price is headed back up to a daily high, you might jump back into the stock as a buyer at this low point and ride it up to a point you are comfortable with and take more profits.
This all sounds very easy when you read it in a book, but in practice, it is far from simple. Volatile stocks that trade in a broad range don’t necessarily bounce up and down with any regular pattern. If they all did (and some do), you could make a nice profit following the price up and down as a buyer and seller. In reality, prices don’t follow a nice predictable pattern every day. When they don’t, you get clobbered with losses if you place trades in the opposite direction.

A Higher-Risk Strategy: The Fade

Despite what many think, short-term investors believe they employ strategies that minimize risks rather than exaggerate them. Holding positions for only short periods is seen as a safer move than exposing yourself to all the bad things that can happen when you hold a security for an extended period. While that attitude is debatable on several levels, it is a fact that closing all your positions each day does eliminate exposure to many market factors that can work against you (and some that work for you).
However, some traders are attracted to the possibility of extraordinary gains made possible by taking more risk. The market rewards risk, but also penalizes traders in proportion. It is important that we be clear that taking a higher risk position is not the same as gambling. If a trader has a clear head, entering a high-risk position is a legitimate strategy. If greed or fear is pushing the trader to take extra risks, the situation is dangerous and the trader is headed for financial disaster. In Chapter 24, we’ll examine some of the emotional requirements necessary for successful active trading.
Market Place
Short-term active trading offers many opportunities for traders to get their feet wet in the world of fast decisions and big money. Many find this a more comfortable invitation than traditional investing and its much longer holding periods.

Playing the Fade

You’ll find that trading terms often are shared by other endeavors. One of the terms you may hear in trading circles is fade, which is a term that appears in a number of environments from sound to haircuts to shooting dice. It is the definition used in dice that may be most analogous to the meaning in trading. To fade someone in dice is to bet they will not make their point—in other words, to bet they will lose.
In trading, to fade is to bet the prevailing price trend is going to reverse (or lose). Traders employing this strategy buy as prices trend down and sell short as they trend up—a contrarian strategy that pays handsome profits if things go your way, but the odds are against you.
146

Fade Strategies

One of the ways traders play the fade is when a stock gaps at opening. A gap is the difference between the previous close price and the next day’s opening price. A gap of a few cents is nothing unusual; however, when there is a significant news event or economic news, a stock may have a large (more than a point) gap either up or down at opening.
Traders with a tolerance for risk can fade those gaps. If a stock gaps up—meaning the opening price is higher than the previous close—a trader can short the stock. If the stock gaps down, the trader would buy. You can see these are contrary moves.
If the stock gaps up, the initial reaction is that it will be moving up for the day. The trader who shorts the stock is betting that won’t be the case and the gap will close, but back toward the lower close. When that happens, his short position stands to make a significant profit when covered. Likewise, the trader anticipates that a down gap will close back up to the previous close, making his shares worth more for a nice profit.
147
Margin Call
Fading is one of the more high-risk strategies available to short-term active traders. While holding out the possibility of high returns, it can fail more often than succeed.
 
Obviously, the danger in fading is that a stock could gap up and continue to rise. This will put a short seller in a tough position very quickly and the trader will have to exit before the losses become too large. If a stock that opens with a down gap continues the trend, the trader who bought betting the stock would go up is now holding a losing position and must also exit in a hurry to reduce losses.
One clue for traders who want to play the fading strategy is the volume at the opening gap. If a stock gaps with a heavy volume, traders should be cautious that the price will continue the opening direction. However, a gap on weak volume is a clue that the direction at opening may not hold a trend and would be a good fade candidate.
Fading is not a strategy for beginning active traders. However, with some experience in the market, and practice, you can take calculated risks for larger returns.

For Additional Short-Term Trading Strategies

Short-term trading is a challenging way to make a living. We have only scratched the surface of the different strategies that traders use. If you choose to make short-term trading a career, an investment in more in-depth resources and training is required to be successful. There is a wealth of material available to help you get started. If what you’ve read so far sounds like it is something you would find challenging, continue reading and consult Appendix A for additional resources.
The Least You Need to Know
• Short-term trading is confined to opening and closing positions the same trading day.
• Scalping or taking very small profits is a central strategy to short-term trading.
• Short-term traders short securities for additional profit opportunities.
• Fading is a contrarian strategy favored by some short-term traders.
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