Chapter 1 What Is Active Trading?
In This Chapter
• Several short-term trading strategies
• Assuming a higher degree of risk
• Using leverage to enhance capital
• Active trading as a supplement to investing
Most investment advice suggests that the best strategy for the average investor is to “buy and hold.” The idea is to identify great companies, buy the stock at a reasonable price, and hold it for years. An active trader, however, is more concerned with short-term profits from price changes in stocks and has little interest in what the company does or its future prospects.
Active trading is more risky because traders deal in volatile price changes over short time periods and often use leverage (short-term borrowing) to enhance their position. A move in the wrong direction can spell disaster for the active trader. Despite the higher degree of risk involved, serious active traders are not gamblers. The actions they take are calculated to maximize return and minimize risk.

Defining Active Trading

Active trading is best known by its holding periods, which can range from seconds to weeks. There are several types of active traders, but they all have one thing in common: they attempt to profit from price changes (sometimes very small price changes) in the securities they trade. While investors measure their holding in years, some active traders consider anything beyond 8 to 12 weeks way too long to be in one position. On the other end of the active trader spectrum are those who will not conclude a trading day without liquidating all of their accounts and starting fresh each morning.
The intraday price is the price quote of a security during active trading. It is neither the opening nor closing price and will change many times in the course of the trading day.
Traditional investors are not concerned with the intraday price movement of a stock. In fact, they are little concerned with daily changes unless the stock is trending down as a reflection of a change in the fundamentals or key financial ratios that measure the company’s economic health. The buy-and-hold investor knows that over time great companies produce superior results as measured against the market and other companies in the same industry.
Active traders, on the other hand, focus on price changes over short time periods. They use tools to help them predict when a stock’s price movement will start or stop or reverse direction. These changes in intraday prices may be just fractions of a dollar, but short-term active traders (such as day traders) can capitalize on those movements if they are clever and quick. Other active traders look for securities to make a move (either up or down) and ride that wave for as long as they can earn profits, which may be hours, days, or weeks.

Investor or Active Trader?

It is important to clearly distinguish between investors and traders. The actions of active traders are often contrary to what investors consider sound practices. Consider a marathon runner and a sprinter. Both runners’ goals are the same—to win—but the races are different, requiring different skills and tools to succeed.
Investors typically focus on long-term goals and make their investment choices to match these needs. One of the main goals investors work toward is a financially secure retirement. To achieve this goal, they hope to pick investments that will give them above-average returns year after year, in all types of market conditions. The ideal investment will grow in value at a rate greater than inflation and better than the market to provide a real rate of return. Investors measure their holding periods in years.
Trading Tip
Many people, including some in the media, use the terms investor and trader interchangeably. However, it is a mistake to lump active traders in with long-term, buy-and-hold investors.
Active traders, on the other hand, are more concerned with a very short holding period. While investors are seldom concerned with how a security is doing on any particular day, active traders are very interested in price and price velocity. The direction and velocity of price changes tells traders it’s time to buy or sell. Active traders try to capture short-term profits by recognizing when the market has temporarily mispriced a security.
Active traders who focus on very short-term price changes are also known as day traders. The term “day trading” simply means all trades originate and conclude within the same trading day. Day traders were the superstars of the boom in the late 1990s. The practice skyrocketed on the back of a super bull market and advances in trading technology that reduced the time and expense of turning around quick trades. When the bubble popped, many of the day traders of that time discovered that making a living in a declining market took more skill than they possessed.
Since then, many in the industry have moved away from the term and embraced the broader descriptive name of active trader. Active traders include day traders, but also several other types of traders who deal in slightly longer holding periods. We will explore more differences between investors and traders in Chapter 2 because understanding the different motivations and strategies is central to understanding the science and art of active trading.

Going Against the Grain

Active traders seemingly go against the grain of conventional investing wisdom. Many knowledgeable investment professionals strongly urge investors to avoid frequent trades because of the increased transactions costs and the tax implications. Commissions paid to stockbrokers, even the deep-discount online brokers, add up. You pay a commission when you buy and again when you sell. Those dollars come out of any profit you make in a winning investment and increase your losses when you bail out of a losing position.
If you take a profit before holding the security a full year, your gain is taxed at ordinary income tax rates rather than the preferable long-term capital gain for securities held more than one year. You can offset some gains with losses; however, it is generally better to hold a security longer than one year and qualify for the long-term capital gains treatment. You should always consult a tax professional before making decisions that have tax consequences. We’ll explore tax issues in more detail in Chapter 21.
Conventional wisdom also cautions that money needed any sooner than five years does not belong in the stock market because of the volatility. While a chart tracking a stock over a lengthy period might appear to be on a steady path, a closer look at intraday prices might reveal a different story. Hotly traded securities can experience wide swings during a trading day. Likewise, securities may suffer prolonged periods of decline before beginning a long climb to record highs.
Investors who need their money when a security is stuck in a low point are in trouble. That’s why it’s important to begin converting a substantial portion of your portfolio out of equities and into fixed-income securities as you approach retirement. You don’t want to be caught with all your cash tied up in stocks during a bear market. Active traders will get out of a losing position quickly; however, they risk dumping a stock that suffers a temporary decline but rebounds sharply. Unlike investors, active traders look for profits now. An active trader is not trying to build wealth by holding investments over lengthy periods, so they are not caught in the same dilemma as investors. However, active traders can use conventional investing strategies to build a retirement account, for example.
Margin Call
The stock market experiences a bear, or down, market about every four to five years on average. However, it can suffer major retreats that don’t qualify as full bear markets at any time. Active traders get in and out of the market quickly, so the volatility helps them, but it can be deadly to investors.

Active Traders Are Investors, Too

Many active traders are also buy-and-hold investors. Active trading is how they earn a living, just like the job you go to every workday. However, they invest for long-term goals like everyone else, because they know that active trading is a means to build your investment portfolio. Smart active traders will move some of the profits from trading into an investment account and keep it there to preserve it.
Active traders who have been in the business for some years know how hard it is to make money in a market. They don’t take extra chances just to generate income, because taking chances is a short road to ruin. Tough markets come and go and active traders adjust. The ones who survive are disciplined in their trades and in their money management. Active traders work hard to minimize risk and maximize return, which is a strategy that can’t succeed without discipline.
Many professional active traders view their trading as a supplement to investing, not a substitute. The fact that both activities involve the buying and selling of securities is not coincidental, but the approaches are completely different. Active traders who set thresholds in terms of what their trading capital is have a better chance at succeeding.

Active Traders Begin as Investors

Many active traders are experienced investors. This was, and remains, a problem for novices who view active trading as an easy road to quick riches. Novice traders were drawn to the lure of easy money during the boom. Thanks to a wild market, some of them did very well, at least for a short time.
It is possible to learn to be an active trader with no previous investment experience, but your odds of succeeding are low. Many investors view active trading as a way to take advantage of very short-term price movements that are otherwise wasted on traditional investors. They also see the opportunity to use a small portion of their investment capital in a higher risk strategy that has the opportunity to significantly beat the market.
Market Place
Although active trading and investing have different approaches, most active traders begin as investors. Understanding securities and what moves the markets can be very helpful to active traders.
For these investors, active trading is another tool, but not an exclusive tool. They remain primarily traditional investors in terms of the amount of capital they allocate between traditional investing and active trading.

Investors Can Learn From Traders

While it may be helpful to have some background in investing before beginning active trading in earnest, the traditional investor can learn from the active trader as well. Traditional investors normally don’t have much use for the tools employed by active traders except at two important points in any investment: buying and selling. One of the keys to successful investing is buying at a good price and knowing when to sell.
Many traditional investors try to determine a company’s intrinsic value through fundamental analysis (see “Fundamental vs. Technical Analysis”). If they can buy at or below this price, they have entered at a good point. Obviously, investors would like to sell when the stock is peaking. However, because traditional investors usually hold a good stock for years, they are not too concerned about pinpointing an entry and exit price down to the penny. They set a target entry and exit and are happy to get both.
Active traders focus on short-term and very short-term price changes. They look for technical signs that indicate a price movement in one direction or the other and move to take advantage of the change. They aren’t always right because the time frame they work in is so short and much is happening that can change the environment rapidly. However, they aren’t guessing either.
Where the two investment strategies meet is forecasting the correct time to buy or sell. If traditional investors wanted to convert a security to cash and use some of the tools available to active traders, that knowledge might influence when they actually sold. If the stock looks like it is in danger of a reversal, investors may want to accelerate the sale, for example.
Market Place
Investors may approach the problem differently, but finding the right entry point—that is, buying a security at the right price—sets up potential profits. Both investors and active traders put a great deal of effort into this one decision.
When buying a security, traditional investors have an entry point in mind. If active trading tools indicated the stock could be had at a lower price, traditional investors would be interested in lowering their entry point and possibly increasing the profit potential.
The tools used by active traders are available to anyone, including traditional investors willing to learn how to use them. As we’ll see in later chapters, the tools are guides, not absolute predictors of price changes. Investors still need to use good judgment and common sense when making investments.

Fundamental vs. Technical Analysis

Traditional investors tend to rely on fundamental analysis, which is a detailed examination of companies to identify those that will be market leaders and provide above-average returns. Fundamental analysis focuses on what a company does and how efficiently it converts assets into earnings.
Technical analysis, a process of identifying price changes and movement of stocks, is the primary tool of active traders. Technical analysis is concerned with short-term price changes. It assumes a stock’s price is reflective of everything that is known about the company—in other words, there is nothing hidden in the price that is known only by a few investors. Technical analysis also assumes that price changes follow trends and that these trends can often be seen and predicted. It is expressed primarily through charts that are easy to read for the experienced eye.
Technical analysis is part science and part art. In rapid intraday trading, no tool will tell you what a stock’s price will be in the next few minutes or hours. However, if you are a practiced active trader, you will gain a confidence in reading the indicators and making quick and frequent trades to take advantage of the price changes. Successful active traders will count it a good day’s work if more trades are profitable than not.
We’ll examine technical analysis in more detail throughout this book and see how active traders use it in their decision-making. You’ll also see that serious active traders don’t guess or “have a feel” for the market. They base their trades on solid evidence and judgment honed by experience.
Margin Call
Many investors and certainly very short-term active investors live by technical analysis and the charts it produces. On the other hand, there are investors who look at technical analysis as a step above voodoo. It is not an exact science, but it is not smoke and mirrors either.

Using Leverage

Most active traders, especially those who make a living at it, are serious users of leverage to enhance their trading potential. Leverage is simply short-term borrowing to give you more investment capital. Some traditional investors also use leverage, but active traders frequently use it in every trade they make, whereas traditional investors typically use it less frequently.
Leverage in the investment world is also known as margin. In its simplest form, you borrow up to 50 percent of the price of a stock purchase from your stockbroker. For example, if you have $10,000 in capital, your stockbroker might lend you another $10,000 so you could buy $20,000 of a stock. If the stock goes up 20 percent to $24,000, you sell and pay back the $10,000 to your stockbroker and pocket $14,000.
You earned 40 percent on your $10,000 investment. Had you only invested your $10,000, your profit would have been $2,000 or 20 percent. Leverage doubled your profit (obviously, I’m ignoring interest on the loan from the stockbroker, commissions, and taxes for the purpose of this illustration).
Leverage can help active traders achieve spectacular returns. However, it cuts both ways. If the trade goes sour, leverage works as hard against you as it did for you. Using the same numbers as above, suppose your $20,000 investment suffers a 20 percent loss instead of a profit. Now your account is worth $16,000. Your stockbroker requires you to maintain a certain account balance, which means you must either put cash into your account to raise the equity or sell out and pay off the note to the stockbroker.
If you sell at $16,000, you pay back the stockbroker and are left with $6,000, which is a 40 percent loss of your original $10,000 investment. Had you not used margin, you would have suffered a $2,000 loss on your $10,000 of original capital, or 20 percent. Leverage doubled your loss and, because of the stockbroker’s margin requirements, you may have been forced to sell when you would have preferred not to.
Margin is the ability to borrow against the value of a security to extend your investment capital. Margin accounts with brokerage firms usually let you borrow up to 50 percent of the account value for a reasonable interest rate.

The Price of Risk

Whether you are a conservative “buy and hold” investor or an active trader, risk is part of the investment equation. Even though active trading typically carries a higher degree of risk than traditional investing, serious traders take calculated risks—meaning they understand what the risks of a trade are before making it.
Beginning active traders typically have more losing trades than winners, in part because of the high-risk nature of the trades and in part because of inexperience. This is where an education can become expensive. Frequent trades mean more commissions paid to brokerage accounts and potentially higher fees. You can mitigate this expensive learning process by trading with practice accounts or paper trading that most brokerage firms provide. These accounts let you trade using real market data, but you aren’t actually risking real money. This will give you a feel for the market and help you learn the trading platform or direct access broker system you choose.
Direct access brokers offer trading services to active traders that include sophisticated trading software, often called a trading platform. Trades through this platform go directly to the market, which means almost immediate execution of your buy or sell order. Conventional online or discount brokers take your order and then pass it through their trading system, which creates a delay in the actual execution. As we’ll see in later chapters, quick execution is what gives active traders an advantage. Direct access brokers also offer sophisticated trading tools and information such as Level
II Nasdaq quotes, which are essential for active traders to succeed. Chapter 12 discusses direct access trading in detail.
However, paper trading is no substitute for trading real money. When you invest real rather than play money, your emotions become a factor. If you can’t handle losing some of your own money, active trading is not for you. Almost everyone who starts off in active trading loses money in the beginning. Managing risk is a top priority in learning how to actively trade.
Trading Tip
Practice or paper trading at most stockbrokers or trading platforms is just like the real thing. You may, or may not, see live data, but the experience is as close to real trading as possible. It is a safe way to get familiar with the trading software and comfortable with the markets.

Important Considerations for the Active Trader

To many people, active trading means buying and selling stocks, but the market is awash with securities that lend themselves to active trading—and some that don’t work so well. Because active traders have a short-term perspective, their requirements for a security to trade are different from traditional investors’ concerns.
A security is any type of investment product such as stocks, bonds, options, future contracts, and so on that is traded in an open market such as a stock exchange. These products are called securities because they are all registered with regulatory authorities that govern how the security is created, bought, and sold.
A primary concern of active traders is liquidity of the security, which means the security trades frequently on a readily accessible market. Liquidity gives the trader the ability to buy and sell the security with ease, knowing there will be a market.
Some securities trade infrequently or only seasonally (some commodities, for example crops that are only harvested during certain seasons). Active traders need securities that trade frequently so their trade won’t upset the market price levels. Active traders want to move into and out of a security that is moving up (or down) and change that direction with their transaction.
Volume is another important factor for active traders. Traders want a high volume of transactions in the security because it allows the opportunity for quick profits without disturbing the market price. Volume is also an important technical indicator, especially when paired with price changes. This relationship will give you strong hints about which direction the security’s price is likely to continue to go. We’ll examine these indicators in more detail in Chapter 16.
The best securities for active traders also let them employ leverage—in some cases a lot of leverage. Not all securities readily allow you to leverage them. For example, some common stocks are not allowed to be leveraged. You can actively trade these securities, but you lose the advantage that leverage gives you.
Market Place
With so many securities to choose from, you may find it hard to focus on one type, but you will have better success if you identify one type of security and stick with that one until you are comfortable with how it trades.
Another important characteristic that active traders look for in a security is volatility. Volatility is how much the security’s price changes over a given period of time. A security that trades in a very narrow range—$24 to $26, for example—does not provide as much opportunity as the security that trades between $18 and $28. These two securities could have the same average price of $25, but the one that varies from that average is more likely to produce profit opportunities.
Traders measure this variation from the average with a formula that calculates the standard deviation. The standard deviation is a mathematical way to measure volatility and risk. The trading platform you use will show this value, but in short the higher the number (meaning the greater the variance) the higher the volatility. Higher volatility translates into more opportunities for active traders to capture profits.

What Active Traders Trade

Many active traders focus on stocks, but thanks to the growth in technology that delivers prices and markets for other products, traders can also specialize in bonds, options, futures, commodities, and currencies.
Stocks may be the most popular choice of active traders, especially novices, because they are the easiest to understand and most familiar. There is a wealth of technical analysis and charting software covering stocks. Stocks have all the qualities active traders look for in a security (ready market, liquidity, marginability, volatility, and so on). The most popular trading platforms all cover stocks with the tools and information you’ll need to be successful.
Many active traders focus on one type of security until they feel proficient and then add another security type to their skill set. This gives them the flexibility to find profitable trades in two or more different areas, so if stocks are flat, for example, they can switch to another security type to look for opportunities. While many of the skills in one market translate to another, each market has its own characteristics and patterns. The difference in the securities dictate different trading strategies in some cases.
We will explore the individual products in more detail in Chapter 8.

Types of Active Traders

This book focuses on four generally recognized types of active traders: short-term active traders, also known as day traders (including scalpers), momentum traders, swing traders, and position or trend traders. The length of holding period is one, but not the only, difference that marks the four different active trading styles from each other.
The form of active trading with the shortest holding period of all is called, ungraciously, scalping, which will be a familiar term to those with a history in day trading. Scalpers grab very small profits on dozens of trades each day. These traders must have swift reflexes and move quickly to take advantage of small changes in price. Really aggressive scalpers may make 100-plus trades a day. Scalpers make the most use of information from trading platforms.
They may follow a particular security that is consistently volatile. Scalpers close out their positions at the end of each day.
Trading Tip
Scalping and momentum trading are the two most intense and risky forms of active trading. They are the classic forms of day trading with traders huddled around multiple computer monitors staring at rivers of data looking for opportunities.
Momentum traders also hold positions for a very short period. However, unlike the scalper who may be in and out of a position in a matter of minutes or seconds, momentum traders may ride a trade for several hours. Momentum traders spot price trends, either rising or falling, and ride them until signs indicate a reversal. The idea is that once a trend is established it wants to keep going. These price trends are short-term intraday changes, not the long-term growth or decline traditional investors watch. Like scalpers, most momentum traders close out their positions each day.
Swing traders look for securities with short-term price trends and may hold it for one to four days or until the trend slows or stops. Swing traders look for one thing: a trending price change that they can identify through technical analysis.
The last type of active trader, position or trend traders, may hold a position for months (usually holding an asset for a year or more would qualify as investing as opposed to trading). Both look to establish a position in an asset as it begins a trend up (or down) and hold on until the security reverses course, which could be months.
We will examine each type of trading in more detail and look at how active traders put this information to use in actual trades.

A Final Word of Caution

Active trading is risky. Don’t invest your retirement fund (and certainly not your mortgage). Active trading is not a get-rich-quick scheme, and it is not gambling. Some estimates indicate that up to 80 percent of the people who try very short-term active trading lose money. If you are serious about this as a career, be prepared to lose money while you learn.
The Least You Need to Know
• Active trading is riskier than traditional investing.
• Active traders follow short-term strategies including scalping or day trading, momentum, swing, and position trading.
• Active traders rely on technical analysis, not instinct, to guide trades.
• Active traders may hold a position from a few seconds to months.
• Most beginning active traders lose money.
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