Chapter 2
Characteristics of the Active Trader
In This Chapter
• Personal and professional characteristics of active traders
• Risks of active trading
• Active trading as a career choice
• Emotional and intellectual challenges
Active trading may seem like the investing equivalent of the National Football League, where aggressiveness, supreme self-confidence, and a no-excuse attitude are rewarded. While those characteristics come into play, they alone won’t make you a winner as an active trader. In fact, most active traders work very hard to keep their emotions out of their business. Emotions cloud judgment and, when you are doing very short-term trading, can trick you into following one bad trade with another. People who trade on emotion or gut instinct usually don’t last long.
Most active investors do it as a full-time career. Like any other complicated profession, it requires dedication and practice to master. The capital, equipment, and services needed for active trading make a part-time effort inefficient. The extremely fast-paced action of active trading would be difficult to adjust to on an infrequent basis.

What Makes an Active Trader Tick

Active traders come in all ages and genders. The market doesn’t care if you’re a man or woman, young or old. The traders you compete against don’t give anyone a break and, in that sense, trading is one of the most egalitarian businesses you can enter.
Most active traders focus on very short-term trading patterns—still called day trading in many circles. This is the most intense and complicated form of active trading. It is the one that requires the greatest commitment if you have any hope for success.
Market Place
Like most endeavors that are worth doing, active trading requires a commitment of time, energy, and money. The idea that anyone can be successful with little effort on his or her part is not true.
Despite what you might see on late-night television ads, this form of active trading is not something that most people can do an hour or two each day and be successful. Day trading requires all the skills and personality traits that make a full-time trader successful.
Most successful active traders seem to have a combination of personality characteristics that increase the odds of success.

Most Active Traders Are Quick Learners

Short-term active trading (such as day trading and momentum trading), where you make dozens of trades each day in a market that changes with every tick, requires a mental agility to adapt to new conditions instantly. You have to see the market by looking at rows of numbers and charts. This learning process takes time, but if you take too much time, you’ll run through your investment capital before grasping some notion of what the market is telling you. This is one of the main reasons (along with poor money management) that many beginning active traders fail. As we look into the actual mechanics of active trading, you will see how important it is to always be a learner.
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Trading Tip
Practice trading is a must for beginners, but it can only take you so far. You can learn the trading platform and how the markets work, but you won’t really know if you’re cut out for active trading until you risk real money.
Not only do you need to learn the market, there is usually the fairly complicated software used by the trading platform of your direct access broker. Both are complicated and you shouldn’t plan to pick up all you need to know in 20 minutes of tinkering around. A caution that will reappear repeatedly throughout this book is to use the practice accounts offered by direct access providers to learn the software and get familiar with the market in which you choose to work. It’s a free and painless way to get the basics down.

Active Traders Process Lots of Information

If you choose to try active trading, be prepared for data overload. The amount of information you must process is staggering. Trading platforms are marvels at assembling information, and most will let you customize the presentation of onscreen information. Still, many short-term active traders use more than one computer monitor to have access to all the information they want at one time. You must develop the ability to look over those areas of the screens that are the most urgent and evaluate what you see quickly. When we look at trading platforms in Chapter 16 and at screen shots throughout this book, you will notice the large number of areas competing for your attention.

Active Traders Make Quick Decisions

Very short-term active trading requires split-second decisions, especially if you are scalping profits. If you are hesitant to make a decision where money is involved, active trading is probably not for you—at least, very short-term active trading. Not only do you need to “pull the trigger,” but you need to move on quickly if the trade doesn’t work. Beating yourself up over a bad trade or mistake in the middle of trading action leads to more mistakes or missed opportunities. Quick decisions should not be confused with guessing. Active traders make a trade because it fits their plan and the technical signs are right.

Most Active Traders Review Their Work

We just noted that traders do not tarry over a bad trade or mistake. However, at the end of the day, active traders take the time to review what happened and why. Going over the day’s trades, both the winners and losers, gives traders an opportunity to check their performance. Traders are self-critical in a positive way to determine how they can improve their performance in future trading.
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Margin Call
Active traders, beginners and even veterans, make dumb trades on occasion. It is important to learn from mistakes, but if you harp on failures, it will hold you back and taint future decisions.
Traders review their trading plan and question whether they need to make adjustments or simply improve execution.

Most Active Traders Work Alone

Thanks to high-speed Internet connections available almost everywhere and high-performance trading platforms offered by direct access providers, most active traders work from their homes or private offices. There are still a few day trading centers where traders gather and access the markets through workstations often provided by a stock brokerage company. However, most traders work alone, and that can be daunting for people who thrive on contact with others. Active traders are very focused and many would find others distracting. If you enjoy the camaraderie of a traditional office or work environment, you probably won’t enjoy sitting in front of multiple monitors by yourself for hours.

The Emotional Challenges

The market doesn’t care about you or your personal problems. That may sound harsh, but anyone who enters active trading with the hope that newcomers get any kind of break is in for a rude awakening. Active trading is not like investing. When you buy a stock for an investment, you are not trying to beat someone else out of a profit; your intent is to hold the asset for at least one year or more. Active traders compete against other traders for a profit.
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Trading Tip
Most active traders set a schedule around when the securities they specialize in trade. They stick to this schedule as a way to avoid becoming compulsive about trading and to give themselves time to recharge emotionally and intellectually.
As we’ll see in Chapter 18, day trading and momentum trading involve a highly charged atmosphere where traders use a variety of tricks and feints to manipulate prices or the appearance of price change in order to grab a profit when others fall for the bait. This is not a gentle way to make a living.
Emotionally, active trading can be devastating if you aren’t prepared for the stress and able to suffer resounding defeat and come back the next day as if nothing happened. Many active traders find the isolation of working alone too emotionally vacant.
Successful traders find ways to cope with the stress and are passionate about what they do. The danger on the other end of the emotional scale is that the active trader will become consumed by trading. With markets open 24 hours a day somewhere, it is possible for active traders to become virtually addicted to trading. This, of course, is not healthy and can only lead to deterioration in proficiency.

Active Trading as a Substitute for Gambling

Active trading is not gambling. It is a serious and thoughtful way to make money on price changes of securities. However, thanks to infomercials and misguided stories in the media, there is a perception among some that active trading is easy money. Unfortunately, the facts are that over 80 percent of the people who take up active trading lose money.
Still, the image of quick and easy money attracts people who are inclined to have problems with gambling. They believe active trading will give their gambling problem an air of social acceptance. It certainly sounds better to say you are an active trader than it does to say you are a gambler.
Some people may make money in active trading by guessing (gambling), but they won’t last long. You can be lucky for only so long before it turns on you. People who gamble tend to be poor money managers also, so early luck is soon consumed by later bad luck. If you have a problem with gambling, active trading is not a substitute that will make your problem go away. You will lose money just as quickly (probably quicker) in the market as you will in a casino.

Full- and Part-Time Active Trading

Many active traders, especially those engaged in scalping and momentum trading, do it as their full-time occupation. These two forms of active trading are the most intense and require the longest learning curve. The trading platforms are complicated. The markets are challenging and the pace of trading is unbelievably fast. Learning all there is to know about these two forms of active trading is usually best done by immersion. Active traders are driven to know all they can know about their business, while realizing there is something new to learn every day they trade.
We’ll dig deeper into these forms of short-term trading in Chapter 3 and then look at what it is like to actually be an active trader in Chapter 17 and beyond. You’ll see more clearly why day traders have a passion for what they do. Without some internal drive to do this type of work, most people don’t stick with it for long. It is a difficult way to make a living, but if you have the right skills and personality, you may find you love it.
It is possible to be a part-time active trader. However, you will still need most of the same equipment and services a full-time trader needs. This means your overhead costs are not spread over as much trading activity and become a bigger percentage of your costs.
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Trading Tip
Active traders spend more time with their investment capital than typical investors do because they are interested in exploiting current profit opportunities, not building for the future.
If you have a job that starts later in the day or you can adjust your work schedule, you may decide to trade only half a day. Some markets trade 24 hours a day. Another option is to only trade two or three days a week. If you work on weekends, you may want to trade on your days off.
If you opt for one of the longer-hold active trading systems, such as swing trading or position trading, you have much more flexibility. Many people do this without leaving their present job. When we look at these two opportunities in Part 4, you will see that they lend themselves to a much less intense level of activity. However, they also lack the hard competition and chances to score well that the short trading strategies offer. You can, however, employ them on your lunch hour, something not really practical or advisable with day trading or momentum trading.

Understanding Risk and Return

You can define risk several ways, but for long-term investors and active traders it usually means the chance that you won’t earn the return you expected. Investors may go to great lengths to avoid losing money, which is not a bad thing. However, in doing so they rob themselves of the opportunity to earn returns that will beat inflation and truly increase their wealth.

Connecting Risk and Return

The problem for many investors and traders is they don’t connect risk and return properly. This is one of the most important concepts for both investors and traders, since it is directly related to your success in either endeavor. The rule of the investing/ trading jungle is this: the higher the risk, the higher the potential return.
The risk/return rule has several stumbling blocks for investors and active traders.
People don’t understand the risk. One of the most serious problems facing investors and traders is understanding the risk of a particular investment. Investors have a big edge here because they typically hold for long periods. Temporary setbacks can be recovered over time if you have invested in a good company. Active traders face a much more challenging task since they must usually decide quickly and hold only for a very short period.
People don’t understand the return. Too many novice investors and traders enter the game with unrealistic ideas about the return they can earn. They may remember the dot.com days and hope to become rich overnight. An equally serious and more common problem is investors and traders taking too much risk for too little potential return. Why take a big risk for a potential 9 percent return, when you can take very little risk for an 8 percent return?
It is a potential return. Taking the risk doesn’t mean you will earn the return—if it did, then it wouldn’t be a risk. Yet, some investors and traders are incredulous when they take a risk and it doesn’t work out. One secret of successful investing and trading is finding a level of risk you can tolerate and adjusting your financial goals to that expected return.
Market Place
It is important to understand your personal risk tolerance. You cannot be successful with a trading strategy that pushes you outside your comfort zone.

The Risks of Active Trading

Since active traders hold for such short periods, the risks can be higher in some areas than for long-term investors. Depending on the security being traded, intraday prices can change rapidly and swing widely. This may create opportunities for day and momentum traders, but it also is challenging to determine if a downtick is the start of a general downward price trend or just a bump before prices rally. Active traders can make money if prices go either way, but they must be right in the direction—taking a position that prices are moving one way only to have them reverse is a big risk.
Active traders follow price trends (which we’ll discuss in more detail in subsequent chapters). Those traders shoot for the biggest profit trade at the extremes—that is, they attempt to buy at the bottom just before the price begins an upward trend and sell just before that climb stops or reverses. Identifying those points is not an exact science. Using charts and factors from technical analysis, traders combine science and art into their own trading system. Many traders don’t shoot for the highest possible profit, but aim for a certain return and exit when they hit that mark, knowing that a fast-moving market can take away their profit in a heartbeat if they are not careful.
On the other hand, short-term traders close out their positions at the end of the trading day. They won’t suffer any losses because of bad news that happens after the markets close. Investors and active traders holding shorter-term positions risk the effect news events or corporate announcements (a change in earnings estimates, for example) have on prices of securities they hold.

Time and Money Management

One of the important skills active traders need is the ability to manage their time and money. Time management is important because traders cannot afford to waste time on nonproductive efforts during trading hours. Money management is important because traders will lose money, especially those just beginning. Managing those losses requires discipline and a plan.

The Importance of Time Management

Active traders are bombarded with data—some of it useful, a lot of it noise. Some of the noise may be interesting, as in news items or new trading technology. There is a time for exploring those items, but it is not during the active trading day. Many successful active traders have a set routine they follow every trading day. This schedule helps keep them focused on what is important for success during trading that day.

The Importance of Money Management

Successful active traders have a trading plan that covers how much of their investment capital they will risk at any one time. They stick to this plan and don’t change it without careful consideration. Most traders set a percentage of their investment capital as the maximum they will trade at any one time. This limits their risk somewhat, should things go badly.
It is a good idea to have a plan and limits in place so you will not have to think about what is right during the heat of trading. If you set daily limits and hit those during a trading session, close out your positions and take the rest of the day off. It is better to take a small loss so you can come back another day than to stubbornly hang on and watch a small loss turn into a big loss.
We’ll discuss time and money management in greater detail in Chapter 23.
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Margin Call
Failure to manage investment capital is one of the main reasons active investors fail. If you do not have a plan for risking your capital and sticking to it, you may let emotions interfere with trading decisions.

Active Trading as a Business

Earlier we talked about active trading as a career choice. Another way to look at it that people find helpful is as a business. There may be some tax consequences for actually setting yourself up as a one-person business. We’ll look at those in more detail in Chapter 21.
As a business, active traders put their capital at risk, the same as other business people who start an enterprise. Your trading plan is how you will run the business and manage your money. For many people, it is important to think of their active trading in these terms because it helps keep emotion out of decisions. The failure rate for small businesses is high, and the business of active trading is no different. If you remain focused on your strategy and learn from your mistakes, like other small business people, you’ll improve your odds for success.
 
The Least You Need to Know
• Active traders are quick learners who keep their emotions in check, are able to process lots of information, and are comfortable working alone.
• Active traders usually work at it full-time as a career.
• Active trading has its own set of risks that can be managed.
• Active traders are concerned with managing their time and money.
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