Day Trading: Beat the System and Make Money in Any Market Environment

INTRODUCTION

Depending on whom you ask, the term day trader has most people imagining either a wealthy twentysomething trading in front of multiple monitors, or a disheveled gambler losing thousands of dollars in mere minutes.

In reality, a day trader is somewhere in between.

It’s true that individuals day trading stocks tend to lose more money than those using a buy-and-hold strategy. In a famous study titled Trading is Hazardous to Your Health, UC Berkeley researchers looked at 66,465 households with accounts at a discount brokerage between 1991 and 1996.¹ They found that those trading the most earned 6.5% less than the market average, and only a small subset of them managed to consistently make money from day trading. The researchers attributed the traders’ poor performance to overconfidence, which prompted more frequent trading, as well as the tendency to hold on to losing positions and sell winning ones. In some cases, risk-seeking also led traders to under-diversify their portfolios by investing almost all of their money in only one or two stocks.

These tendencies have led many financial experts to compare day trading to gambling. In some ways, the analogy makes sense. Most day traders act like gamblers, their trading informed by emotion, all the while paying commissions to brokers for the privilege. Combine that with data that shows most day traders lose money, and the comparison with gambling becomes inescapable. That’s why many experts recommend that the average person stick to long-term investing as the best way to generate passive income from the financial markets.

A better analogy for day trading, however, would be the game of poker.

Like the average poker player, the average day trader does not trade for a living. The average poker player loses money in the long run, just as the average, nonprofessional trader loses money in the long run. Everyone in a poker room must pay a rake to the casino; likewise, everyone in the market must pay commissions to a broker. What makes poker different from other games is that there are gamblers who make a consistent living by playing better than others at the table. In a study of 415 million hands of poker, economist and statistician Randall D. Heeb found that the skill of a poker player had a statistically significant effect on the amount of money won or lost.² The same goes for day trading: Some professionals are able to consistently make money, and more often so than others.

Professional day traders employ detailed trading strategies and sound money management techniques to steer clear of the problems most amateurs face—such as overconfidence. Using statistical analysis techniques, professional day traders identify high-probability trades and act on them with precision in order to generate a quick profit, while limiting their overall risk exposure. By contrast, amateur day traders often haphazardly enter a trade, see the stock moving lower, become worried about mounting losses, and prematurely sell the stock before it rises again.

Here’s an example: An amateur and professional day trader both identify a promising stock exhibiting a potential breakout chart pattern. The amateur might invest half of his total account value in the stock in the hopes of a breakout, whereas the professional determines the trade’s upside and downside potential, and then decides to invest 5% of his account value. The stock subsequently moves 5% lower. The amateur may worry—especially given the large investment—and sell at a loss, whereas the professional knows that the 5% decline is still within their bounds and decides to let the trade continue. The stock then moves 20% higher in a breakout. The amateur didn’t have a plan and let fear guide his decisions; the professional, on the other hand, had a well-defined plan and ended up profiting from the trade.

The good news is that professional day trading is a learned skill. It is something that most people can master by devoting enough time, energy, and capital. Similarly, it’s possible to learn how to play the odds and become a professional poker player. This book is written for people who are looking to become professionals at day trading, whether it’s something they end up doing full-time, or just to supplement their income. In this book you’ll learn the mechanics of the markets, common day trading strategies, and tips for finding an edge in one of the most competitive industries in the world.

Many people who claim to be experts at day trading sell guides to novice day traders for a lot of money. In reality, the day trading strategies that work today won’t work tomorrow, and there is no single strategy that works for everyone. If there was, day traders could simply retire and let computers place trades on their behalf all day! Like professional poker, day trading is a profession that requires an instinct for reading the market and identifying promising trades. This book is designed to provide you with a solid level of knowledge of day trading and show you how to develop these instincts over time.

We will also prepare you for the emotional roller coaster that day trading is. The SEC itself—the regulatory body governing trading and investing—warns that most individual investors do not have the wealth, time, or temperament to make money and to sustain the devastating losses that day trading can bring. This book will not only discuss money management strategies to avoid these devastating pitfalls, but also describe techniques for dealing with the stress and emotional volatility that are unique to the day trading profession.

In the end, the goal of this book is to help you decide whether day trading is a good fit for you; provide you with a basic grasp of the methodology and its application; and show you the path to becoming a better day trader.

THE MARKET

Most people are familiar with the market in a layperson’s sense. When they go to the supermarket to buy groceries, they understand that the store is essentially a place where buyers and sellers meet to exchange goods (e.g., foods). The picture becomes less clear when one turns on the television and sees media pundits discussing the market’s performance. It can be unclear what market they are talking about, or how the stock and bond markets work.

In this section, we’ll look at markets from a conceptual standpoint, and give you an overview of the functioning of financial markets such as stocks and futures.

WHAT IS THE MARKET?

Suppose that a grocery store in Florida expects the price of orange juice to rise significantly over the coming month and wants to stock up on its supplies. The grocery store could go to an orchard and request 15,000 pounds of orange juice, but it would be difficult to settle on a fair price and find a seller that would be able to supply the full amount. As a result, the grocery store might have to identify multiple sellers, buy orange juice at different prices, and then try to calculate its future costs. In addition, the grocery store would have to coordinate delivery and incur storage costs for all this orange juice (carrying costs).

The futures market makes buying 15,000 pounds of orange juice trivial. By purchasing a $20,000 futures contract for 15,000 pounds of orange juice to be delivered the following month, the grocery store can conduct business as usual and still know that it will be able to offset any potential higher prices with the profit derived. The grocery store could then turn around and sell the futures contract for a profit on its expiration date, without even taking delivery of the product. In the end, the grocery store’s bottom line would be the same as if it had actually accepted delivery.

On the other hand, suppose that a farmer is looking to sell 15,000 pounds of orange juice. Not only would the farmer have to coordinate all of the buyers, he would also have to come up with the cash to grow the oranges before realizing any profit. Again, the futures market makes selling 15,000 pounds of orange juice very simple: The farmer puts the contract up for sale, receives the proceeds from the contract, and then supplies the goods at a future time. The transaction makes the farmer’s income more stable, and enables him to receive a fair price.

The futures market, the stock market, and other markets are mediums for facilitating transactions between buyers and sellers. Instead of individuals and companies having to negotiate small private transactions among themselves, financial markets provide greater transparency so that everyone knows they received a fair market price, which was created by matching a given product’s supply with its demand. In most cases, these transactions take the form of an auction, to ensure the best possible price for both parties. The electronic nature of modern markets also helps lower transaction costs, and gives anyone with an Internet connection access to trading contracts, assets, securities, and other products worldwide.

What does this mean for day traders?

Using the same orange juice example, suppose that a day trader notices an unusual spike in demand for orange juice futures. The trader could purchase the contract for $20,000, wait the course of the day for the price to rise to $21,000, and then sell the contract for a $1,000 profit (or 5% gain)—all within the same day. In doing so, the trader purchases the rights to 15,000 pounds of orange juice and can sell those rights to a different party for a nice profit.

Day traders help make markets more efficient by including all relevant information in the price of an asset. Drawing on the above example, suppose that a farmer in Brazil was selling the orange juice futures contract without knowing that there was a spike in U.S. demand for oranges due to a drought in Florida. The market ensures that the information about the drought is automatically included in the latest price, since the day traders would have closed the price gap very quickly. As a result, the farmer in Brazil knows that the current price reflects all of the information available to the market, even if he himself does not possess all of that information.

These dynamics highlight just how powerful global markets have become. Day traders, long-term investors, and end users come together to determine fair prices for everything—from commodities like orange juice to companies like Apple. For day traders, there are literally hundreds—if not thousands—of different markets to trade in, and therefore countless opportunities to gain profit. These profits are derived from capitalizing on changing expectations and speculating where market prices are headed based on the information available.

WHERE DOES THE MONEY COME FROM?

The first question that many aspiring day traders ask themselves is, Where does the money come from? At first glance, the market seems like a zero-sum game where there are winners and losers. This is true for markets like futures and options, where there is always a winning and a losing side to every transaction. However, other financial markets like the stock market are not necessarily zero-sum games.

A company whose stock is consistently rising can produce many winners and no losers. The stock may never come down to its original levels if the company is able to continue generating revenue and profit growth. Such dynamics make the stock market a powerful tool for wealth creation in society, as economies drive wealth creation at a faster rate than inflation destroys it.

The corollary to this is that there are instances in these same markets when everyone loses. During the 2008 economic crisis, one might wonder where all the money that had been lost by banks and investments had gone. The answer is that the price the market is willing to pay for such assets can simply decrease, and the assets become less valuable—even if nobody makes a single trade; after all, any asset is only worth as much as someone is willing to pay for it. A second great example of this phenomenon has to do with what happens when a company goes bankrupt: The money invested wasn’t necessarily taken by executives—it simply disappeared, along with the expectations that the investors had had for the company’s future.

The good news is that stock prices have trended higher historically due to the economy’s positive rate of growth, which, in turn, has made the stock market a powerful tool for wealth creation, at least for those who participate in it.

As mentioned earlier, futures and options are two instances in which the market does function as a zero-sum game. A farmer making $20,000 by selling the rights to 15,000 pounds of oranges that he plans to grow next month will lose out if prices rise to $25,000 by next month, whereas the grocery store that purchased the futures contract will pay $5,000 less than the market price that month. While there are some exceptions, most options contracts operate the same way: Someone selling the rights to their stock at a certain price will lose out if the stock rises above that price before the contract expires.

In the end, market prices are determined by supply and demand. When more people want to buy an asset, the asset’s price increases, and vice versa. Rumors, the news, and one’s own earnings—among other factors—influence a trader’s perception of a company, commodity, or asset. These perceptions in turn influence supply and demand, and, therefore, price changes.

HOW DOES THE MARKET WORK?

Suppose a day trader places a market order of 500 shares of Apple stock after determining that the price is likely to rise in the future. Although the shares appear on his computer screen nearly instantly, there are actually a number of different steps that need to be executed executed in just milliseconds to make this happen. Day traders should familiarize themselves with these steps, so as to ensure that they are getting the best possible prices and to prevent costly mistakes.

Stocks are originally created or issued in the primary market via public offerings, such as an Initial Public Offering (IPO). Once issued, these stocks are traded in the secondary market between traders and investors. This trading process doesn’t involve the company at all. Large institutional traders usually dominate initial public offerings and then sell shares to smaller retail traders, although retail traders can also secure some of these shares with the help of their brokers.

Most day traders start their interaction with the market by communicating—either online or by phone—with a broker trading in the secondary market. Since trading is a regulated activity, brokers are necessary intermediaries who, in exchange for a fee or commission, buy and sell stocks or other assets on behalf of individuals or institutions. Instead of communicating with their clients personally, most modern brokers have online platforms that execute instant transactions, thus making trading a largely hands-off task that is still highly secure and regulated.

Brokers buy and sell stock on behalf of their clients, either on an exchange or over the counter. In general, most trades occur over exchanges like the NYSE, NASDAQ, or NYMEX, although many derivatives trade over the counter in deals made directly between the buyer and seller rather than through an intermediary. Exchanges are responsible for matching buyers and sellers. In the past, specialists handled the process on a trading floor where loud shouting and lots of shoving used to take place, with tons of paper lying around. Most modern exchanges have switched to electronic processes in order to improve efficiency and enforce controls.

Exchanges maintain lists of buyers and sellers in what is known as an order book. On one side, there are bids, which represent prices and amounts that buyers are willing to pay for a security. On the other side, there are asks, which represent prices and amounts that sellers are willing to accept for their security. Matching engines are used to determine which orders can be fulfilled. When a bid and an ask are matched, a new market is made, and the trade price becomes the security’s new price.

The entire process works like this: A day trader places an order of 500 Apple shares with his broker. The broker’s system combines this trade with other orders of Apple shares from other client accounts, and submits a big order for the stock to an exchange. The exchange checks the order book and fills the buy order with the best prices available. The exchange then sends the shares to the broker. The broker divides up the shares among its clients, and the number of shares that each day trader ordered appears on his screen, along