DAY TRADING FOR INVESTORS
It takes a special person to be a day trader — one who has quick reflexes, a strong stomach, and a short-term perspective on the markets. Not everyone’s meant to parcel out their workdays a minute at a time. Most people do better with a long-term perspective on their finances, looking to match their investments with their goals and thinking about their investment performance over months or years rather than right now.
But those patient long-term investors can learn a thing or two from the frenetic day trader, and that’s what this chapter is all about. Many day-trading techniques can help swing traders, position traders, and investors — people who hold positions for days, months, or even decades — improve their returns and make smarter decisions when it comes time to buy or sell.
Let’s face it: In theory, investors might be willing to wait forever to see great stock picks play out, but in reality, they only have so much time and money. A company’s stock may be ridiculously cheap, but the stock can languish a long time before everyone else catches on and bids the price up. The investor who buys and sells well can add a few extra dollars to his investment return, and who doesn’t want that?
Not all day-traders close out every night, and some long-term investors will take a day-trading flyer on a hot idea. I cover some trading and analysis techniques used by day traders to help longer-term investors improve their returns. Then I discuss some ways that long-term investors might want to add day trading to their list of tricks to achieve better total return.
And heck, maybe a few investors want to give day trading a try, especially for those securities that they have followed long enough to know how the market reacts to news and whether those reactions are appropriate. For a long-term investor, given the time to test strategies and set limits, day trading in known markets might result in some nice incremental short-term returns.
The Trader’s Discipline
Successful day traders have an innate sense of discipline. They know when to commit more money to a trade and when to cut their losses and close up shop for the day.
Unfortunately, a lot of long-term investors can get sloppy. They have done so much research and committed so much time waiting for a position to work out that they often forget the cardinal rule of the trader: The market doesn’t know that you’re in it. The stock doesn’t know you own it, so it’s not going to reward your loyalty. Securities go up and down every day for no good reason, and sometimes you are going to make a mistake and you will have to cut your losses. There’s no shame in that, as long as you learn from it.
Now, how can you get that discipline? Start by developing an investment and trading plan. Although investing is probably not your primary occupation, you do want to have in writing what your objectives are and how you plan to meet them given other constraints: time, tax considerations, and risk tolerance. Then carefully evaluate your performance and keep a trade diary so that you know what you are trading and why. Are there ways to improve? Are you making mistakes that could be avoided?
Traders have to go through these exercises in order to survive. Investors often skip these steps, but they shouldn’t.
A quick way for an investor to improve her trading discipline is to set up a sell rule, a rule that tells her when to cut her losses and move on. For example, if a stock is down 20 percent from where it was purchased or where it traded at the beginning of the year, it might be time to sell, regardless of what you hope it will do.
Momentum investors look for securities that are going up in price, especially if accompanied by acceleration in underlying growth. In a sense, they are looking for the same thing day traders are — a security that is going to move big — but they have the expectation of making money over a longer period of time. The thought is that if a security is starting to go up in price, it will keep going up unless something dramatic happens to change it. In the meantime, there is plenty of money to be made.
The knock on momentum investing is that instead of buying low and selling high, the goal is to buy high and sell even higher. Like most investors, a momentum investor starts with careful fundamental analysis, analyzing a security to determine what will make it go up. In addition, some momentum investors rely on chart services, especially the Value Line and William O’Neil charts, to help them identify securities that are likely to have momentum.
Earnings momentum is the province of the investor, not the trader. The investor is looking at the earnings that a company reports every quarter to see if they are going up at a faster rate, say from a steady rate of 10 percent a year to 12, 13, or more. This often happens because of a new technology or product that turns a decent company into a hot property in the stock and options markets. If the earning growth rate is accelerating, then the underlying price should go up at an accelerating rate, too.
Day traders don’t look for earnings momentum, but they do look for price momentum. The two are usually related.
When a security goes up in price, especially at a fast clip with strong demand underneath it, it is said to have price momentum. Most day traders are looking for price momentum in order to make a swift profit. Many long-term investors should look for momentum in order to avoid being stuck with a position for months before it starts to move. It pays to be patient, but it pays even better if your money is working for you while you wait.
Many momentum traders don’t care why something is going up in price; they only know that it is going up and that they can profit if they’re there for even part of the ride. Some of the different indicators that they look at are the following:
- Relative strength: There are different ways to calculate this, but the basic idea is that if the security is going up faster than the market as a whole, it is showing momentum and might be a buy.
- Moving average convergence/divergence (MacD): This indicator looks at how the average price of the security is changing over time. Is it staying relatively level, meaning that the price is moving slowly back and forth, or is the indicator gradually going up, meaning that the price is gradually going up, too? If you plot the moving average against the actual price levels, a wide gap means that the security is moving up or down faster than the average, and if it’s moving up, you’d probably want to buy it.
- Stochastics index: This is the difference between the high and the low price for a security over a given time period. Some analysts look at days, some at weeks. The idea is that if the difference is getting bigger, that may be because the security is moving up or down in price at a faster than normal rate, creating an opportunity for a momentum buyer.
At an extreme, momentum investing leads to bubbles, like the infamous dot com bubble in the late 1990s. People were buying the stocks because they were going up, not because they necessarily thought that the businesses were worth much. It was fun while it lasted, but a lot of people lost a lot of money when reality set in during March and April of 2000.
For investors only: momentum research systems
Many day traders rely on different research systems to help them identify buy and sell opportunities in the course of a trading day. These systems usually don’t work for an investor, simply because investors are less concerned about short-term movements. They wouldn’t see the value in systems that scan the market and identify short-term price discrepancies, for example.
However, many investors use their own research services to help identify good buy and sell opportunities. Two of the more popular ones are Value Line and the William O’Neil charts.
Value Line is one of the oldest investment research services. The company’s analysts combine price and trading volume information on stocks with financial data. The numbers are crunched through a proprietary model to generate two rankings: a stock’s timeliness and its safety. The higher the stock is on the timeliness ranking, the better it is to buy or hold it now. Historically, Value Line’s most timely stocks have outperformed the Dow Jones Industrial Average and the S&P 500, so people are willing to pay for access to the company’s data. In addition, many libraries subscribe to Value Line’s print service or online database, so you may be able to get access that way. (Hey, one of the advantages of being an investor is that you have the time to go to the library to look something up, a marvel to a day trader who’s afraid to go and get a cup of coffee.)
William O’Neil started a company to distribute his technical analysis system on stocks and the stock market, started a newspaper called Investor’s Business Daily, and wrote a book called How to Make Money in Stocks. The company’s data services are available only to large institutional investors, such as mutual fund and insurance companies, but between the book and the newspaper, individual investors can learn a lot about identifying momentum in order to pick good times to buy or sell a stock.
Many traders — in all securities, not just stocks — find Investor’s Business Daily to be at least as useful as The Wall Street Journal, because it looks at the markets from a short-term trading perspective more than from a long-term, business management angle.
The company’s ranking system is based on what it calls CAN SLIM, which is a mnemonic for a list of criteria that a good stock should meet. Note that it combines both fundamental and technical indicators:
- Current quarterly earnings should be up 25 percent from a year ago.
- Annual earnings should be up 25 percent from a year ago.
- New products or services should be driving earnings growth, not acquisitions or changes in accounting.
- Supply and demand, meaning that the number of shares being purchased each day, is going up.
- Leading company in leading industry is the stock in the best position to do well.
- Institutional sponsorship means that the stock is becoming more popular with mutual funds, pension funds, and other large shareowners.
- Market indexes, such as the Dow, the NASDAQ, and the S&P 500, should all be up.
Of course, there aren’t too many stocks out there that meet all the CAN SLIM criteria, but the indicators can give an investor a way of thinking about better times to buy (when more criteria are met) or sell (when fewer are being met).
The most serious momentum investors tend to be swing traders, who hold positions for a few weeks or months. Longer-term investors often rely on some momentum signals, though, to help them identify when it’s a good time to buy a stock that has been languishing.
Breaking News and Breaking Markets
One reason that the markets are so volatile is that they are responding to news events. Prices reflect information. That’s why prices change when any little bit of information comes into the market — even if it is just that someone wants to buy and someone wants to sell right now. The problem is that sometimes the market participants don’t react in proportion to the news they receive. Good traders have an almost innate ability to discern news that creates a buy from news that creates a sell. Sometimes traders want to go with the market and sometimes they want to go against it.
When it’s your investment idea that’s been affected by a news announcement, you need to consider how your position — and you — will react. After all, no matter how long your time horizon and how careful your research, things happen to companies: CEOs have heart attacks, major products are found to be defective, financial statements turn out to be fraudulent. How are you going to respond?
The first point is that you have to respond. The market doesn’t know your position, and the market doesn’t care. You need to assess the situation and decide what to do. Given the information, is it time to buy, sell, or stay put? It’s often okay to hold your long-term position in the face of long-term news, but that should be an active decision, not a fallback. The trick is to be objective, and that’s not easy when real dollars are at stake.
Successful day traders are able to keep their emotions under control and keep the market separate from the rest of their lives. Good investors should be able to do the same. Chapter 8 has some ideas that might help.
When evaluating news, day traders look at how the news is different from expectations. Investors can also consider how the news is different relative to the known facts about the company to date.
For example, let’s suppose that The Timely Timer Company is expected to report earnings of $0.10 per share. Instead, the news hits the tape saying that earnings will be only $0.05 because of accounting charges. The trader might see that the earnings are below expectations news and sell all his shares to minimize his losses for the day, moving on to another position. The investor might know that the accounting charges were expected and go in and buy more shares while the price is depressed.
The fact that there is a way for a buyer and a seller to match their differing needs is the whole reason that the financial markets exist!
To a day trader, perception is reality. To a keen-eyed investor, the difference between perception and reality might be an opportunity to make money.
Day traders have to think about the psychology of the market, because everything moves so quickly. Investors sometimes forget about psychology because they can wait for logic to prevail. When it comes time to place a buy or sell order, however, understanding the psychological climate that day can give the investor a price advantage, and every bit of profit improvement goes straight to the bottom line.
Day traders keep their sanity by closing out positions at the end of the day, so that they get on with their lives until the next market open. Investors, on the other hand, might want to know what’s happening to their positions at other times. Many brokerage firms offer mobile phone alert services, which I think are a terrible idea for a day trader but might not be a bad idea for an investor.
Setting Targets and Limits
Good day traders set limits. They often place stop and limit orders to automatically close out their positions when they reach a certain price level. They have profit targets in mind and know how much they are willing to risk in the pursuit of those gains.
Good investors should set similar limits. It can be harder for them, because they have often done so much research that they feel almost clairvoyant. Why worry about the downside when the research shows that the stock has to go up?
Well, the research might overlook certain realities. And even if the analysis was thorough, things change. That’s why even the most ardent fundamentalist needs to have a downside risk limit. In most cases, stop and limit orders are bad ideas for a long-term investor because they’ll force the sale of a security during a short-term market fluctuation and they’ll force the sale when it’s really a good time to buy more. Investors have a different risk profile than day traders, so they need to manage risk differently. They still need to manage risk, though.
With a stop order, the broker buys or sells the security as soon as a predetermined price is met, even if the price quickly moves back to where it was before the order took effect. A limit order is only executed if the security hits the predetermined level, and it stays in effect only if the price is at that level or lower (for a buy limit order) or at that level or higher (for a sell limit order).
Martha Stewart’s defense in her insider trading case was that she sold her ImClone stock because she had a pre-arranged sell order in place with her broker, but it was not actually a stop order. The phone call with possible inside information had nothing to do with it, she said, and in fact, the prosecutors could not disprove her. She was found guilty of obstruction of justice, not insider trading.
Day traders close out their positions at the end of each day, so they rarely review their limits. A swing trader or an investor, holding for a longer period of time, needs to review those limits frequently. How much should a position move each month, quarter, or year before it’s time to cover losses or cash out with a profit? How has the security changed over time, and do the limits need to change with it?
When the position is working out, an investor will think of letting it ride forever. But, alas, few investments work that long into the future, so the investor also needs to think in term of relative performance. Is it time to sell and put the money into something else with greater potential?
When managing money, day traders usually think about maximizing return while minimizing the risk of ruin. For an investor, the goal is maximizing return relative to a list of long-term objectives, including a target for risk. But because long-term objectives change, the portfolio will have to as well. That means that a position that has been working out fine might have to be changed in order to meet the new portfolio goals. The discussion is starting to get beyond the scope of this book, but the point remains: Like successful day traders, successful investors have a plan for how they will allocate their money among different investments, and they adjust it as necessary.
Although investing is a long-term proposition and lacks the frenzy of trading, it is still an active endeavor. Instead of putting energy into buying and selling, the investor puts it into monitoring.
When an Investor Should Go Short Term
Many day traders are also long-term investors. Sure, they trade for the short term, but they regularly take some of their profits and put them toward investments that have a longer time frame. It’s smart risk management for a business that has a high wash-out rate. After all, even a short-term trader has long-term goals.
But does it ever make sense for a long-term investor to take up short-term trading? It might. There are three reasons: the idea proves itself to be short-term, the research shows short-term trading patterns that might be profitable, and fundamental analysis supports short selling.
Don’t try riskier trading strategies unless your portfolio can handle the risk. As with full-time day trading, part-time and occasional trading strategies should only be done with risk capital, which is money that the trader can afford to lose. Money needed to pay the mortgage this month or pay for retirement in 30 years is not risk capital.
The idea proves to have a short shelf life
It happens to every long-term investor once or twice: He buys a security intending to hold it forever, and within a few days or weeks, some really bad news comes out. Or he buys only to see two days later that the company is being sold. That great long-term buy-and-hold idea no long fits the original parameters, so it’s time to sell. Despite the goal of holding forever, it’s time to get out and move on, even if it’s only a day later.
Your research shows you some trading opportunities
Good investors monitor their holdings, and some become intimate with the nuances of a security’s short-term price movements even though the objective is to hold the position for the long term. An investor who gets a feel for the trading patterns of a specific holding might want to turn that into swing trading and day trading opportunities. Yes, it adds risk to the portfolio, but it can also increase return.
For example, suppose that an investor who is fascinated with technology stocks notices that the stocks always rise in price right before big industry conferences and then fall when the conference is over. She might not want to change any of her portfolio holdings based on this, but she might also want a way to profit. So, she buys call options on big technology companies before the conference and then sells them on the meeting’s first day. That short-term trade allows her to capture benefits of the price run-up without affecting her portfolio position.
You see some great short opportunities
Short selling allows a trader to profit from a decline in the price of a security. The trader borrows a security from the broker, sells it in the market, and then waits in hopes that the price goes down. When it does, the trader buys the security back at the lower price and repays the loan, keeping the difference between the purchase price and the sale price.
Because the broker charges interest on the loaned securities, short selling can get expensive. Traders who sell short are usually looking for a relatively short-term profit, not necessarily over a single day, but over months rather than years.
In addition to the interest, short selling faces another risk, which is that the security can go up in price while the trader is waiting for it to go down. In order to reduce that risk, most short sellers do careful research to make sure that they’re right about the security being all wrong. And who else does careful research? Many long-term investors.
For the investor who loves to do research and who has some appetite for risk, short selling is a way to make money from those securities that would make terrible long-term holdings because it seems obvious that they aren’t going to do well. When these investors come across securities that are headed for trouble, they can short them in the hope of making a nice short-term profit.
Judging Execution Quality
Day traders rely on outstanding trade execution from their brokers. They need to keep costs as low as possible in order to clear a profit from their trading, especially because their profits are relatively small.
Investors may have a greater likelihood of making a profit, given that they are waiting for a position to work out rather than closing it out every night. Even then, better execution will lead to better profits. The magnitude of the few extra cents might be smaller relative to the entire profit, but it still counts.
Your broker makes money three ways. The first is on the commission charged to make the trade. The second is on the bid-ask spread (also called the bid-offer), which is the difference between the price that the broker buys the security from customers and the price that the broker sells it to customers. The third is any price appreciation on the security between when the broker acquired it and when the firm sold it to the customer. Because three sources of profit are available, some brokers don’t even charge commission. But note that the broker can still make money — lots of money — even without a commission.
When choosing a broker, consider total execution costs, not just commission. Some brokers offering deep commission discounts make money from high levels of trading volume, but others make their money from execution.
The broker has a few tricks for improving execution. The first trick is to invest heavily in information systems that can route and match orders, as even one second can make a difference if the markets are moving. The second is to have a large enough customer base to be able to match customer orders quickly. Finally, and most importantly, the firm has to decide that execution is a strategic advantage it can use to keep customers happy. Many brokerage firms would rather concentrate on research, financial planning, customer service, or other offerings to keep customers happy instead of offering excellent execution.
In general, a firm that offers low commissions and emphasizes its services to active traders will have better execution than a firm that emphasizes its full service research and advisory expertise. But there are exceptions, and in some cases, the exceptions vary with account size.
Brokerage firms use several numbers to evaluate their execution, including the following:
- Average execution speed: This is the amount of time it takes the firm to fill the first share of an order. Firms also track — and sometimes disclose — how long it takes to fill an entire order, on average.
- Price relative to National Best Bid or Offer: At any time, there is a list of bid and ask prices in the market, and your broker might not have the best spread. The National Best Bid or Offer is the best price in the market. You might not be able to get this price for all sorts of reasons, usually because of the number of shares you want to buy or sell. For example, if the best bid is for 100 shares, and you want to sell 500, you won’t be able to get it. Brokerage firms track and report how close the price you received was to the best bid or offer at the time.
- Price improvement: Most brokerage firms buy and sell securities for their own account. In fact, working as a trader at a brokerage firm might be a great alternative to day trading. Because the firm might own the security or want it for its own account, it might give you a slightly better price than what is in the market.
- Average Effective Spread: This measures how much the spread between the bid and the offer differed from the National Best Bid or Offer, on average. The lower the Average Effective Spread, the better.
Certainly, your results will vary based on what types of securities you are trading, what market conditions are like when you are trading, and how big of an account you have with the firm. But investigating the averages for a brokerage firm can help long-term investors decide whether it makes sense to change firms in order to improve profits.
So what can you do to improve your execution? Here are three suggestions:
- Ask the brokerage firm for its policies. The firm should be willing to provide this, as well as to give you some of its recent data, so that you can decide whether the total value of the firm’s services matches the total cost.
- Check the weekly “Electronic Trader” column in Barron’s as well as the magazine’s annual review of online brokerage firms. Execution cost is a key component of Barron’s evaluation.
- Update your own hardware and Internet connection so that it’s as fast as possible. If you are a day trader, it’s imperative to have good data. If you are not a day trader but actively manage your investment account, you might want to consider an upgrade as well. A few seconds can make a difference.