Showing posts with label day-trading-for-dummies. Show all posts
Showing posts with label day-trading-for-dummies. Show all posts

FUN WITH REGULATION

FUN WITH REGULATION




The financial markets are wild and woolly playgrounds for capitalism at its best. Every moment of the trading day, buyers and sellers get together to figure out what the price of a stock, commodity, or currency should be at that moment, given the supply, the demand, and the information out there. It’s beautiful.

One reason the markets work so well is that they are regulated. That may seem like an oxymoron: Isn’t capitalism all about free trade, unfettered by any rules from nannying bureaucrats? Ah, but for capitalism to work, people on both sides of a trade need to know that the terms will be enforced. They need to know that the money in their accounts is there and is safe from theft. And they need to know that no one has an unfair advantage. Regulation creates the trust that makes markets function.

Day traders may not be managing money for other investors, and they may not answer to an employer, but that doesn’t mean they don’t have rules to follow. They have to comply with applicable securities laws and exchange regulations, some of which specifically address those who make lots of shortterm trades. Likewise, brokers and advisors who deal with day traders have regulations that they need to follow, and understanding them can help day traders make better decisions about whom to deal with.

How Regulations Created Day Trading

With the advent of the telegraph, traders could receive daily price quotes. Many cities had bucket shops, which were storefront businesses where traders could bet on changes in stock and commodity prices. They weren’t buying the security itself, even for a few minutes, but were instead placing bets against others. These schemes were highly prone to manipulation and fraud, and they were wiped out after the stock market crash of 1929.

After the 1929 crash, small investors could trade off the ticker tape, which was a printout of price changes sent by telegraph, or wire. In most cases, they would do this by going down to their brokerage firm’s office, sitting in a conference room, and placing orders based on the changes they saw come across the tape. Really serious traders could get a wire installed in their own office, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker rather than having direct access to the market, so they could not count on timely execution.

Another reason there was so little day trading back then is that all brokerage firms charged the same commissions until 1975. That year, the Securities and Exchange Commission ruled that this amounted to price fixing, so brokers could then compete on their commissions. Some brokerage firms, such as Charles Schwab, began to allow customers to trade stock at discount commission rates, which made active trading more profitable. (Some brokerage firms don’t even charge commissions anymore, but don’t worry; they get money from you in other ways.)

The system of trading off the ticker tape more or less persisted until the stock market crash of 1987. Brokerage firms and market makers were flooded with orders, so they took care of their biggest customers first and pushed the smallest trades to the bottom of the pile. After the crash, the exchanges and the Securities and Exchange Commission called for several changes that would reduce the chances of another crash and improve execution if one were to happen. One of those changes was the Small Order Entry System, often known as SOES, which gave orders of 1000 shares or less priority over larger orders.

Then, in the 1990s, Internet access became widely available, and several electronic communications networks started giving small traders direct access to price quotes and trading activities. This meant that traders could place orders on the same footing as the brokers they once had to work through. In fact, thanks to the SOES, the small traders had an advantage: They could place orders and then sell the stock to the larger firms, locking in a nice profit. Day trading looked like a pretty good way to make a living.

Larger institutional traders and NASDAQ market makers resented the way that traders using SOES exploited their advantage, referring to these people as SOES bandits.

Your library and bookstore might have older books talking about how day traders can make easy money exploiting SOES. That loophole is long gone, so stick to newer guides. There’s a list in the appendix.

In 2000, the Small Order Execution System (SOES) was changed to eliminate the advantage the small traders had, but few of them cared right away. More and more discount brokerage firms offered Internet trading while Internet stocks became wildly popular. No one needed SOES to make profits when Amazon.com and Webvan were going up in price day after day, at least for a while. But then reality caught up with the technology industry, and the market for those stocks cratered in 2000.

We’re now in a new era, with new trading practices and new regulation.

Who Regulates What

In the United States, financial markets get general regulatory oversight from two government bodies: the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Both have similar goals: to ensure that investors and traders have adequate information to make decisions and to prevent fraud and abuse.

Neither body has complete authority over the markets, though. Instead, much of the responsibility for proper behavior has been given to self-regulatory organizations that brokerage firms join, and to the exchanges themselves. It’s not straightforward, but the overlap between these organizations seems to ensure that problems are identified early on and that the interests of companies, brokers, and investment managers are fairly represented.

Stock and corporate bond market regulation

The stock and corporate bond markets are the most prominent. Regulators are active and visible because these markets have a relatively large number of relatively small issuers. There’s not one government issuing currency — there are a whole bunch of companies issuing shares of stock. When it turns out that one of these companies has fraudulent numbers, the headlines erupt, and suddenly everyone cares about what the SEC is up to. That’s just the first layer in regulating this market.

Given the rate at which exchanges are merging and organizations are rearranging themselves, the following list may well be obsolete by the time you read it. But even if the organizations go away, the regulations won’t.

The U.S. Securities and Exchange Commission (SEC)
   
   www.sec.gov

The SEC is a government agency that ensures that markets work efficiently. The Commission has five commissioners, appointed by the President and confirmed by Congress, who serve staggered five-year terms. This structure is designed to keep the SEC nonpartisan. One of the commissioners is designated as the chair.

The SEC has three functions:
  • To ensure that any companies that have securities listed on exchanges in the United States report their financial information accurately and on time, so that investors can determine whether investing in the company makes sense for them
  • To provide oversight to the markets by ensuring that the exchanges and self-regulatory organizations have sufficient regulations in place and that those regulations are enforced
  • To regulate mutual funds, investment advisors, and others who make decisions for other people’s money


The National Association of Securities Dealers (NASD)

   www.nasd.com

The NASD represents and regulates all stock and bond brokerage firms and their employees. More than 5,000 firms are members, with 660,000 employees registered to sell securities. The NASD administers background checks and licensing exams, regulates securities trading and monitors how firms comply, and provides information for investors so that they are better informed about the investing process.

The NASD also requires brokers to know who their customers are and whether an investment strategy is suitable for them. I discuss suitability later in this chapter, but for now, know that that’s an NASD function.

A good first stop for a day trader is the NASD’s BrokerCheck service. The Web site address is too unwieldy to reprint here, but you can go to www.nasd.org and click on the link to BrokerCheck from that home page.

BrokerCheck allows you to look up brokerage firms and individual brokers to see whether they are in good standing. If there have been any complaints filed, you can see what they are and decide for yourself how you feel about them. It’s great information that can help you head off problems early on.

The NASD started as a self-regulatory organization, but in the late 1960s it saw that member firms needed a better way to trade over-the-counter securities (securities that do not trade on an organized exchange like the New York

Stock Exchange). In 1971, it formed its own electronic communication network, the National Association of Securities Dealers Automated Quotation system, or NASDAQ, pronounced as one word: “NAZ-dack.” In 2000, the NASD divested NASDAQ, which is now known only by that name, and returned to its self-regulatory organization roots. Although the two are now separate, brokerage firms that trade securities on NASDAQ must be members of the National Association of Securities Dealers.

The exchanges

Each of the major stock and bond exchanges — the New York Stock Exchange (NYSE), the American Stock Exchange (ASE), and NASDAQ — has its own regulatory body that makes sure that companies with securities traded on the exchange meet the criteria that have been set for their listing. These criteria include timely financial reporting with the SEC and minimum numbers of shares that are actually traded.

The exchanges also monitor how securities are traded in order to look for patterns that might point to market manipulation or insider trading. Each works with brokerage firms that are allowed to trade on its exchange to make sure they know who their customers are and that they have systems in place to make certain these customers play by the rules.

The NYSE used to oversee and license brokers that worked for member firms. At the time of this writing, it is in the process of merging those functions with the NASD. As all NYSE firms are also members of the NASD, this should reduce much duplication of effort.

Treasury bond market regulation

Treasury bonds are a slightly different animal than corporate bonds. They are issued by the U.S. government, so regulation is handled by the Treasury Department’s Bureau of the Public Debt (www.treasurydirect.gov) with additional oversight from the SEC.

Derivatives market regulation

The derivatives markets, where options and futures are traded, don’t deal in stocks and bonds directly. Instead, they link buyers and sellers of contracts where the value is linked to the value of an underlying security. Derivatives are popular with day traders, because they give them a way to get exposure to interest rates and market index performance with less capital than would be required to buy treasury bonds or large groups of stocks directly.

Derivatives markets have their own regulatory bodies, but they match the format and hierarchy of stock and bond market regulation. The organizations may not be household names, but their functions will seem familiar.

Commodity Futures Trading Commission (CFTC)

   www.cftc.gov

The CFTC is a government agency founded in 1974 to oversee market activities in agricultural and financial commodities. The government realized that these markets needed some regulation but were sufficiently different from traditional stock exchanges that the SEC might not be the best agency to handle it. The CFTC is structured similarly to the SEC, with five commissioners holding staggered five-year terms, appointed by the President and confirmed by Congress. One of the commissioners is designated as the chair. This structure is designed to keep the CFTC nonpartisan.

For decades, futures trading was regulated by the U.S. Department of Agriculture, because it involved nothing but agricultural commodities like grain, pork bellies, and coffee. As traders demanded such new products as futures on interest rates and currencies, it became clear that a new regulatory body was needed, and that was the CFTC.

The CFTC has two main functions:
  • To ensure that the markets are liquid and that both parties on an options or futures transaction are able to clear (that is, to meet their contractual obligations)
  • To provide oversight to the markets by ensuring that the exchanges and self-regulatory organizations have sufficient regulations in place, and that those regulations are enforced


National Futures Association (NFA)

   www.nfa.futures.org

The NFA regulates 4,200 firms and has 55,000 employees who work on the different futures exchanges. It administers background checks and licensing exams, regulates futures trading and monitors how firms comply, and provides information for investors so that they are better informed about futures trading and how it differs from more traditional investments.

Firms that handle futures are known as futures commission merchants, or FCMs, rather than brokers. You can find information on FCMs and their employees through the NFA’s Background Affiliation Status Information Center, which has the clever acronym BASIC. You can access it at www.nfa.futures.org/ basicnet/ or through the NFA’s home page. BASIC allows you to look up futures firms and employees to see whether they are registered and whether any complaints have been filed against them. If there have been any complaints filed, you can see how the problem was resolved. It’s like that legendary permanent record that your elementary school teachers said would follow you for the rest of your life.

Trading in options on stocks is regulated by the Securities and Exchange Commission and the National Association of Securities Dealers, but trading on options on futures is regulated by the Commodity Futures Trading Commission and the National Futures Association. As the lines between derivative products get blurrier, you may find a lot of overlap, and many in the industry predict that the SEC and CFTC will merge at some point. Because it’s possible to research firms and people through several self-regulatory organizations, you may as well take the time to do it. Don’t be alarmed if someone is listed one place and not the other, but do be alarmed if a firm or person isn’t listed anywhere.

The exchanges

The Chicago Board Options Exchange (CBOE), Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME, also called the Merc), New York Board of Trade (NYBOT), New York Mercantile Exchange (NYMEX), and other derivatives exchanges have their own regulatory groups that ensure that their traders comply with exchange rules and rules of other organizations, especially the CFTC. They also develop new types of trading contracts that satisfy market demands while complying with applicable laws.

The exchanges also monitor how derivatives are traded in order to look for patterns that might point to market manipulation or insider trading. Each works with the futures commission merchants that are allowed to trade on its exchange to make sure that they know who their customers are and that they have systems in place to make sure these customers trade well, if not profitably.

Foreign exchange (forex) regulation

Because it is the largest, most liquid market in the world, many day traders are taking up trading in foreign exchange, also known as forex. But here’s the tricky thing: These markets are not well regulated. There’s nothing to stop someone from exchanging U.S. dollars for Canadian dollars; tourists do it every day, often at a hotel desk or retail shop. There’s no paperwork, no hassle — and no oversight.

Oversight isn’t necessary for someone at a convenience store buying a tube of Smarties (no, not the horrible dry tablets wrapped in cellophane, but rather a fine chocolate candy not available in the States, so if you cross the border, please pick some up for me!) with bucks and getting loonies in return. Unfortunately, this has allowed some firms to misrepresent forex trading to day traders, and it has allowed some day traders to get badly burned. Forewarned is forearmed, as the cliché goes.

Options and futures on currency

Most currency is traded in the spot: Traders exchange one currency for another at the current exchange rate. The spot market is not regulated. But many trade currency using options and futures, to bet on where exchange rates might go and to hedge the risks of unexpected changes. Options and futures on currency are regulated as derivatives, through the CFTC, the NFA, and the relevant futures exchanges. In some cases, though, FCMs get customer referrals from foreign exchange firms that are not themselves registered, which can make it unclear whether customers understand what they are getting into.

If you are participating in an unregulated market like forex, you can protect yourself by doing your research so that you know what the risks and rewards are. For that matter, every market has a few unscrupulous individuals, so you will always be better off if you find your own facts rather than rely on someone else. The exchanges and self-regulatory organizations all have great Websites with lots of information, and you can see a directory of them in this book’s appendix.

Banks and oversight

Banks are responsible for most foreign exchange trading, and banks are heavily regulated. This means that the Federal Reserve Banks and the U.S. Treasury Department are paying attention to forex markets, looking for evidence of manipulation and money laundering. This keeps the market from being a total free-for-all, even though anyone is allowed to trade currency. Bank oversight isn’t enough to protect your from the outlandish claims from crooked forex trading firms, but it does ensure that your contracts are fulfilled.

Brokerage Basics for Firm and Customer

No matter who regulates them, brokers and futures commission merchants have to know who their customers are and what they are up to. That leads to some basic regulations about suitability, pattern day trading, and money laundering — and extra paperwork for you. Don’t get too annoyed by all the paperwork you have to fill out to open an account, because your brokerage firm has even more.

Are you suitable for day trading?

Brokerage firms and FCMs have to make sure that customer activities are appropriate. The firms need to know their customers and be sure that any recommendations are suitable. When it comes to day trading, firms need to be sure that customers are dealing with risk capital — money that they can afford to lose. They also need to be sure that the customers understand the risks that they are taking. Depending on the firm and what you are trying to do, you might have to submit financial statements, sign a stack of disclosures, and verify that you have received different guides to trading.

It’s no one’s business but your own, except of course that the various regulators want to make sure that firm employees aren’t talking customers into taking on risks that they should not be taking. Sure, you can lie about it. You can tell the broker you don’t need the $25,000 you’re putting in your account, even if that’s the money paying for your kidney dialysis. But if it’s gone, you can’t say you didn’t know about the risks involved.

Staying out of the money Laundromat

Money laundering is the process of giving a provenance to money acquired from illegal activities. Your average drug dealer, Mafia hit man, or corrupt politician doesn’t accept credit cards, but he really doesn’t want to keep lots of cash in his house. How can he collect interest on his money if it’s locked in a safe in his closet? And besides, his friends are an unsavory sort. Can he trust them to stay away from his cache? If this criminal fellow takes all that cash to the bank, those pesky bankers will start asking a lot of questions, because they know that most people pursuing legitimate business activities get paid through checks or electronic direct deposit.

Hence, the felon with funds will look for a way to make it appear that the money is legitimate. There are all sorts of ways to do this, ranging from making lots of small cash deposits to engaging in complicated series of financial trades and money transfers, especially between countries, that become difficult for investigators to trace. Sometimes these transactions look a lot like day trading, and that means that legitimate brokerage firms opening day trade accounts should be paying attention to who their customers are.

Fighting money laundering took on urgency after the September 11, 2001 attacks, because it was clear that someone somewhere had given some bad people a lot of cash to fund the preparation and execution of their deadly mission. The U.S. and several other nations increased their oversight of financial activities during the aftermath of the strikes on the World Trade Center and Pentagon. That’s why a key piece of paperwork from your broker will be the anti-money laundering disclosure. The U.S. Treasury Department’s Financial Crimes Informant Network (www.fincen.gov), which investigates money laundering, requires financial institutions to have enforcement procedures in place to verify that new investments were not made from ill-gotten funds.

In order for your brokerage firm to verify that it knows who its customers are and where their money came from, you’ll probably have to provide the following when you open a brokerage account:
  • Your name
  • Date of birth
  • Street address
  • Place of business
  • Social Security number or Taxpayer Identification Number
  • Driver’s license and passport
  • Copies of financial statements


Special rules for pattern day traders

Here’s the problem for regulators: Many day traders lose money, and those losses can be magnified by the use of leverage strategies (trading with borrowed money, meaning that you can lose more money than you have in the quest for large profits. If the customer who lost the money can’t pay up, then the broker is on the hook. If too many customers lose money beyond what the broker can absorb, then the losses ripple through the financial system, and that’s not good.

The National Association of Securities Dealers has a long list of rules that its member firms have to meet in order to stay in business. One, known as NASD Rule 2520, deals specifically with day traders. It sets the minimum account size and margin requirements for those who fit the definition of day traders, and I’ll give you a hint: The requirements are stricter than for other types of accounts, to reflect the greater risk.

The NASD defines day trading as the buying or selling of the same security on the same day in a margin account (that is, using borrowed money). Execute four or more of those day trades within five business days, and you are a pattern day trader, unless those four or more trades were 6 percent or less of all the trades you made over those five days.

The National Futures Association does not have a definition of day trading, because futures trades by their very nature are short term.

Here’s why it matters: If you are a pattern day trader, you can have margin of 25 percent in your account, which means you can borrow 75 percent of the cost of the securities that you are trading. Most customers are only allowed to borrow 50 percent. That’s because pattern day traders almost always close out their positions overnight, so there is less risk to the firm of having the loan outstanding. However, you have to have a margin account if you are a pattern day trader. This means you have to sign an agreement saying that you understand the risks of borrowing money, including that you may have to repay more than is in your account and that your broker can sell securities out from under you to ensure you pay what is owed.

Under Rule 2520, you have to have at least $25,000 in your brokerage account. If you have losses that take your account below that, you have to come up with more money before your broker will allow you to continue day trading. You can’t plead your case, because the broker has to comply with the law. In fact, if you don’t make the deposits necessary to bring your account up to at least $25,000 and at least 25 percent of the amount of money you’ve borrowed within five business days, you have to trade on a cash basis (no borrowing), assuming the firm will even let you trade.

The rules set by the NASD and other self-regulatory organizations are minimum requirements. Brokerage firms are free to set higher limits for account size and borrowing, and many do in order to manage their own risks better.

Tax reporting

On top of the identity paperwork, you have forms to fill out for tax reporting. IRS Form W9 keeps your taxpayer information on record. Then, at the end of the year, the brokerage firm sends you a 1099 form listing how much money you made in your account. After all, the taxman always gets his cut.

Hot Tips and Insider Trading

The regulations are very clear for things about suitability and money laundering. You get a bunch of forms, you read them, you sign them, you present documentation, and everyone is happy. The rules that keep the markets functioning are clear and easy to follow.

There’s another set of rules that keep markets functioning — namely, that no one has an unfair information advantage. If you knew about big merger announcements, interest rate decisions by the Federal Reserve, or a new sugar substitute that would eliminate demand for corn syrup, you could make a lot of money in the stock market, trading options on interest rate futures or playing in the grain futures market.

Insider trading is not well defined. Any non-public information that a reasonable person would consider when deciding whether to buy or sell a security would apply, and that’s a pretty vague standard — especially because the whole purpose of research is to combine bits of immaterial information together to make investment decisions.

Day traders can be susceptible to hot tips, because they are buying and selling so quickly. If these hot tips are actually inside information, though, the trader can become liable. If you get great information from someone who is in a position to know — an officer, a director, a lawyer, an investment banker — you may be looking at stiff penalties. Civil penalties are usually three times your profits, but the government might decide that your trading was part of a criminal enterprise, making the potential penalties much greater.

Insider trading is difficult to prove, so federal regulators use other tools to punish those it suspects of making improper profits. Martha Stewart wasn’t sent to prison on insider trading charges; she was charged with obstructing justice by lying to investigators about what happened.

Whenever a big announcement is made, such as a merger, the exchanges go back and review trading for several days before to see whether there were any unusual activities in relevant securities and derivatives. Then they start tracing it back to the traders involved through the brokerage firms to see if it was coincidence or part of a pattern.

The bottom line is this: You may never come across inside information. But if a tip seems too good to be true, it probably is, so be careful.

Taking in Partners

Once your day trading proves to be wildly successful, you might want to take on partners to give you more trading capital and a slightly more regular income from the management fees. You can do it, but it’s a lot of work.

If you are trading options and futures, you need to register with the National Futures Association if you’re operating a commodity pool or working as a commodity trading advisor. If you’re trading stocks and bonds, you have to register with the Securities and Exchange Commission unless you meet the exemption tests that would let you operate as a hedge fund instead.

Registration is not a do-it-yourself project. An error or omission may have tremendous repercussions, including fines or jail time, down the line. If you want to take on partners for your trading business, spend the money for qualified legal advice. It will protect you and show prospective customers that  you are serious about your business.

To qualify as a hedge fund, which is a private investment partnership that does not qualify for registration under the Investment Company Act of 1940, you have to deal only with accredited investors (those with at least $1 million in net worth or an annual income of $200,000) or qualified purchasers (those with $5 million in investable assets). The idea is that these people should have enough money to lose and be able to understand the risks that they are taking. Hedge funds do not have to register with the SEC, but they may have to register with the NFA. However, prospective investors will want to see proof that you know what you are doing and know how to handle their money. That step is beyond the scope of this book, but it’s something for a successful day trader to consider.

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WAKE UP TO DAY TRADING

WAKE UP TO DAY TRADING




Make money from the comfort of your home! Be your own boss! Beat the market with your own smarts! Build real wealth! Tempting, isn’t it? Day trading can be a great way to make money all on your own. It’s also a great way to lose a ton of money, all on your own. Are you cut out to take the risk?

Day trading is a crazy business. Traders work in front of their computer screens, reacting to blips, each of which represents real dollars. They make quick decisions, because their ability to make money depends on successfully executing a large number of trades that generate small profits. Because they close out their positions in the stocks, options, and futures contracts they own at the end of the day, some of the risks are limited. Each day is a new day, and nothing can happen overnight to disturb an existing profit position.

But those limits on risk can limit profits. After all, a lot can happen in a year, increasing the likelihood that your trade idea will work out. But in a day? You have to be patient and work fast. Some days there is nothing good to buy. Other days it seems like every trade loses money. Do you have the fortitude to face the market every morning?

In this, I give you an overview of day trading. I cover what exactly day traders do all day, go through the advantages and disadvantages of day trading, cover some of the personality traits of successful day traders, and give you some information on your likelihood of success.

You may find that day trading is a great career option that takes advantage of your street smarts and clear thinking — or that the risk outweighs the potential benefits. That’s okay: The more you know before you make the decision to trade, the greater the chance of being successful. If it turns out that day trading isn’t right for you, you can apply strategies and techniques that day traders use to improve the performance of your investment portfolio. 

It’s All in a Day’s Work

The definition of day trading is that day traders hold their securities for only one day. They close out their positions at the end of every day and then start all over again the next day. By contrast, swing traders hold securities for days and sometimes even months, whereas investors sometimes hold for years.

The short-term nature of day trading reduces some risks, because there’s no chance of something happening overnight to cause big losses. Meanwhile, many investors have gone to bed, thinking their position is in great shape, then woke up to find that the company has announced terrible earnings or that its CEO is being indicted on fraud charges.

But there’s a flip side (there’s always a flip side, isn’t there?): The day trader’s choice of securities and positions has to work out in a day, or it’s gone. There’s no tomorrow for any specific position. Meanwhile, the swing trader or the investor has the luxury of time, as it sometimes takes a while for a position to work out the way your research shows it should. In the long run, markets are efficient, and prices reflect all information about a security. Unfortunately, it can take a few days of short runs for this efficiency to kick in.

Day traders are speculators working in zero-sum markets one day at a time. That makes the dynamics different from other types of financial activities you may have been involved in. 

When you take up day trading, the rules that may have helped you pick good stocks or find great mutual funds over the years will no longer apply. This is a different game with different rules.

Speculating, not hedging

Professional traders fall into two categories: speculators and hedgers. Speculators look to make a profit from price changes. Hedgers are looking to protect against a price change. They’re making their buy and sell choices as insurance, not as a way to make a profit, so they choose positions that offset their exposure in another market. For example, a food-processing company might look to hedge against the risks of the prices of key ingredients — like corn, cooking oil, or meat — going up by buying futures contracts on those ingredients. That way, if prices do go up, the company’s profits on the contracts help fund the higher prices that it has to pay to make its products. If the prices stay the same or go down, it loses only the price of the contract, which may be a fair tradeoff to the company.

The farmer raising corn, soybeans, or cattle, on the other hand, would benefit if prices went up and would suffer if they went down. To protect against a price decline, the farmer would sell futures on those commodities. Then, his futures position would make money if the price went down, offsetting the decline on his products. And if the prices went up, he’d lose money on the contracts, but that would be offset by his gain on his harvest.

The commodity markets were intended to help agricultural producers manage risk and find buyers for their products. The stock and bond markets were intended to create an incentive for investors to finance companies. Speculation emerged in all of these markets almost immediately, but it was not their primary purpose.

Markets have both hedgers and speculators in them. Day traders are all speculators. They look to make money from the market as they see it now. They manage their risks by carefully allocating their money, using stop and limit orders (which close out positions as soon as predetermined price levels are reached) and closing out at the end of the night. Day traders don’t manage risk with offsetting positions the way a hedger does. They use other techniques to limit losses, like careful money management and stop and limit orders.

Knowing that different participants have different profit and loss expectations can help a day trader navigate the turmoil of each day’s trading. And that’s important, because to make money in a zero-sum market, you only make money if someone else loses.

Understanding zero-sum markets

In a zero-sum game, there are exactly as many winners as losers. There’s no net gain, which makes it really hard to eke out a profit. And here’s the thing: Options and futures markets, which are popular with day traders, are zero-sum markets. If the person who holds an option makes a profit, then the person who wrote (which is option-speak for sold) that option loses the same amount. There’s no net gain or net loss in the market as a whole. 

Now, some of those buying and selling in zero-sum markets are hedgers who are content to take small losses in order to prevent big ones. Speculators may have the profit advantage in certain market conditions. But they can’t count on having that advantage all the time.

So who wins and loses in a zero-sum market? Some days, it all depends on luck, but over the long run, the winners are the people who are the most disciplined. They have a trading plan, set limits and stick to them, and can trade based on the data on the screen — not based on emotions like hope, fear, and greed.

Unlike the options and futures markets, the stock market is not a zero-sum game. As long as the economy grows, company profits will grow, and that will lead to growing stock prices. There really are more winners than losers over the long run. That doesn’t mean there will be more winners than losers today, however. In the short run, the stock market should be treated like a zero-sum market.

If you understand how profits are divided in the markets that you choose to trade, you’ll have a better understanding of the risks that you face as well as the risks that are being taken by the other participants. People do make money in zero-sum markets, but you don’t want those winners to be making a profit off of you.

Some traders make money — lots of money — doing what they like. Trading is all about risk and reward. Those traders who are rewarded risked the 80 percent washout rate. Knowing that, do you want to take the plunge? If so, read on. And if not, read on anyway, as you might get some ideas that can help you manage your other investments.

Keeping the discipline: closing out each night

Day traders start each day fresh and finish each day with a clean slate. That reduces some of the risk, and it forces discipline. You can’t keep your losers longer than a day, and you have to take your profits at the end of the day before those winning positions turn into losers.

And that discipline is important. When you are day trading, you face a market that does not know and does not care who you are, what you are doing, or what your personal or financial goals are. There’s no kindly boss who might cut you a little slack today, no friendly coworker to help through a jam, no great client dropping you a little hint about her spending plans for the next fiscal year. Unless you have rules in place to guide your trading decisions, you will fall prey to hope, fear, doubt, and greed — the Four Horsemen of trading ruin.

So how do you start? First, you develop a business plan and a trading plan that reflect your goals and your personality. Then, you set your working days and hours and you accept that you will close out every night. As you think about the securities that you will trade and how you might trade them, you’ll also want to test your trading system to see how it might work in actual trading.

In other words, you do some preparation and have a plan. That’s a basic strategy for any endeavor, whether it’s running a marathon, building a new garage, or taking up day trading.

Committing to Trading as a Business

For many people, the attraction of day trading is that traders can very much control their own hours. Many markets, like foreign exchange, trade around the clock. And with easy Internet access, day trading seems like a way to make money while the baby is napping, on your lunch hour, or working just a few mornings a week in between golf games and woodworking.

That myth of day trading as an easy activity that can be done on the side makes a lot of traders very rich, because they make money when traders who are not fully committed lose their money.

Day trading is a business, and the best traders approach it as such. They have business plans for what they will trade, how they will in invest in their business, and how they will protect their trading profits. So, much of this book is about this business of trading: how to do a business plan, how to set up your office, tax considerations, and performance evaluation. If you catch a late-night infomercial about trading, the story will be about the ease and the excitement. But if you want that excitement to last, you have to make the commitment to doing trading as a business to which you dedicate your time and your energy.

Trading part-time: an okay idea if done right

Can you make money trading part-time? You can, and some people do. To do this, they approach trading as a part-time job, not as a little game to play when they have nothing else to going on. A part-time trader may commit to trading three days a week, or to closing out at noon instead of at the close of the market. A successful part-time trader still has a business plan, still sets limits, and still acts like any professional trader would, just for a smaller part of the day.

Part-time trading works best when the trader can set and maintain fixed business hours. Your brain knows when it needs to go to work and concentrate on the market, because the habit is ingrained.

The successful part-timer operates as a professional with fixed hours. Think of it this way: My son is a patient in a group pediatric practice that has some part-time doctors. They keep set hours and behave like any other doctors in the practice; it’s just that they do it for fewer hours each week. They commit their attention to medicine when they are on the job, and patients only know about their part-time hours when it comes time to make an appointment. These doctors don’t pop into the office and start giving shots during their lunch break from their “real” job, sneaking around so that their “real” boss doesn’t find out. And what patient would want to be seen by a doctor who won’t dedicate themselves to providing health care, even if it’s just for a few hours a day?

If you want to be a part-time day trader, approach it the same way that a parttime doctor, part-time lawyer, or part-time accountant would approach work. Find hours that fit your schedule and commit to trading during them. Have a dedicated office space with high-speed Internet access and a computer that you use just for trading. If you have children at home, you may need to have child care during your trading hours. And if you have another job, set your trading hours away from your work time. Trading via cell phone during your morning commute is a really good way to lose a lot of money (not to mention your life if you try it while driving).

Trading as a hobby: a bad idea

Because of the excitement of day trading and the supposed ease of doing it, you may be thinking that it would make a great hobby. If it’s a boring Saturday afternoon, you could just spend a few hours day trading in the forex market (foreign exchange), and that way you’d make more money than if you spent those few hours playing video games! Right?

Uh, no.

Trading without a plan and without committing the time and energy to do it right is a route to losses. Professional traders are betting that there will be plenty of suckers out there, because that creates the losers that allow them to take profits in a zero-sum market.

The biggest mistake an amateur trader can make is to make a lot of money the first time trading. That first success was almost definitely due to luck, and that luck can turn against a trader on a dime. If you make money your first time out, take a step back and see if you can figure out why. Then test your strategy, as a guide, to see if it’s a good one that you can use often.

Yes, I have two warnings in this section, and for good reason: Successful day traders commit to their business. Even then, most day traders fail in their first year. Brokerage firms, training services, and other traders have a vested interest in making trading seem like an easy activity that you can work into your life. But it’s a job — a job that some people love, but a job nonetheless.

If you really love the excitement of the markets, there are ways to invest on a hobbyist’s schedule. First, you can spend your time doing fundamental research to find long-term investments, which is described a little bit. You can look into alternative investments to help diversify your portfolio; can get you started on that. You can also trade with play money, either in demo accounts or in trading contests, to try out trading without committing real money.

Working with a Small Number of Assets

Most day traders pick one or two markets and concentrate on those to the exclusion of all others. That way, they can learn how the markets trade, how news affects prices, and how the other participants react to new information. Also, concentrating on just one or two markets helps a trader maintain focus.

And what do day traders trade? has information on all of the different markets and how they work, but here’s a quick summary of the most popular assets with day traders right now:

  • Financial futures: Futures contracts allow traders to profit from price changes in such market indexes as the S&P 500 or the Dow Jones Industrial Average. They give traders exposure to the prices at a much lower cost than buying all of the stocks in the index individually. Of course, they tend to be more volatile than the indexes they track, because they are based on expectations.
  • Forex: Forex, short for foreign exchange, involves trading in currencies all over the world to profit from changes in exchange rates. Forex is the largest and most liquid market there is, and it’s open for trading all day, every day except Sunday. Traders like the huge number of opportunities. Because most price changes are small, they have to use leverage (borrowed money) to make a profit. The borrowings have to be repaid no matter what happens to the trade, which adds to the risk of forex.
  • Common stock: The entire business of day trading began in the stock market, and the stock market continues to be popular with day traders. They look for news on company performance and investor perception that affect stock prices, and they look to make money from those price changes. Day traders are a big factor in some industries, such as technology. The big drawback? Stock traders can get killed at tax time if they are not careful.


Managing your positions

A key to successful trading is knowing how much you are going to trade and when you are going to get out of your position. Sure, day traders are always going to close out at the end of the day — or they wouldn’t be day traders — but they also need to cut their losses and take their profits as they occur during the day.

Traders rarely place all their money on one trade. That’s a good way to lose it! Instead, they trade just some of it, keeping the rest to make other trades as new opportunities in the market present themselves. If any one trade fails, the trader still has money to place new trades. Some traders divide their money into fixed proportions, and others determine how much money to trade based on the expected risk and expected return of the security that they are trading. Careful money management helps a trader stay in the game longer, and the longer a trader stays in, the better the chance of making good money.

To protect their funds, traders use stop and limit orders. These are placed with the brokerage firm and kick in whenever the security reaches a predetermined price level. If the security starts to fall in price more than the trader would like, bam! It’s sold, and no more losses will occur on that trade. The trader doesn’t agonize over the decision or second-guess herself. Instead, she just moves on to the next trade, putting her money to work on a trade that’s likely to be better.

Day traders make a lot of trades, and a lot of those trades are going to be losers. The key is to have more winners than losers. By limiting the amount of losses, the trader makes it easier for the gains to be big enough to generate more than enough money to make up for them. 

Focusing your attention

Day traders are often undone by stress and emotion. It’s hard, looking at screens all day, working alone, to keep a steady eye on what’s happening in the market. But traders have to do that. They have to concentrate on the market and stick to their trading system, staying as calm and rational as possible.

Those who do well have support systems in place. They are able to close their positions and spend the rest of the day on other activities. They do something to get rid of their excess energy and clear their minds, such as running or yoga or meditation. They understand that their ability to maintain a clear mind when the market is open is crucial. 

Traders sometimes think of the market itself, or everyone else who is trading, as the enemy. The real enemies are emotions: doubt, fear, greed, and hope. Those four feelings keep traders from concentrating on the market and sticking to their systems.

One of the frustrations of trading is that some days, there will be more opportunities to trade than you have time or money to trade. Good trades are getting away from you. You simply don’t have the resources to take advantage of every opportunity you see. That’s why it’s important to have a plan and to concentrate on what works for you.

Personality Traits of Successful Day Traders

Traders are a special breed. They can be blunt and crude, because they act fast against a market that has absolutely no consideration for them. For all their rough exterior, they maintain strict discipline about how they approach their trading day and what they do during market hours.

The discipline begins with a plan for how to start the day, including reviews of news events and trading patterns. It includes keeping track of trades made during the day, to help the trader figure out what works and why. And it depends on cutting losses as they occur, reaping all profits that appear, and refining a set of trading rules so that tomorrow will be even better. No, it’s not as much fun as just jumping in and placing orders, but it’s more likely to lead to success.

Not everyone can be a day trader, nor should everyone try it. In this section I cover some of the traits that make up the best of them.

Independence

For the most part, day traders work by themselves. Although some cities have offices for traders, known as trading arcades, the number of these places has been declining over the years because the cost of setting up at home has gone down dramatically. Computers and monitors are relatively inexpensive, high-speed Internet connectivity is easier to get, and many brokerage firms cater to the needs of traders who are working by themselves.

So that leaves the day trader at home, alone, stuck in a room with nothing but the computer screen for company. It can be boring, and it can make it hard to concentrate. Some people can’t handle it.

But other traders thrive on being alone all day, because it brings out their best qualities. They know that their trading depends on them alone, not on anyone else. The trader has sole responsibility when something goes wrong, but he also gets to keep all the spoils. He can make his own decisions about what works and what doesn’t, with no pesky boss or annoying corporate drone telling him what he needs to do today.

If the idea of being in charge of your own business and your own trading account is exciting, then day trading might be a good career option for you.

And what if you want to trade but don’t want to be working by yourself? Consider going to work for a brokerage firm, a hedge fund, a mutual fund, or a commodities company. These businesses need traders to manage their own money, and they usually have large numbers of people working together on their trading desks to share ideas, cheer each other on, and give each other support when things go wrong.

No matter how independent you are, your trading will benefit if you have friends and family to offer you support and encouragement. That network will help you better manage the emotional aspects of trading. Besides, it’s more fun to celebrate your success with someone else! 

Quick-wittedness

Day trading is a game of minutes. An hour may as well be a decade when the markets are moving fast. And that means a day trader can’t be deliberative or panicky. When it’s time to buy or sell, it’s time to buy or sell, and that’s all there is to it.

Many investors prefer to spend hours doing a careful study of a security and markets before committing money. Some of these people are enormously successful. Warren Buffett, the CEO of Berkshire Hathaway, amassed $37 billion from his careful investing style, money that he is giving to charity. But Buffett and people like him are not traders.

Traders have to have enough trust in their system and enough experience in the markets that they can act quickly when they see a buy or sell opportunity. Many brokerage firms offer their clients demonstration accounts or backtesting services that allow traders to work with their system before committing actual dollars, helping them learn to recognize market patterns that signal potential profits.

A trader with a great system who isn’t quick on the mouse button has another option: automating trades. Many brokerage firms offer software that will execute trades automatically whenever certain market conditions occur. For many traders, it’s a perfect way to take the emotion out of a trading strategy. Others dislike automatic trading, because it takes some of the fun out of it. And let’s face it, successful traders find the whole process to be a good time. 

Decisiveness

Day traders have to move quickly, so they also have to be able to make decisions quickly. There’s no waiting until tomorrow to see how the charts play out before committing capital. If the trader sees an opportunity, she has to go with it. Now.

But what if it’s a bad decision? Well, of course some decisions are going to be bad. That’s the risk of making any kind of an investment, and without risk, there is no return. Anyone playing around in the markets has to accept that.

But two good day trading practices help limit the effects of making a bad decision. The first is the use of stop and limit orders, which automatically close out losing positions. The second is closing out all positions at the end of every day, which lets traders start fresh the next day.

If you have some downside protection in place, then it’s psychologically easier to go ahead and make the decisions you need to make in order to make a profit. And if you are one of those people who has a hard time making a decision, day trading probably isn’t right for you. 

What Day Trading Is Not

There is much mythology about day trading: Day traders lose money. Day traders make money. Day traders are insane. Day traders are cold and rational. Day trading is easy. Day trading is a direct path to alcoholism and ruin.

I’m going to bust a few day trading myths. Someone has to do it, right? There’s both good news and bad news in this section, so read it through to get some perspective on what, exactly, the day trader can expect from this new endeavor.

It’s not investing . . . 

Day traders never hold a position for more than a day. Swing traders hold positions for a few days, maybe even a few weeks, but rarely longer than that. Investors hold their stakes for the long term, with some looking to hang onto their securities for decades and maybe even hand them down to their children.

Day trading is most definitely not investing. It’s an important function to the capital markets because it forces the price changes that bring the supply and demand of the market into balance, but it doesn’t create new sources of funding for companies and governments. It doesn’t generate long-term growth.

Many day traders withdraw their trading capital on a regular basis to put into investments, helping them build a long-term portfolio for their retirement or for other ventures they might want to take on. There’s a good chance the trader will have someone else manage this money, because investing and trading have different mindsets.

But it’s not gambling . . . 

One of the biggest knocks on day trading is that it’s just another form of gambling. And as everyone knows, or should know: In gambling, the odds always favor the house.

In day trading, the odds are even in many markets. The options and futures markets, for example, are zero-sum markets with as many winners as losers, but those markets also include people looking to hedge risk and who thus have lower profit expectations than do day traders.

The stock market has the potential for more winning trades than losing trades, especially over the long run, so it’s not a zero-sum market. The odds are ever-so-slightly in the trader’s favor.

And in all markets, the prepared and disciplined trader can do better than the frantic, naïve trader. That’s not the case when gambling, because no matter how prepared the gambler is, the casino has the upper hand.

People with gambling problems sometimes turn to day trading as a socially acceptable way to feed their addiction. If you know you have a gambling problem or suspect you are at risk, it’s probably not a good idea to take up day trading. Day traders who are closet gamblers tend to make bad trades and have trouble setting limits and closing out at the end of the day. They turn the odds against them.

It’s hardly guaranteed . . .

Given the participation of day traders in securities markets, researchers are always trying to figure out whether they make money. And the answers aren’t good. Here I review some of the literature to show you the current state of day trading success rates. Note that they are low. Few people who take this up succeed, in part because few people who take this up are prepared. And even many of the prepared traders fail.

Much of the research covers performance in the late 1990s, when day trading became wildly popular. It grew along with the commercial Internet, and it fell out of favor when the Internet bubble burst.

Day trading is difficult, but it is not impossible. You can improve your chances of success by taking the time to prepare and by having enough money to fund your initial trading account. During the first year, you’ll want to handle trading losses and still be able to pay your rent and buy your groceries. Knowing that the basics of your life are taken care of will give you more confidence, and that will help your performance.

“Do Day Traders Make Money? Evidence from Taiwan”

This paper, written in 2004 by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean (and available at http://faculty.haas.berkeley.edu/ odean/papers/Day%20Traders/Day%20Trade%20040330.pdf) found that only 20 percent of day traders in Taiwan tracked between 1995 and 1999 made money in any six-month period, after considering transaction costs. Median profits, net of costs, were U.S. $4,200 for any six-month period, although the best traders showed semi-annual profits of $33,000. The study also found that those who placed the most trades made the most money, possibly because they are the most experienced traders in the group.

“Report of the Day Trading Project Group”

In 1999, the North American Securities Administrators Association, which represents state and provincial securities regulators in the United States, Canada, and Mexico, researched day trading so that its members could provide appropriate oversight. The report, which you can see at www.nasaa. org/content/Files/NASAA_Day_Trading_Report.pdf, did not include performance data. However, it cited several cases where brokerage firms were sanctioned by regulators for misrepresenting their clients’ performance numbers, including one firm that had no clients with profits.

“Trading Profits of SOES Bandits”

Paul Schultz and Jeffrey Harris looked into the profits made by the so-called SOES bandits, day traders who took advantage of loopholes that existed in NASDAQ’s Small Order Entry System in the 1990s. These people were the first day traders. Did they make money? The authors looked at a few weeks of trade data from two different firms. What they found was that about a third of all round-trip trades (buying and then later selling the same security) lost money before commissions. Only a quarter of the round-trip trades had a profit of $250 or more before commissions. The 69 traders in the study made anywhere from one to 312 round-trip trades per week. They had an average weekly profit after commission of $1,690; however, almost half of the traders, 34 of them, lost money in an average week.

You can see the abstract at http://papers.ssrn.com/sol3/papers. cfm?abstract_id=137949. The full article is available through many libraries.

But it’s not exactly dangerous . . .

Yes, a lot of day traders lose money, and some lose everything that they start out with. Many others don’t lose all of their trading capital; they just decide that there are better uses of their time and better ways to make money.

A responsible trader works with risk capital, which is money that she can afford to lose. She uses stop and limit orders to minimize her losses, and she always closes out at the end of the day. She understands the risks and rewards of trading, and that keeps her sane.

Many day trading strategies rely on leverage, which is the use of borrowed money to increase potential returns. That carries the risk of the trader losing more money than is in his account. However, the brokerage firm doesn’t want that to happen, so it will probably close a leveraged account that’s in danger of going under. That’s good, because it limits your potential loss.

It’s not easy . . .

Along with the relatively low rate of success, day trading is really stressful. It takes a lot of energy to concentrate on the markets, knowing that real money is at stake. The profit amounts on any one trade are likely to be small, which means the trader has to be persistent and keep placing trades until the end of the day.

Some traders can’t handle the stress. Some get bored. Some get frustrated. And some can’t believe that they can make a living doing something that they love.

But then, neither are a lot of other worthwhile activities

Day trading is tough, but many day traders can’t imagine doing anything else. The simple fact is that a lot of occupations are difficult ways to make a living, and yet they are right for some people. Every career has its advantages and disadvantages, and day trading is no different.

When you finish this book, you should have a good sense of whether or not day trading is right for you. If you realize that it’s the career you have been searching for, I hope it leaves you with good ideas for how to get set up and learn more so that you are successful.

And if you find that maybe day trading isn’t right for you, I hope you get some ideas that can help you manage your long-term investments better. After all, the attention to price movements, timing, and risk that is critical to a day trader’s success can help any investor improve their returns. What’s not to like about that?

Putting day trading success rates in perspective

When I was doing research for this book, I talked to one very successful trader who told me two things. First, he was suspicious of all the books and training programs on day trading, because he didn’t think that they really helped people learn to trade. Despite that, he liked that they existed, because trading had proven to be a great way for him to make a good living and support his family, and he thought it would be great if those people who are cut out for trading discovered the business.

Yes, most day traders fail — about 80 percent in the first year, as I noted earlier. But so do a large percentage of people who start new businesses or enter other occupations. That’s why I’ve combed through several different reports and databases to show how well people do in other fields. (My sources are Realty Times; Barber, Lee, Liu, and Odean; American College of Sports Medicine; ACT; Ohio State University; and the National Center for Education Statistics.)

Field                                                                     First Year Failure Rate (%)
Real estate sales                                                      86
Day trading                                                              80
Training for a marathon                                        70
College                                                                       33
Restaurants                                                              26
Teaching                                                                    13 

If you understand the risks and keep them in perspective, you’ll be better able to handle the slings and arrows of misfortune on the way to your goal.

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