Day Trading for Dummies (Paperback)

Chapter One

In This Chapter

* Figuring out just what day traders do anyway

* Setting up a trading business

* Concentrating on a few assets, a few dollars at a time

* Knowing what it takes to be a successful trader

* Dispelling some of the myths of 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 chapter, 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.

REMEMBER

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.

REMEMBER

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 (all of which you can learn about in Chapter 2).

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.

REMEMBER

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. Both of these steps are covered in Chapter 2. As you think about the securities that you will trade (Chapter 3) and how you might trade them (Chapters 12 and 13), you''ll also want to test your trading system (Chapter 11) 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.

REMEMBER

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 (Chapter 2), how to set up your office (Chapter 6), tax considerations (Chapter 10), and performance evaluation (Chapter 11). 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?

TIP

If you want to be a part-time day trader, approach it the same way that a part-time 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.

WARNING!

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.

WARNING!

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, using Chapter 11 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.

TIP

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 in Chapter 12. You can look into alternative investments to help diversify your portfolio; Chapter 3 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. Chapter 20 has some ideas on that.

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? Chapter 3 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: