Lewis Borsellino - The Day Trader's Course.pdf

Andreyforexwarez

THE DAY TRADERS COURSE

Low-Risk, High Prot Strategies for Trading Stocks and Futures

Lewis Borsellinowith

Patricia Crisafulli

JOHN WILEY & SONS, INC.New York Chichester Weinheim Brisbane Singapore Toronto

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page v

Andreyforexwarez

FFOORR SSAALLEE && EEXXCCHHAANNGGEE

wwwwww..ttrraaddiinngg--ssooffttwwaarree--ccoolllleeccttiioonn..ccoomm

MMiirrrroorrss::

wwwwww..ffoorreexx--wwaarreezz..ccoomm wwwwww..ttrraaddeerrss--ssooffttwwaarree..ccoomm

wwwwww..ttrraaddiinngg--ssooffttwwaarree--ddoowwnnllooaadd..ccoomm

JJooiinn MMyy MMaaiilliinngg LLiisstt

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page viii


CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page i

WILEY TRADING ADVANTAGEBeyond Candlesticks / Steve NisonBeyond Technical Analysis, Second Edition / Tushar ChandeContrary Opinion / R. Earl HadadyCybernetic Trading Strategies / Murray A. Ruggiero Jr.Day Traders Manual / William F. EngDynamic Option Selection System / Howard L. SimonsEncyclopedia of Chart Patterns / Thomas BulkowskiExchange Traded Funds and E-mini Stock Index Futures / David LermanExpert Trading Systems / John R. WolbergFibonacci Applications / Robert FischerFour Steps to Trading Success / John F. ClayburgFundamental Analysis / Jack SchwagerGenetic Algorithms and Investment Strategies / Richard J. Bauer Jr.Hedge Fund Edge / Mark BoucherIntermarket Technical Analysis / John J. MurphyIntuitive Trader / Robert KoppelInvestors Quotient / Jake BernsteinLong-Term Secrets to Short-Term Trading / Larry WilliamsManaged Trading / Jack SchwagerMathematics of Money Management / Ralph VinceMcMillan on Options / Lawrence G. McMillanNeural Network Time Series Forecasting of Financial Markets / E. Michael AzoffNew Market Timing Techniques / Thomas R. DeMarkNew Market Wizards / Jack SchwagerNew Money Management / Ralph VinceNew Options Market, Fourth Edition / Max AnsbacherNew Science of Technical Analysis / Thomas R. DeMarkNew Technical Trader / Tushar Chande and Stanley S. KrollNew Trading Dimensions / Bill WilliamsNonlinear Pricing / Christopher T. MayOption Advisor / Bernie G. SchaefferOption Market Making / Alan J. BairdOption Strategies, Second Edition / Courtney SmithOptions Course / George A. FontanillsOptions Course Workbook / George A. Fontanills

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page ii

Andreyforexwarez

Outperform the Dow / Gunter Meissner and Randall FolsomPattern, Price & Time / James A. HyerczykPoint and Figure Charting, Second Edition / Thomas J. DorseySchwager on Futures / Jack SchwagerSeasonality / Jake BernsteinStock Index Futures & Options / Susan Abbott GidelStock Market Course / George A. Fontanills and Tom GentileStock Market Course Workbook / George A. Fontanills and Tom GentileStudy Guide for Trading for a Living / Dr. Alexander ElderStudy Guide to Accompany Fundamental Analysis / Jack SchwagerStudy Guide to Accompany Technical Analysis / Jack SchwagerTechnical Analysis / Jack SchwagerTechnical Analysis of the Options Markets / Richard HextonTechnical Market Indicators / Richard J. Bauer Jr. and Julie R. DahlquistTrader Vic II / Victor SperandeoTraders Tax Solution / Ted TesserTrading Applications of Japanese Candlesticks Charting / Gary Wagner and

Brad MathenyTrading Chaos / Bill WilliamsTrading for a Living / Dr. Alexander ElderTrading Game / Ryan JonesTrading in the Zone / Ari Kiev, M.D.Trading Systems & Methods, Third Edition / Perry KaufmanTrading the Plan / Robert DeelTrading to Win / Ari Kiev, M.D.Trading with Crowd Psychology / Carl GyllenramTrading with Oscillators / Mark EtzkornTrading without Fear / Richard W. Arms, Jr.Ultimate Trading Guide / John Hill, George Pruitt, and Lundy HillValue Investing in Commodity Futures / Hal MasoverVisual Investor / John J. Murphy

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page iii

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page iv


Low-Risk, High Prot Strategies for Trading Stocks and Futures

Lewis Borsellinowith

Patricia Crisafulli

JOHN WILEY & SONS, INC.New York Chichester Weinheim Brisbane Singapore Toronto

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page v

Copyright 2001 by Lewis Borsellino and Patricia Crisafulli. All rights reserved.

Published by John Wiley & Sons, Inc.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning,or otherwise, except as permitted under Sections 107 or 108 of the 1976 United StatesCopyright Act, without either the prior written permission of the Publisher, or authoriza-tion through payment of the appropriate per-copy fee to the Copyright Clearance Center,222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Re-quests to the Publisher for permission should be addressed to the Permissions Depart-ment, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212)850-6011, fax (212) 850-6008, E-Mail: [email protected].

This publication is designed to provide accurate and authoritative information in regard tothe subject matter covered. It is sold with the understanding that the publisher is not en-gaged in rendering professional services. If professional advice or other expert assistanceis required, the services of a competent professional person should be sought.

Designations used by companies to distinguish their products are often claimed by trade-marks. In all instances where the author or publisher is aware of a claim, the productnames appear in Initial Capital letters. Readers, however, should contact the appropriatecompanies for more complete information regarding trademarks and registration.

Library of Congress Cataloging in Publication Data:Borsellino, Lewis J., 1957

The day traders course / Lewis Borsellino with Patricia Crisafulli.p. cm.(Wiley trading)

Includes index.ISBN 0-471-06515-31. Day trading (Securities) 2. Electronic trading of securities. I. Crisafulli,

Patricia. II. Title. III. Series.HG4515.95 .B673 2001332.64'2'0285dc21 2001045304

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page vi

For my wife, Julie, and my children:Joey, Briana, Anthony, Lewis, Nick, Jamie, and Nicole

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page vii

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page viii

Acknowledgments

Trading is a solitary endeavor. Whether you trade at home, in a tradingroom, or on the oor of an exchange, its you versus the market.

But as a profession, trading is really a community. In this book, Iwish to salute all the traders, brokers, and clerks who ever put on ajacket at the Chicago Merc and at our sister exchanges across thecountry. I welcome into our profession the new breed of screentraders, who will help to revolutionize this business.

I also want to thank the entire team at TeachTrade.com, speci-cally: my partner, Brad Sullivan; our technician, Jim Sebanc; VinceAllegra; Pat Tabet; and my cousin and friend, Bob Borsellino, as wellas Brenda Hilker of DTN and our graphic artist Mark Smith.

And nally, I acknowledge my coauthor and TeachTrade.com siteeditor, Tricia Crisafulli. Without her talent, experience, and dedica-tion, this book could not have been written.

L.B.

ix

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page ix

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page x

Preface

Trading is a profession unlike any other. It requires a unique set ofskills and requires discipline all its own. No matter what your back-ground, personal or professional, when you begin trading you muststart at step one.

My goal in writing this book is to give you an introduction into thediscipline and techniques of trading. The lessons include the topics Ifeel are the most important for any trader, in any market: mentalpreparation, technical analysis, devising a trading plan, trade execu-tion, and, above all, discipline.

When I started trading some 20 years ago, I learned by workingwith and watching some of the best traders in the business. It was adifferent world then at the Chicago Mercantile Exchange, a place Improud to have called my professional home for two decades. Tradingwas done in the pit exclusively. The term electronic trading was notpart of our vocabulary.

Today, the computer screen has brought the market to traders likeyou, wherever you are. This has made for profound changes in howfutures and stocks trade, and will trade in the future. But there aretimeless lessons that are as valid today as they were 20 years ago andundoubtedly will be 20 years hence.

This book contains those lessons, especially of the psychologicaland emotional variety, as well as the techniques we use to trade insome of the most active and volatile markets in the worldnamelythe Standard & Poors (S&P) 500 and Nasdaq futures.

xi

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page xi

Trading is best learned by doing, especially with a mentor or guideto help you. While I cant sit at your side (obviously) as you trade, Iwanted to replicate the kind of teaching and coaching that we give thetraders we bring on board at our company, TeachTrade.com. Seeingwhat we see in a chart, understanding our interpretation of the market,and dissecting our trade executions, I believe, will give you the bestinsight into what trading is all about.

As you trade, you will also learn lessons about yourself, particu-larly how well you master your emotions, your ego, and your abilityto take losses and to keep prots in perspective.

Good luck . . . and good trading.

xii PREFACE

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page xii

Contents

1 The Mental Game 1

2 Getting Started 21

3 Technical Analysis 101 53

4 Technical Analysis 102 75

5 The Myths, the Risks, and the Rewards 93

6 Intraday Dynamics 119

7 Stepping through the Trades 145

8 Trading the Nasdaq 161

9 After the Bell 179

RESOURCES

Economic Calendar 197

Glossary 203

Useful Web Sites 217

Index 221

xiii

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page xiii

CCC-Day Trade FM (i-xiv) 9/11/01 12:55 PM Page xiv

1The Mental Game

At rst you thought it was going to be easy. You read the hype andhoopla that day trading would bring you the sun, moon, and stars. Youopened an online account and jumped into trading with both feet. Youscored on the rst few trades. It seemed too easy to be true: You bought astock. It went up. You sold at a prot. What you didnt realize, however,was that in 1999 the market as a whole was up. As the old saying goes,A rising tide raises all boats. In this case, the markets upward surgebrought the majority of stocks with it.

Then came the downturn. The Nasdaq Composite, the highierthat had posted nearly an 86 percent gain in 1999, ended 2000 witha loss of more than 39 percent. The Standard & Poors 500-stockcash index (S&Ps), the benchmark for individual stock and fundperformance, declined 10 percent from the close of 1999 to theclose of 2000.

Even on the last trading day of the yearDecember 29, 2000theNasdaq Composite index dropped 63 points or 2.5 percent to 2493.Cisco Systems Inc. (CSCO) and Microsoft Corporation (MSFT) ledthe way downward, with Cisco trading off 13/8 at 383/16 and Microsoftdown 15/16 at 431/4. (U.S. Tech Stocks Fall on Final Trading Day ofYear 2000, Reuters, December 29, 2000.)

Blame the tech wreck, or recession fears, or overzealous activity

1

CCC-Day Trade 1 (1-74) 9/11/01 12:55 PM Page 1

efforts by the Federal Reserve in 1999 to curb a runaway economy.Whatever the reason, the market was down. Period.

As all traders know, you cant ignore the facts. The price on thescreen is as immutable as the ngerprints on your own hands. Youcant change the price by an act of will any more than you can maketime stand still. And the fact was (and is) the much-touted new mil-lennium raised far more questions about the new economy than WallStreet had answers. The sufx .com no longer was a license toprint money (or raise it from eager venture capitalists). Flight toquality meant out of Nasdaq and its dominant tech sector and intohousehold names. Even a surprise rate cut early in 2001 by the Fed-eral Reserve wasnt enough to jump-start the markets and keep themrunning positively.

As we write in rst quarter 2001, the talk is of economic slowdownand the possibility of recession, with all eyes on Mr. Greenspan & Co.to bail us out. Markets and leading stocks continue to struggle.Traders who had ridden on the bulls coattails are now nose-to-nosewith the bear.

In the trading arena, a bear market is what separates the amateursfrom the pros. Put another way, welcome to the traders law ofphysics: What goes up must come downoften in gyrations andsometimes with ever-increasing volatility and for reasons that mayconfound you. The result can be panic and confusion. Fearful of los-ing money, the uninitiated cling to positions that move increasinglyinto the reduntil they face a margin call on a deated stock or thebrokerage house yanks them out of a futures position.

Clearly, they have neglected the cardinal rule of trading: Alwaysprotect against losses. Prots take care of themselves.

In this book I will address not only the how-tos of technical analy-sis and trade execution, but, more important, the mental discipline thatmust be a part of every trade. You can never underestimate the mentalside of trading, whether youre placing your rst order through a bro-ker or youve been trading successfully for years. Discipline is asmuch a part of my trading plan today as it was when I rst walkedonto the oor of the Chicago Mercantile Exchange 20 years ago.

It was a different world then. In 1981, stock index futures had not

2 THE MENTAL GAME


been launched as yet at the Chicago Mercantile Exchange, where Istill trade today. I started out as a 22-year-old runner and clerk at theMerc, an apprentice to Maury Kravitz, a major trader in those daysat the exchange. After a few months, I became a broker, lling cus-tomer orders in the gold futures pit, a contract that is no longer tradedin Chicago. Later, I traded for my own account and lled orders, sincedual-trading was allowed at the Merc in those days.

It was a tough learning curve for me just as it wasand isforevery beginning trader. Your expectation is that youll make money atthis, because you want to make money. But dont be discouraged ifyou dont see any prot the rst year. In fact, if you can just coveryour cost of trading the rst year, you should consider yourself a suc-cess. The most important lesson for you, particularly in the rst year,is to learn how to take lossesquickly, with a clear head, and withoutpanic. In my rst year of trading, I was barely able to cover my costs.I had to take a job at night to support myself. I nearly gave up, I wasso discouraged.

What I couldnt see then was that I was gaining a valuable educa-tion in the University of the Market that would serve me well over theyears. Then, when a lucky out-trade (see Glossary) netted me a wind-fall of $57,000, I had ample capital for the rst time. I headed to thehot new pit at the Mercthe S&P futures pitand I never left. But Iwent to that market a wiser trader. I had withstood the test of the mar-ket. I had endured losses and kept my head when I made prot.

Today, I trade in the S&P pit on the oor of the Merc for an hour ortwo a day. Then, I trade or monitor my position at the screen at myChicago-based trading rm, where I also run an educational and mar-ket commentary web site for traders, TeachTrade.com.

Ive gone through a lot of change as a trader. But one thing that re-mains constant is the psychological side of trading. Trading is a men-tal game. The emotional and psychological aspects of trading cannever be overlooked or underestimated. For one thing, there is the mo-tivation of trading. (Yeah, you say to yourself, its money, right?) Well,if it were only the money, then most of us would have found some-thing else to do. If you doubt that, consider the failure rate of traders.In equities, those who try day trading last about six months. In futures,

THE MENTAL GAME 3


the average life span is about three months, although trading activitydwindles signicantly in the latter two months.

The one thing I know about trading is that its infectious. Onceyouve made a couple of trades and turned a prot, it gets into yourblood. The most successful traders Ive known live and breathe trad-ing and the markets. The money is part of it, to be sure. But a biggerpart is the adrenaline rush you get from the market. You can also tellthis from the retail side of the trading business with average investorsand speculators who trade through a broker. Many times beginningtraders who try their hand at this will lose their capital, but they dontclose their accounts. They leave a small amount to keep them open,and as soon as they get some more capital to trade, they try again.

Now, before you tell yourself that this wont happen to you, thatyoull somehow beat the odds, remember that the success rate amongtraders is slim. The only way to improve your chances of survivaland there is no guaranteeis with education. That is the purpose ofThe Day Traders Course.

Whether you trade stocks, futures, or even options, you must have acarefully executed plan. You shouldnt buy because you heard a tip atthe health club or on television. Your trades ought to be the result ofthe execution of your plan. And if your trade goes against you, thenext step is a reexamination of that plan to learn what went wrong andwhat youll do differently next time.

The foundation of this plan is technical analysis, which will be ad-dressed at length in later chapters. But the quality that must be devel-oped and maintainedrst, last, and alwaysis discipline. More thanan analytical mind and the ability to make quick decisions, disciplineis an attribute that will keep you in the trading game. Discipline al-lows you to make the best decisions based on the market conditions(not your ego, your need to make money, or your fear of loss). Anddiscipline will allow you to execute your trades according to plan, in-cluding getting stopped out of a trade.

There are highs and lows in trading equivalent to those experiencedin a competitive sporting event. When youre trading, its the ultimateDavid versus Goliath situation, for it is truly you versus the market.Whether youre a one-lot trader or an institution swinging around

4 THE MENTAL GAME


1,000-contract positions, you are still in competition with the market-place at large. When you place that trade, you are putting everythingon the linenot only the money involved in that trade, but your re-search and analysis, your decision-making process, and your execu-tion. You will face the ego challenge of knowing that, at least some ofthe time, you will be wrong.

Each time you trade, you are weighing the success and/or failure ofyour plan. And if you do have a protable trade, the challenge then be-comes even harder: You must not allow your ego to be clouded byyour nancial success so that you cant keep a clear sight on yourplan. What you savor is not the money that youve made, but ratherthe fact that youve successfully executed your plan. If you dontthink this kind of successful challenge is the primary motivating fac-tor, ask anyone who has launched or built a business. Entrepreneurswill tell you that the payoff was not the money they made, but the factthat they were successful in conceiving, developing, and merchandis-ing an idea. And, as in trading, it all started with a plan.

The rst step in drafting that plan begins long before the marketopens and you sit down to trade. It begins with your psychologicalpreparedness. You couldnt launch yourself into trading without thiskind of conditioning any more than youd set out for a cross-countryrun without stretching exercises. When I discuss trading, I use a lot ofsports analogies because of the parallels of intensity, physical andmental demands, ego control, risks, and rewards. For traders, thispreparation is a daily routine that will be a personal ritual.

For me, that means an hour workout in my home gym or, when theweather is fair, an hour at the golf course chipping balls onto thegreen. Your choice of preparation may be jogging, meditation, yoga,tai-chi, or whatever. But there must be an activityI prefer a physicalonethat tells your mind, Okay, its time to get ready for trading.The rest of my life has to be put aside for now.

You cant trade effectively during times of personal problems, dis-ruptions, or distractions. If something is weighing on your mindwhether its an illness in the family or even a positive event such asbuying a new house or the birth of a childit can and will affect yourtrading. If you cant sufciently clear your mind, you wont be able to

THE MENTAL GAME 5


apply unwavering concentration to your trading. Better just to do yourhomework for that day, watching the market, studying the charts andindicators, than to put your money on the line. If you decide to trade,reduce your trade size so that you have less at risk. Dont bemoan thebig money you could have made; be glad you had the discipline tolimit your exposure.

The backbone of mental discipline is to focus on the trade, not themoney. This isnt easy for the novice or even the professional trader.In fact, professional traders face a special breed of mental demon,born of their own successes. Ive wrestled with these demons on morethan one occasion.

The problem comes when you know you can make money, and agood deal of it, by trading. Youve had ve-gure and six-gure days.So when the money pressure is on, you think you can work yourmagic in the market. Your focus shifts from making a good trade tomaking good money. The result is almost always disaster. As welldiscuss in Chapter 5, you have to trade what the market gives you,which will play a large role in your prot potential on any given day.

What occurs is usually something like this: You go into the marketsaying, Im going to make a lot of money today. Or maybe you say,I need to make a lot of money today, either to make up for previouslosses, to put a down payment on a bigger house, or to buy thatboat/car/vacation property/whatever that youve always wanted.

Complicating this factor is that you know youve had big days inthe past. But, if you examine them, those big days were the result ofmarket opportunities that you reaped for large prots. Put anotherway, you successfully executed a plan that, coupled with market con-ditions that you analyzed properly, yielded a prot.

But if those market conditions do not existif the market is thin interms of volume or participation, rangebound, or quietthen you maybe forcing trades that wont materialize. Youll trade too big or toofrequently and risk too much. Instead of big prots, you may end upwith the exact opposite.

Your goal is to develop a positive mental attitude and to have con-dence in your ability to make good trades and to move quickly beyondthe losing trades.

6 THE MENTAL GAME


In my career, Ive seen so many talented young traders blow it be-cause they lacked the discipline or the ability to take on risk. Eitherthey took on too much risk and lost all their capital in one or a fewtrades, or they became the proverbial deer in the headlights when itcame to risk. The underlying factor was they failed at the mental gameof trading. The singular problem was a focus on the money and not onthe trade. But admittedly, its a tough lesson to become unemotionalabout money.

In my own experience there have been times when Ive been up$17,000 and Id like to make $3,000 morejust to have a nice roundprot number of $20,000. So, I keep trading for the extra $3,000even though the market may have quieted down and there are nolonger that many opportunities to trade. When Im on the oor, that

THE MENTAL GAME 7

Legends, Language, and Lore of Traders

As you trade, you will face your own personal demons. There is greedand its best friend, fear. And of course there is ego. Now, to trade youhave to have a sense of condence and the ability to make a deci-sion, which may be the by-product of a good, healthy ego. But be-ware of letting your ego become so big that it clouds your judgmentand skews your decision making.

Heres a case in point: In the early part of 1987, at the age of 30, Imade $4.5 million trading my own money. I was trading with suchsize that all the order llers came to me. I was used to trading big,and everybody in the pit knew itand my ego liked that. The prob-lem was, after the crash of October 1987, liquidity dried up consider-ably. As a result, I was trading too big for the market. In the end, Imade about $100,000before expensestrading, and I had hugeswings in protability that year.

Thats when I learned a valuable lesson about trading what themarket gives you. I couldnt ing around hundreds of contracts just tosatisfy my ego or because people in the pit expected that of me. I hadto trade what suited both my own plan and the market conditions. Af-ter that, my trading was noticeably back on track.


absence of volume is palpable. When the market is busy, the S&P pitis packed with peopleabout 500 of themall shouting, screaming,waving their arms, and gesturing wildly with their hands. When itsquiet, the noise level and activity are far less. And when its dead . . .well, Ive seen times when traders have tossed a nerf football aroundthe pit theyre so bored.

When the market conditions dont warranton their ownan ob-jective reason to trade, its better to quit for the day. Sticking aroundjust to make some more money is not a good motivation. There havebeen times when, trying to make another $3,000, I lose the $17,000 Ihad in the rst place.

Then there are the days when Im down, say, $15,000. Ill stay inthe pit to make it back, even though I know I should cut my losses,take a break, and regroup. The temptation, even after all these years, isto stay in the pit and keep trading to make it backeven though themarket conditions arent there. The problem is that by focusing on themoney and losing sight of the trading conditions I am at a higher riskfor further loss. What Im trying to tell you candidly is that even after20 years and much success, I still ght these demons. In fact, its abigger mistake for an experienced trader to think that he or she wontface them.

The best days happen when a trader is prepared and the market pre-sents opportunities that can be capitalized upon. The more volatility,the more opportunity to make money. Day traders and short-termtraders live on volatility. But when ranges are tight, volume is light,and the market is slow, its not worth the timeor the riskto trade.The opportunity just isnt there.

One of the signs of experience for a trader is to know when totrade . . . and when to wait. Overtrading, chasing the market, risk andreward out of balanceall of which well discuss in later chaptersare pitfalls that await every trader, no matter how experienced. Thereare simply daysand timeswhen its best to sit on the sidelines.You study the market on days like that, keeping your mind inbutyour money out. For example, you may nd its better to be on thesidelines the day before a Federal Reserve meetingand the market

8 THE MENTAL GAME


is anticipating some kind of interest-rate actionand the morning ofthe day the Fed will make its announcement.

It may not be easy to make yourself sit on the sidelines. If you havea regular day jobwith a salary, benets, and the security that youllbe paid on Fridayits not so difcult to take a day off. If youre sickor you take a personal day, you may be a little busier when you goback, going through the voice mail and sifting through the e-mail, ormaybe putting in another hour or so to make a deadline. But youllstill get paid. When you dont trade, however, you dont have thechance to make money. For beginning traders, the temptation is to bein the market all the time. The more they trade, they tell themselves,the more money theyll make. But, as I outlined earlier, you must bein the market at the most opportune times. Because if the timing iswrong or your mental discipline isnt there, then youre faced with thepossibility that the more you trade, the more youll lose.

Thats a harder lesson to grasp than you might think. For one thing,the lure of making moneybig moneyis very strong in trading.And those who are new to the game usually have the fever; they wantto trade. I remember when I was starting out, and over the years Ivetrained many young traders in the pit. More recently, weve broughtsome aspiring young screen-traders into B&S Trading (for Borsellinoand Sullivan), the day-to-day operation of which is overseen by mypartner, Brad Sullivan, one of the most talented traders Ive ever hadthe privilege to work with.

Over the years, Ive met countless wanna-be traders. Too many ofthem end up being a casualty statistic because they underestimatewhat theyre up against. It doesnt matter what your professionalbackground isyou could be a doctor, a lawyer, a nuclear scientisttrading is an entirely different endeavor that requires a unique set ofdisciplines, techniques, and strategies that must be learned and em-ployed to trade.

Heres an analogy that may prove to be helpful. When I learned toplay golf, I was told that this was a game of misses. No onenoteven a prohits a perfect shot every time. But the difference betweenpros and the rest of us is that the pros misses are slight compared with

THE MENTAL GAME 9


ours. In other words, they dont miss by as much. Trading is the samething. No one trades perfectly. No one can pick the top and the bottomevery time, or identify every move. But the professional traders,thanks to their experience, have fewer market misses than thenovices. They know how to cut their losses, regroup for the next trade,and executewithout damaging their condence and second-guess-ing their abilities in the process.

The other thing that many traders dont fully comprehend is thatthey are entering a competitive arena dominated by experiencedtraders, professionals, and institutions. Its like being a sh in ashark tank.

When you start trading, you will have losses. In fact, with thetraders that Ive sponsored and trained over the years, I never ex-pected them to turn a prot the rst year. The best outcome to antici-pate for the rst year is to cover expenses. We give a similar messageon our web site, TeachTrade.com, telling traders not to expect to domore than cover expenses the rst year. Expectations higher than thisare an invitation to a fall.

Many people who go into trading have an entirely different per-spective. They want to make moneylots of it. And they expect tomake it tomorrow. Ironically, its this kind of attitude that undercuts atraders potential to make money. Theyre so focused on makingmoney that they cant trade effectively.

Here are some examples that are representative of a lot of wanna-bes out there.

Joe is in the building trades, an occupation he now sees as limit-ing. He believes he can do more with his life and his intelligence in adifferent eld. He wants to try his hand at full-time trading. Hes beendabbling part-time, and hes managed to turn a modest prot. He has$5,000 to start trading, and hes ready to go into this full-time. Theonly problem for Joe is that once he quits his current day job, he wonthave another source of income. He has a wife, who doesnt work out-side the home, two small children, and a $1,500 monthly mortgage.

Jane is a 22-year-old with the trading bug. She spent sixmonths working as a clerk for minimum wages to learn the ropes of

10 THE MENTAL GAME


the market. Her family has given her $20,000 to start trading. But in-stead of keeping her monthly living expenses to a minimum, Janerents an apartment in downtown Chicago. Her expenses of rent, food,and entertainment are $3,000 a month.

Both Joe and Jane are starting out with tremendous disadvantagesby underestimating the learning curve. Their lifestyles and their lackof outside nancial cushions demand that they make money their rstyear of trading. That means, from day one, they are going to focus onthe moneyand not on making trades. To start out with the premisethat you must make money is potentially deadly.

To be a trader, you must take a different view of moneyor morespecically the money in your account. Its not a prot, and its notmoney to be spent. Rather, its raw material inventory. You canttrade without this inventory money any more than a paper mill couldoperate without pulp. If you deplete your inventory to pay your billsand nance your lifestyle, you will seriously hamper your potential asa trader. Moreover, youve increased the probability of becoming a ca-sualty statistic.

Now lets take the case of Bill, who has been trading on the sidefor three years. The rst year, he gave back as much as he made trad-ing. The second year he did a little better, and the third year he made agood prot. He has $25,000 to trade and a $15,000 nest egg that hevows he wont touch. Further, his wife works outside the home andhas an ample salary to meet the familys nancial obligations. Bill hasreached the point in his life and in his career that he has to make achange. His trading is getting in the way of his day job. With hiswifes blessing, Bill is going to quit his job and trade full-time.

Obviously, Bill is starting out against a far different backdrop thanare Joe and Jane. He can scratch the rst yearmeaning no prot andno signicant loss after expensesand still do okay. Without thatpressure to make money, Bill has the best likelihood actually to makemoney, at least compared to Joe and Jane. Put another way, think ofthe old saying, Desperate people do desperate things. In traderslingo, Desperate traders take on too much risk and almost certainlyblow up.

THE MENTAL GAME 11


FFOORR SSAALLEE && EEXXCCHHAANNGGEE

wwwwww..ttrraaddiinngg--ssooffttwwaarree--ccoolllleeccttiioonn..ccoomm

MMiirrrroorrss::

wwwwww..ffoorreexx--wwaarreezz..ccoomm wwwwww..ttrraaddeerrss--ssooffttwwaarree..ccoomm

wwwwww..ttrraaddiinngg--ssooffttwwaarree--ddoowwnnllooaadd..ccoomm

JJooiinn MMyy MMaaiilliinngg LLiisstt

12 THE MENTAL GAME


Most traders have an innate respect for money. Its our raw materialwith which we make our living. And, of course, its what pays ourmortgages, feeds our families, and sends our kids to college.

When I have a bad day, I have a ritual that reminds me about thevalue of money. If I lose a few thousand, I go out and buy some-thinga new suit for myself, something my wife has had her eye on,or something for the kids. Then I look at that item (or items) I have justpurchased. I tally up what Ive spent. That brings home, in a tangibleway, what money is. When you trade, sometimes you can becomedisassociated with the value of money. Youre trying not to focus onthe money, so it may seem like playing with poker chips. But whileyou dont focus on money, you cant lose respect for it.

I remember one of my early lessons about respect for money,taught to me by my mentor, Maury Kravitz. I was in my mid-20s and Ihad just had a big daya six-gure day. Maury and I were out tobreakfast.

When the check came, I grabbed it before Maury could. The totalwas $6. I gave the waitress $20 and told her, Keep the change.

Why did you do that? Maury asked me.I had a big day. She works hard. So I gured Id give her a big tip,

I replied.Then why didnt you leave her $100? That would have really

made her day, Maury said.I was beginning to see his point. With a $6 bill, a 20 percent tip

would have been $1.20! The $14 tip I gave the waitress was gener-ous, but I was in danger of thinking that the money didnt mean any-thing.

Just because you had a big day, Maury told me, doesnt meanyou can lose respect for money. Because when youre trading, youcan lose money just as fast as you got it.


Remember: the market, not the money. Think about making goodtrades, not about making money. Focus on the trading process. If thatprocess is sound, the outcome will be a prot.

What goes on in your mind is a vital part of how you trade. For thatreason, lets review what I call my Ten Commandments of Trading. Ifyou follow them more often than not, youll keep yourself on the pathto trader heaven (which is, of course, buying low and selling high).Trader hell is when everything starts out so promisingand then it allblows up.

Commandment 1. Trade for success, not for money. Your motiva-tion is the well-executed trade. We all want to do well and reap the -nancial rewards. But the goal is success itself. In the case of trading,this is the feeling of accomplishment that comes from a well-executedtrade, based on technical research.

Commandment 2. Be disciplined. As I stated previously, the onequality that traders must possess above all others is discipline. Theability to master your mind, your body, and your emotions is the keyto trading. You can have the best technical analysis available, butwithout discipline, it will be difcultif not impossibleto executetrades consistently and protably. Remember this: The disciplinedtraderregardless of prot or losscomes back to trade another day.

Commandment 3. Know yourself. Are you the kind of person whocan handle risk, or do you break out in a cold sweat at the merethought of risking somethingsuch as your own capital? If thethought of putting money on the line makes you unable to sleep atnight, then a diversied, low-risk stock and xed income stock portfo-lio may be all you can handle when it comes to participation in the -nancial markets. But if you can handle risk in a disciplined fashion,then perhaps trading is for you. Remember, the key here is handlingrisk with discipline. Over the years, Ive talked with countless peoplewho think they would be naturals at trading because they love goingto Las Vegas, and they can really lay it on the line when theyre atthe gaming table. If you want to gamblego to Vegas. If you want touse discretionary capital to make well-executed trades based on tech-nical analysis, then consider trading.

THE MENTAL GAME 13


Commandment 4. Lose your ego. The quickest way to end your ca-reer as a trader is to let your ego inuence your decision making. Andthe more successful you are as a trader, the bigger the challenge thiswill be. You need to silence your ego in order to listen to the market,to follow what your technical analysis is indicating and not what youthink should happen. When you can put yourself aside and bow to thewhims of the market, then you will have a greater chance of success.But believing that you are successful because you possess a certainskillor, more dangerously, to believe that you have mastered themarketis a path to almost certain ruin. At the same time, you cannotbe so emotionally fragile that unprotable trades shatter your con-dence. When you trade, put your ego aside. Allow yourself to get outof losing positions quickly, even if that means the humbling experi-ence of having the market prove you wrong. And when youre suc-cessful, never let it go to your head. This is often difcult for peoplewho have been high achievers. They have to realize that part of thetrading plan is dealing with a loss.

Commandment 5. Understand that theres no such thing as hoping,wishing, or praying when it comes to the market. The market goes upwhen there are more buyers than sellers, and it goes down when theopposite occurs. It doesnt, however, rise because you will it to do so,nor does it fall because youre short and you pray that it will godown. Ive seen too many traders, staring panic-stricken at the com-puter screen, actually beg the market to move one way or another.The reason? Theyre stuck in a losing position and wont get out be-cause they hope, wish, and pray that the market will turn around andgo their way. The reality is on the screen. When the market hits yourstop-loss level (the predetermined price at which youll cut yourlosses), get out. Even if the market then turns around and rallies inyour face, you should congratulate yourself for having discipline. Ifyou have solid money-managment skills, you can have a loss and stillkeep trading.

Commandment 6. Let your prots run and cut your losses quickly.This goes with Commandment 5. Know your risk level, and, whenyou hit your stop-loss point, exit the trade. As well discuss in laterchapters on execution, always trade with stops. When you have a

14 THE MENTAL GAME


small loss, get out. Then reevaluate the market and execute a newtrade. At the same time, know how to let your prots run, but dont begreedy. If you trade using technical analysis, youll determine yourentry and exit points before you place the trade. Then when the signalsare conrmed, you make the trade. When you hit the prot target, getout. Youll never go broke taking a prot. Dont get greedy and hangonto a protable trade so long that the market turns against you sud-denly and then you have a loser.

Commandment 7. Know when to trade and when to wait. As wediscussed earlier, it is not practical or possible to trade every day,all day. You trade when your analysis, your system, and your strat-egy say that you have a buy or sell to execute. If the market doesnthave a clear direction, then wait on the sidelines until it does.Meanwhile, keep your mind on the market, but keep your moneyout of it.

Commandment 8. Love your losers like you love your winners.Maybe even more. Losing trades will be your best teachers. When youhave a losing trade, its because of some aw in your analysis or yourjudgment. Or perhaps the market simply didnt do what you thought itwould. Maybe youre trying to trade breakouts, and the market israngebound. Or perhaps you were chasing the market, jumping on theuptrend too late when the market had already topped out. When youhave a losing trade, something is out of sync with the market. Deter-mine what went wrongobjectively; then adjust your thinking, ifnecessary, and enter the trade again.

Commandment 9. After three losing trades in a row, take a break.If youve just had three losing trades this is not the time to take onmore risk, but rather to become extremely disciplined. Sit on the side-lines for a while. Watch the market. Clear your head. Reevaluate yourstrategy, and then put on another trade.

Consider the story of an S&P trader we proled on TeachTrade.comwho trades out of his home in the Smoky Mountains. On October 12,1999, the trader recalls, he went long at the opening bell, only to havethe market go against himand keep going against him until that un-cle point was reached yet again, three losers in a row. The lossesreached the point, the trader says, that he still doesnt want his wife to

THE MENTAL GAME 15


know! He took a break, drove to a quiet place, and thought aboutthingshis life, his trading. Then he went back to trade the afternoonsession, starting small and building back his condence.

By the end of the day, I had gotten it all back, and had a few dol-lars to the plus side, the trader recalls. That day taught me that allthe indicators, systems, books, videos, web sites, and advisers meannothing unless you, yourself, are willing to apply themand applythem on every trade, to every setup, to every entry, to every stopplacement, and to every exit.

Commandment 10. Observe the unbreakable rule. As we allknow, you can break a rule and get away with it once in a while. Butone of these days, the rules will break you. If you continually violatethese Ten Commandments of Trading, you will eventually pay for itwith your prots. Thats the unbreakable rule. If you have troublewith any of these Commandments, come back and read this one.Then read it again.

The goal of these Commandments is to help you keep your headin the game while your money is on the line. Just as the profes-sional athletefrom the golfer to the football playerhas ritualsand exercises to prepare mentally and physically for the next game,so must traders condition themselves before the bell rings. Cer-tainly, when I began trading there was the physical demand ofstandingsometimes from bell to bellin the trading pit, arms ex-tended over my head until I thought my hands had turned into 100-pound weights. Physical fatigue is a big factor for many oortraders (and why the 40-something veterans like me are gladly trad-ing upstairs at the screens).

But even at the screen, you need full concentration when youre inthe market. For someone who has always been physically activewhether it was high school and college football or a workout at thegym todayI believe exercising my body keeps my mind sharp.Thats why the rst step in preparing to trade is to clear your mind ofdistractions. If your money is in the market, your brain had better bethere, too. You cant be thinking, worrying, daydreaming, or obsess-ing about anything else.

16 THE MENTAL GAME


Next, have realistic expectations about your physical and mentallimitations. Yes, when I was a young trader I stood in the pit from bellto bell, largely because I was lling orders for customers. But it is notrealistic for any trader to expect to sit in front of a computer from 8A.M. Central time (a half hour before the market opens) until 4 P.M. (45minutes after equity index futures close) ve days a week. You musttake a break. Work smart. Concentrate your trading time during therst 90 to 120 minutes of trading, and then take a break. Regroup yourthoughts. Do some more research, and then prepare anew for the nal90 to 120 minutes of trading.

Even when I was in the pit for the entire session in my early days, Isaw that the best opportunities (and frankly the busiest times for cus-tomer orders) were from the open at 8:30 A.M. Central time until 10A.M., and then again around 1:30 P.M. until the close. The rest of thetime, I usually got chopped up in thin markets that lacked direction.

Know that you will have bad days. (Remember Commandment8: Youve got to love your losers like you love your winners.) Youmust be able to bounce back psychologically the next day (or theday after that) and look at the market and your trading plan with afresh perspective. Heres what I mean: Its not constructive to say,Yesterday I lost a lot of money. If I dont make a lot of money to-day Im in trouble. (Or worse still, you could put the blame onthemother traders, institutions, arbitrageurs, major centralbanks, economic cartels, your computer, your software program,your parents, your spouse, your dog, the Fed, solar radiation, oryour inner child.)

Just like you might be tempted to brag about your big trades, youhave to own up to your bad trades. You cant go through life (or trad-ing) blaming someone else for your mistakes. The better way to dothis is to say, [Expletive deleted], I really made some mistakes yes-terday that cost me. But Ive learned a few things. I had better start outslow today, make some prots, and then move on. Believe me, thelatter is a far better mental attitude for success. Youll have a restlessnight, but in the morning you will be ready for the market to reopen.Then youll be back in the gameand ready to ght.

THE MENTAL GAME 17


Sure, when youre going through the loss, its very painful. But ex-iting a losing trade provides a tremendous amount of clarity and evenrelief in some cases. When youre out of that tradeits over; thats asbad as its going to get on that trade. Its not the end of the world ifyou lose money. Its only a problem if you let those losses eat at youand cloud your judgment.

Once your mind is ready to trade, its time to focus on the market.In fact, your mental preparation and the study of your indicators andtechnical analysis, which we will address in depth later in the book, gohand in hand.

When I began trading, I would pore over price charts for an hourevery morning, committing the prices on the paper to my memory. To-day, my technical review time is compressed. For one thing, as a large,independent trader (or local, as were called) I am on the front linesof the market every day. I am literally a part of what appears on thatchart. In addition, I employ the services of technicians who provide asynopsis of the market and indicators.

As well discuss in upcoming chapters, you cannot devise a tradingplanwhich governs every trade that you makewithout rst study-ing previous market patterns. Looking at such things as previous highsand lows, moving averages, and so forth will help you determine thetype of market youre inwhether the stock youve been trading isstuck in a range or the futures market is setting up for a trend reversal.

While I focus on the S&P futures, this methodology of trading willwork with any market, whether its a stock, an equity index futurescontract, or commodities. Or, as Im fond of saying, a trader can tradeanything that has enough liquidity and volume. If it has a price thatmoves, a trader can trade it!

One thing to bear in mind as you read this book: My goal is not togive you the holy grail of trading. First of all, there is no holy grailof tradingand if there were, nobody (including me) would sell it toyou for a few dollars. Rather, my goal is to give you some guidanceand support as you move along the learning curve of trading. Theseare the lessons that I, with 20 years experience as a trader, had tomasterand there are some that still challenge me. Let the experi-ence of others help you to shorten your learning curve and offer sup-

18 THE MENTAL GAME


port when you face a difculty. Remember, trading is a disciplinethat is honed.

But there is no substitute for your own hard work. Its your mentaldiscipline that will determine your readiness to trade. Its your techni-cal analysis and homework in the markets that will help you devise aplan. The good news is, youre not in this alone. The goal of thisbookand the mission of my web site, TeachTrade.comis to pro-vide insights for traders from traders, like me.

And with that, lets begin.

THE MENTAL GAME 19


2Getting Started

For day traders of stocks and futures, there is perhaps no better timetechnologically speakingto be in the market than right now. To un-derscore the point, Im not talking about market dynamics. And Imnot saying that an individuals chance of success has improved.Rather, the evolution in market access that weve experienced overthe past 30 years has led to a democratization of the nancial markets.Moving forward, theres no question that this evolution will continuewhen it comes to direct and equal (or near equal) access to the mar-kets, speed of online execution, and competitive offerings of quotesand market information.

What that means for the trader is that the choices for how to tradehave increased. Broker-assisted. Discount brokerage. Online bro-kerage. Direct access. Those changes are happening in both stocksand futures, although the futures markets to this point have laggedthe stocks when it comes to the explosion in online individual participation.

In this chapter, were going to look at the three basic requirementsof any trader for getting started. These three issues comprise the coreof your system, whether youre trading at home or in a trading roomwith other professionals. These requirements are:

21


1. Brokerage (including commissions and fees)2. Leverage and capitalization

3. Sources of market information

Because this is an evolving marketplace for the individual trader,its important to look backward to gain a full appreciation forandunderstanding ofwhere we are today. Equally important, you mustunderstand the changes that have taken place in this marketplace overthe past 30 years so you can assess the brokerage and market accessthats being offered to you.

First, there was the big bang (not the birth of the universe; the otherbig bangthe one that deregulated the U.S. stock market). Before thistime, high commissions were charged uniformly across Wall Street.For example, if you wanted to buy 1,000 shares of a $50 stock in theearly 1970s, it could cost you around $2,500. (Today, by comparison,you can pay as little as one penny per share to buy and sell stock. For1,000 shares, that means $10 to buy and $10 to sell.)

Those high, across-the-board commissions charged by brokeragehouses caught the displeased eye of the Securities and ExchangeCommission (SEC) and the Federal Trade Commission (FTC). Theseagencies efforts to deregulate commissions and to open the door tocompetition among brokerages resulted in the big bang, which, whileit may not have been as big as the birth of the universe, did create awhole new world for traders.

In 1974, the Securities and Exchange Commission mandated a13-month trial period during which certain brokerage transactionswere deregulated. And its no coincidence that this same yearCharles Schwab started his discount brokerage. Then, on May 1,1975, the SEC ofcially approved negotiated commissions, whichmarked the birth of the discount brokerage industry. (CharlesSchwab & Co. web site, www.schwab.com, 19751977: The Birthof Discount Brokerage.)

A discount brokerage delivered what its name implied. It no longercost the same price across Wall Street to execute a trade. The launch

22 GETTING STARTED


of the discount brokerage industry brought competition to the cost ofbuying and selling stock. This was the rst step in the leveling of WallStreets playing eld, a trend that would become more dramatic in the1990s with the explosion in online trading.

But before the Internet and the advent of the dot-com trader, therewas another signicant event that gave the start to stock day trading:the birth of the Nasdaq Small Order Execution System (SOES). TheNasdaq began trading in 1971, some 10 years after the SEC proposedan automated marketplace to be implemented by the National Associ-ation of Security Dealers. But Nasdaq, like the rest of Wall Street, wasa game with limited players.

That changed with the birth of SOES, which was specically meantfor the execution of orders of 1,000 shares or less. This, in turn, gaverise to SOES trading, enabling the automatic execution of small ordersagainst the best quotations. More important from a day traders per-spective, SOES allowed a new breed of day trader to capitalize onprice uctuations and temporary discrepancies in prices quoted bymarket makers. Speculation was no longer a gentlemans game onWall Street. It was in the trenchesfast and sometimes wild.

I was a partner in one of the rst SOES rooms in Chicago, whereI witnessed a room full of would-be traders clicking their way torichesor so they hoped. More often than not, the SOES traders inthe Chicago trading room saw more losses than gains. Why? At thattime, these SOES traders were being charged the full commissionof $25 a trade. I argued with my partners to lower commissions to$7, but they would not hear of it. It was the beginning of the end ofour partnership.

But for our purposes here, the Chicago SOES room illustratedclearly that average people had the desire to trade and to take on risk.This was not a broker in some white-shoe rm. This was an entrepre-neur with guts who made numerous short-term trades to scalp six-teenths and eighths. Cleary, this was not your fathers stockinvesting, to paraphrase the Oldsmobile slogan. This was a shoot-from-the-hip trader who was buying and selling stocks when the pricediscrepancy afforded an opportunity. Later, as the prices became more

GETTING STARTED 23


uniform, these traders looked for stock prices that moved. Theywanted to buy at 10 and sell hours or even minutes later for 101/4 or101/2over and over again, in hopes of making more money than theircommissions and trading costs consumed. They werent investing.They had even moved beyond traditional stock trading to ultra-short-term trading known as scalping.

On the other side of the nancial market lived another breed ofscalperthe futures trader. As a young trader myself back in theearly 1980s, I did my share of scalping. You waited for a big buy orsell order to hit the pit. There would be a momentary upset in theequilibrium that you could take advantage of. If a big order pushedthe market down, you bought at what you thought was the momen-tary low in hopes of selling out a minute or so later when the priceticked higher. In and out, in and outall day long in the market, aslong as it moved.

Now, remember the history of futures. Midwest farmers who soldtheir grain at harvest time needed to set a price earlier in the year andraise money in the process. A group of merchants got together andformed a marketplace, which in time would become the foundation ofthe Chicago Board of Trade. This future selling allowed thehedgerin this case the farmerto meet the speculator. The specula-tor would agree to buy X number of bushels of grain for a set price,which would be delivered at harvest time. The hedger would be ableto lock in a price for his crop. The risk for the speculator was to buytoo high. And the risk for the hedger was to sell too low. But the ad-vantage for each was opportunity.

In time, we evolved to nancial futures, including currencies, Eu-rodollars, and stock index futures. But in these markets, the sameplayers meet. For example, in the S&P futures pit where I trade, thehedgers are the institutions with large stock portfolios that need to layoff risk or lock in returns, or perform any number of complex hedg-ing strategies involving stocks, futures, and options. The speculatorsare those who take the other side of those trades, namely the indepen-dent local traders like me. We provide the liquidity for those specu-lators to trade sometimes hundreds or even thousands of contracts. Asthe buying and selling of contracts ensues the price uctuates, some-

24 GETTING STARTED


times with great volatility, which allows others to speculate solely onthe movement.

Remember, if a market has volume and liquidity, a trader will tradeit. (I used to say a good trader could trade snow futures if there wereenough volume and liquidity and the price moved enough.) And keepin mind that futures traders were the original day traders. We localsdont buy an S&P contract and hang on to it for ve years. We buy andsell all day long, scalping for prots. The vast majority of the time Igo home at, neither short nor long. On a few occasions I do take aposition that will last overnight or occasionally a day or two, but neverlonger than a few days.

At this point, lets bring these two breeds of speculators together:There is the stock day trader who is looking to make quick prots onmomentary uctuations in stock prices, and there is the futures traderwho is day trading in the futures market. They are professionals. Theydont have another day jobtrading is their day job (for howeverlong their capital lasts).

Now, fast-forward to the late 1990s, when the Internet and instantaccess to market information led to a new, hybrid player. They callthemselves day traders, when in fact theyre probably better de-scribed as short-term traders. The stock craze has extended beyondthese would-be day traders to embrace a more active investing public.About half of all U.S. householdsor about 78.7 million peopleown stocks.

As share prices rose in the 1990s and the access to informationand the marketplace increased, the line between investor and specu-lator blurred. People who used to buy mutual funds decided to trytheir hands at doing their own portfolio management by buyingstock. Watching their buy-and-hold investments on a daily basisthey saw price uctuations that tempted them to buy and sellquickly. The transition was from investor to active investor to specu-lator to hybrid day trader.

Unfortunately, many of these day trades were not placed based ontechnical analysis of the market. Rather, people would buy based onwhat they saw, heard, or believedor a tip they got at the health club.Theyd buy and theyd wait. The stock would go up because of a pre-

GETTING STARTED 25


vailing bull market. (Remember 1999? Nasdaq was up 86 percent.)This became so prevalent that many companies banned employeesfrom day trading at their desks.

I got a rsthand view of this phenomenon when I lectured at Hofs-tra University on Long Island in October 1999. I asked some 200 stu-dents or so in a lecture hall how many of them day traded. I expectedmaybe one or two hands. Half the hands went up! I was later told thatstudents had Internet connections at their desks, which had to be dis-connected because they were day trading during class. One studenttold me that it wasnt uncommon for someone to stand up in the mid-dle of a lecture and shout out, I just made $1,000 bucks!

Much has been written about the bonanza of day trading. Yes, therewere some click-quick millionaires, but more commonly the unini-tiated pointed and clicked their ways to ruin. Even dedicated investorswho tried their hands at this short-term speculation got burned in thesubsequent market downturn in 2000. Margin calls of $25,000,$50,000, or even more were not uncommon. As painful as this correc-tion was for many individuals, looking back you can see there issomething wrong with the picture when an amateur trader playing inthe market can make more money there than in his or her day job. Iknow of an orthodontist who had a very successful practice and yetmade $2 million by day trading. That clearly was a bubble that waswaiting to be burstas Fed chairman Alan Greenspan had alluded toit in 1999.

I know one sad story of a young man who thought he could daytrade his way to wealth for himself and his family. His father, who hadworked hard all his life, set him up with a few hundred thousand dol-lars, which the son quickly blew through. Instead of stopping, thesonand the fatherdecided they had to make it back. Greed hadbrought them to this point, and now fear was going to nish them off.By the end of the sons day trading career, his father had to sell his $2million house to pay for the sons trading losses.

It used to be that a dot-com was virtually guaranteed a high price-to-earnings multiple that would keep rising. But what the investingmasses lost sight of was the fact that what goes up must come down.

26 GETTING STARTED


Paper fortunes made in stocks evaporated. Consider CMGI, which istrading far below its once-lofty heights. (See Figure 2.1.)

Or consider Yahoo!, which on March 7 saw a 22 percent decline inits stock price after it issued a second earnings warning and said thatits chief executive ofcer (CEO) would step aside amid a ferociousdecline in prot. (Investors Wallop Yahoo Shares; Earnings Warn-ing, Koogle Removal Take Toll, by Bambi Francisco, CBS Market-Watch.com, March 8, 2001.) Yahoo! as of that date had a 52-weekrange of 2055/8 to 17. In April, it would dip below $12 a share. (SeeFigure 2.2.)

If at this point you are asking yourself why you want to pursue daytrading professionally, thats a good thing. The only way to get intotrading is with your eyes wide open. You must be aware of the odds

GETTING STARTED 27

Figure 2.1 CMGI Historical Chart (Source: www/interquote.com, DTNFinancial Services)

300

May 01 Jul 03 Sep 06 Nov 09 Jan 10 Mar 14

250

200

150

Pric

e

100

50

0

DTN InterQuote www.interquote.com


that are stacked against you if you want to play and ever have the pos-sibility of succeeding.

Another thing to keep in mind is that the virtual explosion in daytrading sparked another revolution in the brokerages. To attract busi-ness, brokerages slashed commissionssometimes even made offersof no commissionsjust to get the business. They made their moneyby taking the other side of some customer orders, by selling the orderow to other brokerages (a common brokerage practice), or on the in-terest associated with margin trades.

Online order execution in the late 1990s really meant a fast way toe-mail your broker. You clicked on your order entry screensay, tobuy 100 shares of IBMand then transmitted an order. A humanbeing at the other end, however, still had to process the order. But,

28 GETTING STARTED

Figure 2.2 YHOO Historical Chart (Source: www/interquote.com, DTNFinancial Services)

Pric

e

160

May 02 Jul 05 Sep 06 Nov 09 Jan 10 Mar 15

140

120

100

80

60

40

20

0



now, direct electronic access is being offered in the equity and futuresmarkets. For the dedicated, professional trader, direct access speedsyour order to the marketplace with a minimum of human and/or elec-tronic intervention. The brokerage that offers direct access has a com-petitive advantage over one that is still offering only the fast way toe-mail your broker service. And, given the downturn in the marketthat has resulted in a decline in casual day traders, brokerages arescrambling to capture and retain traders.

Take Schwab as an example. On January 30, 2001, Schwab said itwas asking nonessential employees to take one day off from workon a Friday in February or March as part of an effort to cut costs.(Schwab to Cut Work Week for Some, by Nicole Maestri, CBSMarketWatch.com.) Then, some six weeks later, Schwab, the numberone U.S. discount and online brokerage, said it was offering its cus-tomers direct access to stock markets and more extensive stockquotes. The move, Schwab said, was aimed at expanding its leader-ship position with active traders who make more than four trades amonth or 48 trades a year. This new service stemmed from Schwabspurchase of CyBerCorp, which catered to stock day traders, about ayear before.

Where, you ask at this point, do you t into all this? Perhapsyouve been dabbling in day trading for a few months, or maybeyouve just gotten back into it after a few losses that scared you tothe sidelines in 2000. Maybe day trading has always appealed toyou, and now, after watching the tech sector sink to a low that youbelieve must be the bottom, you want to get in. What does all thishave to do with you?

As you start out in day trading you will be one of the most soughtafter of commodities: fresh blood for the brokerages. You will be en-ticed with low rates and supposedly surere systems. Thats goodnews for you as a consumer. The brokerage market is competitive,perhaps more so than ever before given the great strides that rmstook to capture retail trading in 1999and the subsequent downturnthey saw in business in 2000 and into 2001.

Dont forget that what has happened to day traders hasnt happened

GETTING STARTED 29


in a vacuum. The retail investor market also has seen its share ofdeclines. In February 2001, U.S. investors pulled a record $13 bil-lion out of stock mutual funds, with a total of $5.5 billion in out-ows from equity mutual funds in the last ve days of February.Keep in mind that huge inows had contributed to the strength ofthe bull market over the past two years. Individual investors makeup about 40 percent of the money in the stock market. (U.S. StockFunds See Record Outows; Estimated $13 Billion Drop in Febru-ary Mirrors Concerns, by Craig Tolliver and Trish Regan, CBSMarketWatch.com, March 1, 2001.)

So when you go out looking for a place to park your trading ac-count, youre going to be very popular. You should know that broker-ages are looking not only for new accounts, but also to gather assets.Brokerages want to hold your portfolio and allow you to trade. Dontforget: If you buy and sell stocks activelyon your own, without abrokers advicethe brokerage can still reap the prots of the com-missions, even at discounted rates. And while you buy and sell in andout of securities at your own discretion, brokerages can also avoid thatscourge of the business, the appearance of churning, or turning overportfolio holdings allegedly to collect commissions. Rather, these so-called day traders have been churning themselves, into and out ofstocks, and the brokerages have been pocketing the commissions ormaking money on selling the order ow, which well address shortly.

Thats why its imperative that you become aware of what youregetting into before you dive into online trading. Caveat emptor. Or inthis case, let the trader beware!

You must consider all the options and aspects of your three main re-quirements for trading, as outlined earlier in the chapter: brokerage;leverage and capitalization; information sources. Well discuss each ofthese separately, addressing specic areas for both stocks and futures.

BROKERAGESTOCKS

When considering a brokerage, most traders and active, short-term investors want to know one thing: Whats my commission

30 GETTING STARTED


rate? But price is not the only consideration. Equally (if not more)important are the issues of reliability and ease of use. So dont just look at the bargain-basement price being offered, under $10 per trade or even free under special conditions and promotionalevents. Understand who is executing your order and how it is beingaccomplished.

For example, if you have an online stock trading account, you can-not assume that clicking on the transmit button will send your orderto buy or sell stock directly into the marketplace. Rather, what hap-pens with traditional online trading accounts is that by hitting the en-ter key you send your order via the Internet to your broker. Thatswhy we call this a faster way to e-mail your broker. At that point,your broker decides which market to send your order to for execution.Thats very similar to what happens when you call your broker toplace a stock trade.

While this doesnt involve an enormous delay, the process can af-fect the price of a particular stock. For example, Stock X may have hityour entry level of $20 on your screen, but by the time you transmityour order to your broker and the order is routed to the marketplaceand lled, the price could very well be highermaybe by a quarter ora half point.

Also keep in mind that price quotes are only for a specic numberof shares. Therefore, you may not receive the price you see on thescreen when you execute your order.

What should you do if you consistently are lled at a signi-cantly different price than what you see on the screen? Heres a tipfrom the SECs Investor Tips posted on the agencys web site(www.sec.gov). No SEC regulations require a trade to be executedwithin a set period of time. But if rms advertise their speed of exe-cution, they must not exaggerate or fail to tell investors about thepossibility of signicant delays.

For you, the retail short-term trader, that statement once againplaces the burden of responsibility squarely on your shoulders. Knowwhat youre getting into before you open an online account. Under-stand that there can be signicant delaysand therefore price discrep-ancieswhen you place a trade.

BROKERAGESTOCKS 31


Also keep in mind that your broker has several choices when itcomes to executing your stock trade. For example:

Your broker may direct your order to a major exchange (such asthe New York Stock Exchange), to a regional exchange, or to athird market maker that buys or sells stocks listed on an ex-change at publicly quoted prices. The SEC notes, As a way toattract orders from brokers, some regional exchanges or thirdmarket makers will pay your broker [emphasis mine] for rout-ing your order to that exchange or market makerperhaps apenny or more per share for your order. This is called paymentfor order ow.

For a Nasdaq stock, your broker may send the order to a Nasdaqmarket maker in that stock. Many Nasdaq market makers alsopay brokers for order ow.

Your broker may route your orderespecially a limit order to betransacted at a certain priceto an electronic communicationsnetwork (ECN) that automatically matches buy and sell orders atspecied prices.

Another option is for your broker to keep the order in-house. Thismeans that your brokerage will take the other side of your order,lling it out of inventory. That allows your brokerage to makemoney on the spread, the difference between the bid and the ask(also called offer) price.

Keep in mind, however, that your broker still has a duty to seek thebest execution that is reasonably available for customers orders. Asthe SEC notes, That means your broker must evaluate the orders itreceives from all customers in the aggregate and periodically assesswhich competing markets, market makers, or ECNs offer the most fa-vorable terms of execution.

If there is a common complaint among novice traders it is that theprice they see is rarely the price they get. Rather, they typically buyhigher and sell lower than their target prices. The reasons are often

32 GETTING STARTED


twofold. In fast-moving markets, the price can change between theclick and the ll, particularly if your broker must still examine androute your order. Also, if the brokerage is taking the other side ofyour order, you may end up buying at the ask or offer and selling atthe bid. Remember, a stock is bid (to buy) at one price and is offered(for sale) at anotherthe ask price. The difference between those

BROKERAGESTOCKS 33


There are times when youre trading either stocks or futures that youjust cant get into the market where and when you want to. Lets sayyou want to be a buyer if a particular stock or futures contract getsabove a specic price level. But when it starts to move, it takes offlike a rocket. The stock is now $1 or $2 higher than your ideal entrypoint, or the futures contract is 10 or 20 handles higher. (A 10-han-dle gain in S&P futures would be from 1310 to 1320.)

Every trader has suffered from this frustration. And the danger,which you resist, is chasing the market (i.e., buying well after the up-trend has been established and begins to top out, or selling long afterthe downturn and the market begins to turn around). If that happens,you can end up with the opposite of what you want: Youre buyinghigh and selling low.

There are many days in a traders life when youre left on the side-lines, unable to capitalize on a move you saw coming because onceit started it just steamrollered by. Then, as well discuss in upcomingchapters, you take a look at your trade setup and what contributed toyou being late on that particular move. Sometimes, it just happens:You cant get in. Your electronic order-entry system goes down. Orthe major players are bidding (or offering) so aggressively that smallerplayers cant get in.

Then remember this: When youre right but the market passes youby, you can congratulate yourself on your ability to spot the trend (al-beit it a little late). And know that when youre wrongand that stockyou buy because you think it will rocket higher zzles insteadyoucan get all you want.

Such is the life of a trader.


two quoteswhich could widen or narrow depending on market con-ditionsis the spread.

That brings up a particular point for beginning traders. Lets say a stock hits your desired priceit has found support on thedownside or an upward move has generated a buy signal. If youplace a market order, you will be lled at the best prevailing mar-ket price at that time for your requested amount of shares. If youplace a limit order, you will be lled at the price if its availablefor your requested amount of shares. Remember, there is no guaran-tee that a limit order can be lled, particularly in a fast-movingmarket. However, that limit order must be lled before the securityis allowed to trade through the limit, unless it was an all-or-none(AON) order.

If youre truly day tradingand that means buying and sellinghundreds or even thousands of shares of stocks from morning untilafternoona 25-cent difference in a stock price really matters.Again, if youre buying and holding, then an eighth or a quarter oreven a half isnt that much of a difference because youre hoping forpotentially a double-digit return in your portfolio. Not so whenyoure truly day trading. For example, lets say your system gener-ates a buy signal in Company X at $20.25 a share and you think thestock could easily go to $21.50 a share and beyond that to $23. Wellsay the stock has baseline support at $20. Its sector (whether tech-nology or nancial or whatever) is in favor, and the broad market(Nasdaq, S&P, or Dow) also is positive. If you want to buy at $20.25but you get lled at $20.50, thats a signicant difference known asslippagethe difference between the price you saw on the screenand the price at which youre lled. Slippage is a fact of life in trad-ing. You wontin fact, you cantget the price on the screen allthe time, because markets can move in split seconds. Moreover, youmay not be able to get the price you want for the volume of sharesyoure moving.

At the same time, a $0.25-a-share difference in price can have amajor impact on your prot-and-loss statement (P/L) when youretrading hundreds or even thousands of shares of stock for a quick

34 GETTING STARTED


scalp, an ultra-short-term trade lasting minutes or hours. (This is thekind of activity that youll work up to, not start off at.)

Thats why serious stock day traders require direct access. Sim-ply put, direct access allows stock traders to enter their orders di-rectly to the marketplace where they can be viewed and acted uponby a variety of broker-dealers. Direct access originated with theNew York Stock Exchanges DOT system and its successor, the Su-per DOT system, which were direct by-products of the securities in-dustry big bang. The DOT was designed to enable brokers to routetheir clients orders directly to the oor of the NYSE. Nowas thesecurities markets become increasingly democraticprofessionalretail traders are able to gain direct access to the DOT systemthrough services offered by third-market rms and day tradingrms. Once routed to the DOT, however, these orders are executedon the oor of the NYSE.

The Nasdaq, meanwhile, has never had a central trading oor perse. Rather, since its inception, the Nasdaq has been a network of deal-ers that make marketsquoting bids and offerson stocks listed onthe Nasdaq. There are several levels of membership in the Nasdaq,and the higher the level of membership the greater your access to themarketplace. The highest level allows broker-dealers to display theirbids and offers under the monikers assigned to their rms, and to in-teract directly with other market makers.

For retail traders, the most common market access for the Nasdaqis Level II. With a Level II screen you are not able to enter your or-der under your own namesay, Jsmithnor can you interact withthe market makers. But you can see what those market makers aredoing. You can see the other bids and offers from various broker-ages, which helps you to see which securities are the most activeatwhat price and in what quantity. From this perspective of the LevelII inner circle, you can trade with potentially the best knowledge ofthe current market.

Level II access used to be limited to an inner circle of broker-dealers. (See Figure 2.3.) Now, Level II quotes are very widely dissem-inated. Once again, this is yet another example of the democratization

BROKERAGESTOCKS 35


of the market. Further, it increases the transparency of the market,meaning the bids and offers of the rmswhich may very well indi-cate the short-term trend of a particular securityare available foryour viewing.

Viewing rsthand the bids and offers in the market, you can nowtake advantage of direct-access trading of Nasdaq stocks. With di-rect access, you do not electronically submit your bid or offer to abroker. Rather, you send it directly to the marketplace via one ofseveral different routes, including ECNs. Among them (in alphabeti-cal order) are:

Archipelago, which allows users to enter bids and offers into itsnational book that appears collectively under the ARCA system.

36 GETTING STARTED

Figure 2.3 InterQuote Level II (Source: www.interquote.com, DTNFinancial Services)



BRUT ECN, which says it offers cost-effective and accessibletrading through brokers that subscribe to the system.

Instinet, which specializes in agency brokerage services to secu-rity industry professionals.

Island ECN, a computerized trading system that allows broker-ages to display and match stock orders for retail and institutionalinvestors.

MarketXT, which provides services to retail brokerages to offerreal-time, after-hours trading to individuals.

In essence, the ECNs provide greater order transparency in the mar-ketplace. With an ECN, you can see the bids and the offers, and thenumber of shares. Remember, with the New York Stock Exchange,large orders from institution to institutionor block ordersaretransacted in the upstairs ofce, and then reported after the fact tothe NYSE. ECNs allow all participants to see more clearly the buyand sell activity in a particular stock at a particular price.

This combination of ECNs and direct access offered by online bro-kerages is going to revolutionize the potential for serious retailtraders and short-term investors. Of course, to be prudent we mustemphasize the word potential. Direct access does not make tradingand short-term investing any less risky. Rather, it carries two poten-tial advantages:

1. Choosing where and how your trades are executed.

2. Speeding your order to the market via direct access, instead ofwith broker intervention to route your order.

Direct-access trading in equities is offered by a variety of onlinebrokerages. But once again, this is something that active stocktraders and investors should graduate tonot start from. In fact,when you are starting out investing there is nothing wrong with the

BROKERAGESTOCKS 37


hand-holding that goes with using a full-service broker. You getwhat you pay for. Investors who need that extra support should seekit out. Eventually, as you become more active, youll be using onlineservices of the brokerage that will allow you to place a trade auto-matically. Then, as you become more experienced and you are trulyday trading and not just actively investing, you may take advantageof direct access.

Online brokerages that offer direct access have descriptions of thisservice and the usual disclaimer-caveats that go with them. In sum-mary, here are some important considerations for direct-access tradingof equities.

Direct access allows you, in effect, to become your own orderdesk, routing orders to specic exchanges or ECNs. To do this ef-fectively, however, you must learn how to nd the liquidity forthe stock you are trading in a given market.

Direct-access software also allows you to see Level II pricing, re-vealing the activitythe bids and offersof the market makers.Aggressive buying or selling in a particular equity could be an in-dication of a short-term trend. Moreover, when a trader enters anorder and it does not get lled immediately, he or she can see, viathe Level II, why it is not getting lledthe prevailing marketprices are far above the traders bid or below the ask. And thetrader can cancel that order and enter a new one that could bemore attractive to buyers or sellers.

Another potential advantage is that, with direct access, traders cansee the spread on a Level II window and, potentially, capture it forthemselvesdepending on the market activity in a given stock at thetime. With online trading, brokers may sell the order ow or execute itfrom their own book of customer orders, with the brokerage makinga prot on the spread.

Keep in mind that neither online trading nor direct access is anybetter than the other. Rather, they tend to appeal to different trading

38 GETTING STARTED


styles. Online trading may be most suited to those short-term traderswho hold positions for a few days or even weeks. Those who are trulyday traders, holding a position for no longer than a day (and often justminutes or a few hours) may nd that direct access gives them agreater advantage when it comes to price.

However, it cannot be stressed too much that direct-access trad-ing is not for the uninitiated. Before you consider direct access youmust be experienced in stock trading, and you must educate your-self on various aspects of the market, from the differences betweenthe various ECNs to watching activity on the Level II for indicationof a market trend. Put another way, as a direct-access trader, younot only have more control over how your trade is executed, youalso have complete responsibility for it. Keep in mind the lessons ofChapter 1: When you have responsibility for your trades, you ownyour losses, as well as your wins. You dont blame the broker or themarketplace or the suns glare on your computer screen for your un-protable trades. You and you alone initiate the trade and live withthe result.

BROKERAGEFUTURES

The evolution of online trading of futures has mirrored that ofstocks. But online futures trading has not seen the explosion in theretail market that stocks have. For one thing, there needs to begreater education in the retail market about the use of futures, in-cluding their use as a complement to a stock-trading strategy. How-ever, as well discuss later in this chapter, there are some deniteadvantages to be considered with futures trading when it comes toleverage and margin.

But before we go further, lets take a look at the various broker-age options available to a retail futures trader. When youre startingout, its probably best to phone your broker to place your orders.Using a full-service brokerand paying a full-service commis-sionduring the start of your learning curve gives you some hand-

BROKERAGEFUTURES 39

CCC-Day Tr

Lewis Borsellino - The Day Trader's Course.pdf

Documents

Transcript of Lewis Borsellino - The Day Trader's Course.pdf