Paying Traders’ Tuition

• September 11, 2002
• HamFon

How do you
become a successful trader — and survive the learning experience, both
financially, and emotionally?

I have only
been trading since April 2002. I have done everything wrong, learned
from mistakes, studied hard, searched charts for hours and hours, been
depressed, been elated, and generally had a great time in trying to make
daytrading my new profession.

I am just now feeling like I have a basic grip on how everything works, things
are starting to click for me more often, and I feel like I have more moments of
trading “in the zone.” I’ve been working hard at making daytrading work — for
almost six months — and I’ve discovered that it’s true, this
is hard work — it is not a get-rich-quick
scheme — and you get out of it what you put in.

When I started, I certainly could have
used some real-people war stories “from the trenches” to help me determine what
was important to learn, what was not, and (the most difficult part) how to deal
with day trading emotionally. I have collected below a list of things that have
helped me along the way — information learned from books and magazines, learned
from other traders, and learned from my own experiences.

• Set
  your goals: “I
  want to be rich” may be a goal, but it’s not well defined. Set
  specific goals. My goal was to be able to
  support my family financially as I have been doing for many years. To do this,
  I determined that a reasonable goal to strive for would be to average one
  dollar per share in my trade size (for example, averaging $100 profit a day
  when trading 100-share lots). This seems to be an attainable goal, and it is
  also nicely scalable once you have reached the goal.

  Assuming 250 trading days a year, each 100-share lot size for trading would
  earn $100 x 250 = $25000 per year. Given sufficient funds in an account, this
  can be scaled by trading larger blocks of shares (up to the point of where
  your trades start having liquidity problems because they are too large). If
  your financial goal is $100K per year, that can be attained by trading
  400-share lots (4 x 25000). Of course, it’s not quite
  as simple as that, because you may add refinements like scaling in and out of
  trades. But — it’s a specific goal — and attainable

   

• 
  Dedicate yourself to reaching your goals:
  If you are really serious about becoming a daytrader, you need to treat
  it like any other job — get the training, learn as much as you can, and
  practice, practice, practice. You can learn a lot of things from books — they
  are essential in getting a framework of knowledge into your head —
  BUT — “…there is nothing that can prepare you
  for the unbridled carnage…” (from the movie, “Trading Places” of course!) of
  the market when you participate in it. Get serious about your education — and
  your apprenticeship.

   

• 
  Study: Buy some books, subscribe to some
  magazines, and study it all. I bought 16 books. Every
  book has taught me something — some books have taught me things you
  will not survive without. I subscribed to Active Trader magazine
  and Technical Analysis of Stocks and Commodities. Of the books I have
  read (so far), I highly recommend:
  

  • “The Disciplined Trader” by Mark
    Douglas — covers the emotional and psychological side of trading
  • “Rules of the Trade” by David
    Nassar — covers all facets — invaluable information
  • “Tools and Tactics of the Master
    Day Trader” by Oliver Velez — some fluff, lots of details about technical
    analysis and day trading techniques
  • “Bollinger on Bollinger Bands” by
    John Bollinger — essential — but don’t read this until
    AFTER you have become very familiar with your
    trading platform, and you have testing and gotten a good feel for technical
    indicator usage

     

• 
  Choose a direct-order-entry trading platform:
  This is the program that you will use to make trades. There are many choices
  (my website lists some). Because
  of my 30-year computer programming background, and my desire to have
  backtesting and trade-automation, I chose
  TradeStation .

  There are several features that you need to prioritize to help you make your
  decision. If you are trading smaller size (100, 200, 500 shares), you may want
  to select a platform that has low commissions for smaller trades. What types
  of charting and data do you need? Some platforms provide the data, and some
  require you to purchase a datafeed from another vendor.

  Some platforms charge you a monthly fee. The best way to choose is to visit
  several websites, download demo programs, and TRY
  them out. Selecting one with many features that you won’t use
  immediately may be a good choice — the platform gives you something to grow
  into — features that you can take advantage of as you become more proficient.

   

• 
  Study some more: Learn how the markets work.
  What’s the difference between the Nasdaq market and the New York Stock
  Exchange? What do Market Makers do? What are Specialists? What are Short and
  Long orders, Limit orders, Stop orders? What is an ECN, and how are your
  orders handled differently with each ECN?

  A lot of this information you can get from magazines and books, but you also
  need to sit down in front of your trading platform and
  USE it until you understand how to place orders, how to cancel
  orders, how to exit orders, how to determine what trades to make, how to
  determine the number of shares to trade, etc.

   

• Pick
  technical indicators: Use your trading
  platform to monitor stocks as they change during the day. Try different time
  frames (I use 1, 2, and 5 minute to select trade entry and exit, and daily to
  get a general trend).

  Try the indicators that your charting package provides: MACD, Stochastics, RSI,
  Simple Moving Averages (SMA), Exponential Moving Averages (EMA), Trend Lines,
  Fibonacci retracements, Bollinger Bands, etc.

  Try different settings – 10, 20, 50 SMA, compared to 8, 13, 65 SMA, compared
  to 10, 20, 50 EMA. Try to determine what the indicators are telling you – how
  well do they help determine entry and exit positions?

  Try different stocks, and different sectors. Do stocks in one sector move in
  unison? Do some sectors follow the market indices, and some move the opposite
  direction?

  One of the biggest problems you can have with technical indicators is trying
  to use too many. Pick one or two — learn how they work, learn what they mean,
  get a good feel for them. One common mistake that traders make is that as soon
  as their current indicator fails, they move on to another one. No indicator
  works perfectly — they all give false readings sometimes.

  Look for agreement of indicators, look for agreement across time frames. Is
  the price bouncing off the top Bollinger Band on the 5 minute
  AND the 2 minute chart? Does RSI indicate that
  the stock is oversold? Is the general trend of the stock down? Is the the
  general trend of the stock’s sector down? Is the general trend of the market
  down? Maybe it’s a good time to short the stock!

  Look for general agreement among your various indicators and timeframes. If
  you wait for ALL indicators to give you an
  agreeing signal, you may never place a trade. You just need enough agreement
  to give you an edge – to make your probability of winning the trade slightly
  more likely than not.

   

• Find a
  Stock Scanner: You need to select a small number of
  stocks to monitor during the day. Stock scanner programs will search through
  thousands of stocks, looking for stocks that match the criteria you specify.

  Maybe you’re looking for stocks that have an average price range of more than
  a dollar each day, and that have a share price from $5 to $50, and that are in
  the Biotechnology sector. TradingMarkets.com offers some good
  
  scanning technology. You can also purchase programs to scan for you – I
  use TC2000 .

   

• 
  Start trading: You’ve already paid for the
  school books – now it’s time to pay the tuition ;) Remember, the purpose is to
  LEARN — if you feel like you will just be able to sit down and start
  making money, fine — best of luck to you!

  A more conservative approach (that does not depend on luck) is to trade in
  small lots as you learn. You will lose
  money! Expect it. Start with enough capital in your trading account that you
  will not be hurt by losing part of it. Don’t trade with money you can’t afford
  to lose (one of the psychological reasons is that if you trade with “scared
  money,” you cannot trade based on charts and trade data — you will be
  affected by fear of losing your money).

  My decision was to trade in 100-share lots until I was consistently
  profitable. Consider the money you lose as you learn to be your “tuition” —
  the same that you would pay a college to train you for a skill.

   

• Keep
  a trading log: During your first few hundred
  trades, you will make a lot of mistakes. You will also have some successes.
  Your goal is to learn what NOT to do – and
  to learn what works.

  If you take notes on your trades (as well as your emotional feelings, and any
  other pertenent information like world events or market happenings), you can
  review these notes to find patterns. Maybe you have a problem getting out of a
  trade after it has gone against you. Be honest
  in your log — you don’t have to show it to anyone else. The more honest and
  objective you are in evaluating your skills, the quicker you will be able to
  progress along the path to profit.

   

• Set
  rules: As you trade, as you make errors, as
  you have successes, develop a set of rules that give you a better edge with
  successes, and minimize the losses. Do you try to catch Opening Reversals in
  the first few minutes after the market has opened? They can provide
  spectacular winnings — and just as easily make a big hole in your trading
  account when they don’t go the direction you guessed.

  Here are some of the rules that I use:

   

  • Trade between 9:45 a.m.
    and 11:30 a.m., and 2:00 p.m. to 4:00 p.m. The
    first 15 minutes of the market opening is often difficult to play, unless
    you have a lot of experience, since the market makers are adjusting prices,
    dealing with overnight orders, and trying to set the opening price.

     

  • Never hold a position
    overnight. I follow this rule for my daytrading
    account because I have more control of trade entry and exit during the day
    — and I’m not willing to gamble my money on gap openings.

    This rule may be modified or removed depending on the timeframe in which you
    trade. It is a good rule if you are strictly a day or range trader (trades
    lasting from a few seconds to at most a few hours). Of course, swing traders
    would not follow this rule, since their timeframe is up to a few days.

     

  • Before entering a trade,
    choose stop loss exit price based on charts (support, resistance,
    Fibonacci levels, etc.), and also choose profit exit price. If the
    loss exit price is too far from the current entry price (too high of a
    risk), don’t take the trade. If the profit exit price is small compared to
    the stop loss exit price (risk-to-reward is not profitable enough), don’t
    take the trade.

     

  • You set that Stop Loss
    — USE IT! You chose the stop loss
    BEFORE you entered the trade because it was not
    an emotional time — so in the heat of battle, trust your stop, and exit
    immediately if it is hit. Go back later and review the trade (for your trade
    log), and at that time, you can determine if the stop loss could have been
    chosen better.

     

  • You set the Profit Exit
    — USE IT! Based on the volatility of a stock, you
    may determine that you want to get 20 cents per share, 50 cents, or
    whatever. Once your goal has been hit, either liquidate the trade, scale out
    (liquidate a portion of the trade), or tighten up your “trailing stop” so
    that you don’t give back the profit that was your goal. The second or third
    options are preferable.

    Watch the Time And Sales screen – watch the Level 2 screen – determine if
    the momentum is slowing down. If the price blasts right past your profit
    exit, let it run! But as soon as it shows signs of weakness, make sure that
    you get at least the profit you planned.

    You may want to get out of a trade early, with a smaller profit, but make
    sure that you do this based on objective evaluation of the charts and
    bid/ask prices, and not because you get nervous about giving back
    ANY money. You need to give the trade enough room to do corrections
    — but not so much room that the correction becomes a reversal.

     

  • Use Limit orders
    whenever possible. Set the price where you want to
    trade, don’t let the market makers set it for you. The only exception I
    generally make to this is when I have a trade go against me and the price is
    moving so fast that it keeps passing my Limit — then I’ll either place a
    Limit outside the Bid/Ask range, or I’ll capitulate and do a “just get me
    the heck out” Market order.

     

  • Enter trades on signals
    that are defined by your analysis. Don’t enter a
    trade unless the conditions meet your criteria. Don’t “feel lucky.” As you
    get more skilled, you may occasionally enter trades that “feel” right,
    without being able to define the exact reasons — but you should not be
    doing that until have had a lot of
    experience.

     

• Find
  one or more mentors:
  Maybe you know a trader personally? Or you may be able to find some good
  traders in various chat rooms. I have visited several chat rooms, and found
  that the TradingMarkets Traders Wire
  Interactive has everything I need. There are people there who can answer
  questions and who can coach and help you.

  Beware of trade rooms – they often have their own agenda. Find one (like TWI)
  that has traders in it who are actively trading, and not just hyping stocks.
  Lurk for a few sessions, watch, learn. Try to determine who the best traders
  are. Try to determine who are the people who are there for an ego trip — and
  may provide you with misleading (or just plain wrong) information.

  You can learn a lot by watching the very best traders in action. When they
  make a trade, bring up the chart and try to determine their reasoning. Ask
  questions (but don’t be a pest!). Remember, these people are there to make
  money — if they don’t answer you, they are probably busy!

   

• 
  Place trades based on your own evaluation ONLY:
  Never ever place a trade because someone in a chat room called it out.
  You can certainly use the call as input — but go check the chart yourself,
  and make sure that the trade follows your own rules.

  Maybe they called out the trade, but it’s for a swing trade, with a 50 cent
  stop loss, and your pain level is no more than 10 cents — pass on the trade.
  Maybe they got a hot tip from a friend – maybe they want to sound like they
  know “inside information” — maybe they looked at the charts and liked the
  trade, but they read the chart wrong — or maybe it’s a good trade. Make sure
  YOU think it’s a good trade before you put your
  own money on the line.

   

• 
  After enough losing trades, take a break:
  This is a personal thing — everyone will have a different level of pain. As
  soon as you start to feel frustration or emotion (“gotta get my money back”),
  walk away from your computer for a few minutes, and don’t start trading again
  until you can trade based on the charts and data, and not based on your
  emotional state.

   

• After
  you’ve read everything, read more: Never stop
  learning — the markets keep changing, and there are so many facets to them
  that there will always be more for you to learn. This will help give you a
  competitive edge (“knowledge is power”), and it will also keep you up to date
  on new products and rules and techniques.

  How do you get a raise as a “traditional” job? (No sarcasm, please!) — you do
  the best you can in your current job, you learn everything you can, and you
  prepare for the next level. Then you prove that you have the knowledge and
  abilities for a promotion. In daytrading, you give yourself raises. You are
  responsible for your own destiny – the better qualified you are, and the more
  experience and knowledge you have, the more you are “worth” — and the more
  money you can make.

   

• Use
  online references for learning and research:
  The TradingMarkets
  University
  website has hundreds of pages of lessons about all aspects of trading. It also
  has stock scanning tools to help you choose which stocks interest you. There
  are many other sites that have useful information, including Implied
  Volatility, Futures, Options, lists of members of sectors, list of the most
  active trading ECNs and market makers for each stock, and more. My
  website has links to many of
  these sites and various daytrading tools and references. Bookmark your
  favorite sites, and include them in your daily research.

   

• 
  Recognize your psychological and emotional weaknesses:
  This is possibly the most difficult part of successful trading
  — being able to control your emotional responses to the market, particularly
  during a trade. Fear will keep you from getting into a trade when your
  indicators say it’s a good bet. Greed will keep you from getting out of a
  trade, waiting for just a little bit more money — and will keep you in the
  trade as it reverses, and you give back all of your potential profit.

  Fear will get you out of a trade early, because you don’t want to give back
  ANY of the potential profit. Greed will cause you to chase a trend, and
  get in “so you don’t miss the boat” – often when the trend about to end and
  reverse.

  Egotism will keep you in a losing trade just because you must
  PROVE that you were right — until the pain
  exceeds your threshold, and you exit the trade for a big loss. You must accept
  that your trades will not always be winners — that doesn’t mean that you were
  “wrong.”

  Since nothing in the stock market is a “sure bet,” you must recognize that the
  laws of probability are active. If you are wrong half of the time, but when
  you are right, you make twice as much profit as you lose (through your stop
  loss) on losing trades, you will be consistently profitable.

  Write your feelings and emotions in your trading log — note every time that
  you do something based on an emotional response rather than a technical
  indication. Review your log to determine what emotional responses adversely
  affect your trading, and make a plan (see the Rules
  section, above) to correct the problem.

   

• Calculate
  the Reward/Risk: For each trade, determine how much
  you might gain, and how much you might lose. Factor in the probability of a
  “win,” then objectively make the decision as to whether the reward is great
  enough to justify the risk. If the risk is too high, don’t take the trade.

  For example, you might have a consolidation (where the stock price is moving
  sideways — not trending up or down), and you have reason to believe that the
  stock may drop in price (maybe the sector is dropping, maybe $TRIN is
  negative, maybe $VIX is increasing, etc.).

  You look at the charts and see that if the stock were to drop in price, there
  is no significant support level for at least 30 cents down. You take the
  trade, with a 10 cent stop loss, and your Reward:Risk is 3:1 – probably a good
  bet. There are more extreme examples.

  You see that the price of the stock is hovering very close to the gap created
  when the stock opened in the morning — and the gap is 75 cents away. However,
  the chart doesn’t give any indication of whether the price will go up or down.

  In this case, your probability of winning is not as good as with the previous
  example, but your potential reward is higher, possibly signaling that you can
  enter the trade. Your goal is to select trades where your winnings
  significantly exceed your losses, over the long run. To do that, you need to
  pick trades carefully, and only enter trades that you think have a good chance
  of giving you a profit.

I have learned much over the last six
months — and I’ve also learned how much I do NOT
know. I wish you the best of luck in your trading endeavors! Make a plan that
stacks the deck in your favor, stick to your plan, and you’ll be successful. It
may take months, or maybe years.

The only indication that trading is not for you is that you are unable to follow
your set of rules — or that you are unable to start making a profit before you
run out of money. Give yourself enough time to learn before you start expecting
results — and give yourself enough money in your daytrading account to weather
Tuition — and to handle drawdowns (losses based on probability swings when you
have a string of losing trades).

Good Trading!

HamFon