is when most news is released in themarket. The risk associated with this trade automatically increasesexponentially because of this, and it becomes even more exacerbated over weekends. The imbalance in supply and demand during these periods create gap openings, which are essentially blankspaces in liquidity where little or no trading takes place. Let us sayJuniper (JNPR) closed at $198 per share and opened at $190. This$8 gap creates exceptional risk. While substantial opportunity isalso created once the stock opens, the high risk of a weekend position is simply not worth it. Because the entire world will see thegap once it starts trading, plenty of opportunity will still exist ifyou choose to engage the stock the next trading session.This leads to my rule that Gaps tend to close. Without beingtoo literal, and understanding that confirming indicators must beconsidered before making any costly assumptions, the basis ofthis rule is that prices often trade into the blank space or void. Inthis case you would expect JNPR to make up some of its lossesand close some of the gap in the morning session. An importantcaution is to monitor the tape and other tools closely to confirmthe bias, and not to blindly assume this to be the case in all situations. Certainly, follow-through can and will result in many situations, but a propensity for a stock to close some of its gap isreasonable to assume. The rationale for this is quite simple if youunderstand the mindset of a specialist or market maker. Becausethese market participants are charged with the responsibility toprovide market liquidity, they don’t want to trap themselves intoa less-than-desirable position. Ask yourself this question, “If youwere required to be a buyer of last resort in order to provide liquidity to sellers who would be expected to be strong on the
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morning following bad news the day before, wouldn’t you bidthe stock lower?” As a result, specialist and market makers willoften do just that, hence opening a stock artificially low (gapdown) so that they are not trapped in owning a stock at highprices. Therefore, they open the stock lower than reasonable,where they expect support. You could almost think of them aswriting an overnight naked put, figuring if they get “put” thestock by panicking sellers on the open at these prices that aremuch lower than the closing price, they are in a better position tobuy weakness.For example, suppose you write the AMD April 35 puts at$2. If the underlying stock (AMD) is trading at $37 at the time,you sold out of the money puts since the put buyer is not goingto exercise his or her put to you (selling) at $35 when the marketis trading at $37. Remember, the put buyer wants to put stock athigh prices relative to the strike price, not low prices. The pointis, the seller of the put wrote the put because he or she does notmind being put the stock at $35 because the perception is thatthe stock is well supported at that level. If AMD trades to $33, theput buyer will exercise, forcing the put seller to buy the stock at$35 (the striking price). But because the put seller received $2premium for selling the put option, his or her breakeven pointis still $33 ($35 cost basis by buying the underlying less $2received in premium). If the stock remains stable or tradeshigher, the option will expire unexercised, and the put seller willrealize a $2 profit per share. This is the same rationale of the specialist or market maker who opens a stock lower, near a pricelevel at which he or she perceives the stock to be well supported.In this sense, “gap” openings to the downside are like naked putsto market makers, since they are forced to buy stock as is a nakedput seller, in order to provide liquidity to the market. Because ofthis, they once again will gap it as low as they can!As other professional market participants recognize the perceived support price, the concept behind this rule is that buyerswill come to market and force stock prices higher, while closingsome or all of the price gap. Keep this general state of mind, andgap trading will work for you. When the trade moves away fromyou enough to meet your predetermined risk tolerance, exit, takeyour lumps, and move on! Don’t expect to always be right. Theprofitable trades will take care of themselves; the losses require
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disciplined attention with this trade strategy, because if the stockdoes not find support at the open in this example, chances arevery strong it falls much further as negative sentiment builds.Gaps obviously occur on the upside as well. But again theimportant caution here is, do not be too literal. Gaps are simplygood highlights to get your attention as well as the attention ofothers. Your skills as a trader need to take over from there. As arule of thumb, down gaps are more reliable to trade higher at theopen than up gaps. I think this is because traders are moreinclined to be bullish and drive a good stock even higher whenstocks gap higher, causing the gap to stay open and even expandwith follow-through buying. My experience is that there isapproximately an 80 percent reliability of a down gap filling tosome degree, while gap ups are less reliable to close by tradinghigher at the open due to bullish follow through.Additional rules that apply to swing trading require you toSize the trade. Sizing a trade takes into account many considerations such as volatility, liquidity, daily range, trend patterns,and time horizons. For an example of how this applies to swingtraders, these positions should be light, which means smallershare sizes for longer periods of time and large point moves, sinceswing traders hold positions for longer periods of time. Where theheavy trader bought 1000 shares, for example, held the positionfor 10 minutes, and took a half-point profit, the swing tradermight trade 200 to 500 shares for two days, expecting multiplepoint movement.Let’s say the swing trader executes 20 round-turn trades in aweek. These well-researched trades are based on technicaland/or fundamental analysis, whereas the day traders’ moves aremore instinctual and momentum oriented. Of the 20 trades, suppose half are profitable and half are not. Of the profitable, 2 generate the 2-point profit, which was the target, and the other 8 arejust marginally profitable of 1⁄2 point each. With good discipline,the losers were held to an average loss of 1⁄4 point. Commissionsand fees cost the trader $1000, or $50 per round turn. This ishigher than the day trader, but the day trader’s volume of 50trades a day is the reason he or she is paying lower commissions.The math works out as follows. Two 500-share trades at again of $2 per share each is $2000. Another 8 winners at $0.50per share times 500 shares is another $2000. The losers cost the
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trader $0.25 per share times 500 shares times 10 trades, whichequals $1250. The commissions cost another $1000. The bottomline is a gain of $1750 for the week. Remember that the rationaleis simple: The added risk acquired by taking overnight positionsmust be mitigated or at least reduced with lower share size!I am often asked which approach—day trading or swingtrading—works best for most traders. I cannot answer thatunequivocally for every trader, but I believe in a multidimensional approach to trading when new. As a new trader, one discipline should be learned at a time. In your written plan, oneplan is written for day trading and a second for swing trading.These plans are at the heart of the discipline needed to succeed.As the student develops into a professional or semiprofessionaltrader, one of the disciplines often emerges as the dominantapproach. But we like to see well-rounded traders who can takeadvantage of quick-profit opportunities and still have the patienceto work a trade over time.
NASDAQ TRADERS: WATCH THE OPEN—DON’T TRADE ITMy next rule for the active trader to know is this: Amateurs control the open; professionals control the close. Many people wantto believe that there is some secret reason that things occur in themarket and don’t trust common sense because it is simply toosimple. The fact is that amateurs do make most of their trades inthe morning as well as early in the week. Some of the reasons forthis are obvious, and some are less obvious. The obvious reasonsare that most people get up early and go to work, take the kids toschool, and so on. Therefore, if they have an idea about something, which in many cases is discussed with their spouse thenight before or over breakfast, they act on the idea in the morning before, at, or near the open. The less obvious reasons areemotional. People are generally more positive in the morningwith a fresh night’s sleep. As I stated earlier, when opening atrade, most of the emotions associated with the trade are positive; otherwise, why open it? Who opens a trade they feel badabout?
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With the positive feeling of a fresh new day, many new totrading and even long-standing investors feel compelled to actupon this burst of subconscious emotion through the act of trading. As a result, this is the most profitable time for professionalsand the most costly for amateurs. Amateurs do things like place“market-on-open orders” to buy stocks that had good earningafter the close the day before as they watch it on CNBC thatmorning. Don’t get me started on this mistake. Giving a marketmaker a market order on the open after seemingly good news ona stock is like dropping fresh red meat in a shark tank—something is going to be eaten very fast!This thought process helps explain what good technicaltraders think about and look for on the charts of stocks. You willhear terms like “overextended” to describe overbought situations, but it’s important to pay more attention to the closingprices of stocks than the opening prices since amateurs influencethe open while professionals influence the close. Which groupdo you want to follow?This is an important rule, but it is also the most ignored. Theopen, particularly on NASDAQ, is known for erratic volatility. Inthe first 15 minutes of trading or so, market makers are often getting themselves in shape for the day (by closing any overnightpositions they may have held) as well as processing all kinds oforders that have been placed overnight such as market-on-openorders. Additionally, news events reported between the close theprior day and before the open will tend to elicit overreactionfrom amateurs, while the professional market makers protectthemselves with trade gaps. Opening stocks aggressively high orlow based on the reaction to either stock-specific news oreconomic news is perhaps the most profitable opportunity formarket makers of the NASDAQ and specialists of the listedexchanges. While the price swings are attractive, it is the singlemost dangerous time of day to open trades.The moral of this story is “Think like a pro—!” and sit outthe open for 15 minutes or so. Let the backlog of orders process,let market makers clean up their positions, and let news events inthe market settle in a bit. Plenty of opportunity will exist after theimmediate open. Be patient and pick your spots carefully. Foolsrush in, and professionals take advantage of that. Another goodreason for waiting 15 minutes or so to trade after the open is that
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sometimes market leaders, like AOL, Yahoo!, or Intel, will set thetone for the day in their given group and sector. A good or badopening for one of these 900-pound gorillas can cast a shadow foran entire trading session, including the listed markets.
COMMON TRADING RULES TO FOLLOWTo close this important chapter, I have included a list of rules thatI believe all new traders and most experienced traders should follow especially when employing an active trading style. Whilethere are always exceptions to rules, these rules when followedwill put the odds more in your favor:• Average winners, not losers. Some brokers might tellyou, “Don’t frown, average down.” I feel this is badadvice for most new traders. Adding to winning positions makes much better sense than putting good moneyafter bad and averaging down. When you learn to average winners, you have learned discipline and you aremanaging greed—two very positive trading characteristics. For example, let’s say you bought 1000 shares of ahighly volatile, high-tech stock, PCMS. It makes one ofits spectacular moves, advancing $10 a share in the first45 minutes of trading. The stock comes in a bit on lowvolume (low-volume pullback). Therefore, based on thisand other confirming indicators, you are convinced it isgoing higher. Here are two strategies you can deploy.One is conservative and the other very aggressive. Bothare intelligent.A conservative approach would be to average yourwinner by sizing down your position—say, selling 500shares for a $10 gain. You have lightened up your position. As we mentioned earlier, the size of your positionis one of the two risk elements that are in your absolutecontrol. You have $5000 in profits, less transaction costs.Now you are in a position to take some heat, meaningyou will be able to withstand another small pullback ifyour analysis is incorrect and PMCS continues lower.
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Many traders may well be taking some or all of theirprofits after the $10 run. So you should expect a retracement in price. If you expect a restart on the trend lineafter a small pullback, you still have a position whilebooking some profit. In this scenario, you have hedgedyour risk while leaving continued upside. This will helpyou grow a $5000 alligator suit to absorb additional heatif the pullback continues while reestablishing a highermental protective stop.The second strategy is much more aggressive.Instead of sizing down the position, you add to the position, hence “averaging your winners.” This approach isbased on your belief that PMCS has pulled back to a“higher low” and is reestablishing a support level duringthe low-volume pullback (indicating the sellers are notthat aggressive). Sizing up the position during this pullback also makes sense and is a common strategy for themore aggressive trader. The mindset is that PMCS is intrend to the upside and is there for a reason, and itmakes more sense to trade with the trend than against it.It is important to note in this scenario that the traderwould be buying the pullbacks since stocks will generally come in at stages of a trend.As experience grows, there are exceptions where itmakes sense to average down. Averaging down has meritat times, and to categorically say that one should neverdo it is a bit bold. Most new to trading never drill anydeeper into the issue and simply average down whenthings don’t go their way. Many will evaluate the priceof stock in relation to their cost basis in the stock. If theyown BGEN at 60 and it falls to 50, the perception is oftenthat the stock is low in price. Unfortunately, that kind ofthinking is very injurious. When traders instead learn toevaluate stocks through filters such as technical indications, then subjective analysis begins to dissipate. Averaging down works best in conjunction with short-termtrading strategies. On intraday trades, I often will beginto open a trade by scaling into it while buying weakness,for example, expecting not to buy the exact bottom. Iwill look for contracting volume through the tape to find
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signs of the sellers’ dissipating. Additionally, I look forbuyers to begin to emerge on Level II and monitor howlong they hold their bids while sellers are hitting thosebids. If the stock ticks lower, I continue to monitor theselling volume and buying sentiment. If a pivot is revealing itself through diminished selling and increasing buying, yet there is still a slight imbalance of sellers overbuyers, I adjust my psychological risk fences and recognize that support is building. I often will scale in somemore and buy some more weakness. This process maycontinue for several minutes, and as long as the indications support the idea, I have conviction to let the tradework for short-term strategies. Discipline, therefore, isdefined by the ability to follow the market and stay withthe trends it shows you rather than to panic and liquidate too soon.• Never let a winner turn into a loser. Greed is perhapsthe most likely reason for this completely inexcusablemistake. Let the market tell you when to exit trades.Your profit and loss in a trade has nothing to do with it!If your trade is acting well, as defined by key indicators,and the market activity is supporting your position, stayin. If not, it’s go time! The last thing you want to do is letit become a loser. In the example of PMCS, if you let the500 shares you still own drop $10 from your entry point,you would break even, not counting commissions andfees. This would be plainly irresponsible. Setting a mental stop-loss price as the stock trends higher protectsprofits that should never be given back to the market.Day traders, as a rule, use mental stops, rather than placing them in the market or with a broker as traditionaltraders do. This is because day traders are at their terminals while trading, and more importantly, are unwillingto reveal their exit price to a broker or other market participant such as a trading desk that buys order flow fromonline trading firms to know where your exit point is.Announcing your exit point is the equivalent of playingcards and letting your opponents know you need kingsfor gin! Never show your hand until you have foundliquidity and are ready to exit the trade. This is another
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example of a proactive versus reactive order. A protective stop is the price at which you will exit the tradeimmediately. You also know that once a volatile techstock starts to move one way or the other, it has a tendency to move very fast with thin liquidity at each pricelevel; therefore, getting in front of the wave of liquiditywill save you the market impact cost (MIC), which I willspeak more about in Chapters 5 and 6.Where should your stop-loss point be? There is nodefinitive answer. The stronger your conviction thatPMCS is going higher in the next hour or so, the moreheat you can take. In this case, without being too literal,we would consider a stop loss at halfway between whereyou entered the trade and where you took a profit. Thatway, you have at a minimum a total profit of $7500 (again of $10 on the first 500 shares sold and a profit of $5on the remaining 500 shares). Another option availableon EDAT systems is conditional order entry (COE). COEallows you to marry decision support tools with directorder execution to send an execution when the criteriathat you set are met. What is powerful about this systemis that the algorithm resides on your PC and does notindicate to other market participants where your buyand sell points are.Back to our PMCS example: Remember that you canalways reenter the trade. If after exiting your entire 1000shares, PMCS begins to show strength again, you canalways buy it again, and I promise you will be muchmore objective deciding to reenter the trade than youwould be while in the trade. Never get in the mindsetthat the trade you happen to be in at the moment is youronly chance to make money that day. Make it a habit toTake profits often.• Never mix disciplines. If you open a day trade, close aday trade. This relates back to marrying losers; don’t doit. Swing trades are meant to last for days; day trades arenot. Never confuse the disciplines. An example wouldbe to hold the remaining 500 shares of PMCS overnight.You have now taken a short-term momentum trade and
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made it into a swing trade—an obvious violation of ourrule and a common practice of new day traders. Youopen yourself to the twin fears of market risk throughtime and heavy share volume through the day trade, andthis is a bad combination. In the morning you will beeither lucky or very sorry. While you would prefer to belucky, as I said before, the market has no room for it, andyou should not rely on it. Once a trader begins to depend on luck, he or she should take his or her businessto the casinos.• Never try to trade back a loser. Emotions get tooinvolved when the last trade you made influences yournext trade, especially when trying to press and get backa losing trade. This is generally a good time to walkaway long enough to become objective again. Subjectivetraders lose; cold hard logicians remain objective andtend to succeed. If you have the good sense or instincts,developed through experience and knowledge, to dumpPMCS if it started to retrace on heavy volume, for example, never look back. Do not be so convinced of youropinion of any stock that you continue to buy it once itbegins a downtrend. Recognize that that is a shortingopportunity, and Don’t fight the tape. This expressionhas been around Wall Street for many years, and itmeans that a trader should never fight the momentum ofthe market, which is reflected through the tape. If youthink you should get back in the stock, wipe your mindof any opinion you have and evaluate the new situationfor what it is—a completely new trade. Apply your trading criteria to the new situation as if you had neverlooked at the stock before.
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RULES FOR STOCKSELECTIONRules of the TradeTrade liquid stocks.Avoid chaotic stocks.Match volume to time.Specialize.Trade stocks with good correlation.Trade strong sectors.Do the research.Forget about chat rooms.
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et’s assume you have followed the rules up to now, and youhave a good idea of the type of trading you will begin within terms of time horizons, research, sectors, and tradingtools. Let’s also assume that you are committed to gaining themechanical and cognitive knowledge of the market throughsome sort of mechanism that helps you understand dimensionsof trading that go beyond the scope of most introductory books.Some of these areas that require in-depth exploration and studyare software usage, market terminology, the differences inexchanges (namely, NASDAQ and listed exchanges), order flow,and the way in which orders are routed to find market liquidity(touched on in Chapter 2).Unfortunately, this introduction to the market is the exception, not the rule. Most new market participants introducethemselves to the market by trading the most volatile issueswith the highest degree of risk. You may recall a programimplemented for young juvenile delinquents called “ScaredStraight.” This program utilized the stories of convicted felonsto instill fear of what the fate will be for those that break therules of life. The program proved quite effective, but no suchprogram exists for traders to scare themselves straight until it isoften too late, when not only has the financial bank accountbeen depleted but also the emotional bank account. I find thattraders fail the fastest because of the stock selection process.This leaves the responsibility to obey the rules of trading onyour shoulders. These rules will be discussed in this chapter,and they can be digested quickly and easily to help you avoidthe biggest pitfalls in trading. This leaves the rest of your trading life to dedicate to developing and refining the intangibleattributes necessary to trade successfully, such as strategy, technique, intuition, and confidence. Don’t make the critical mistakes I will highlight throughout this chapter. Think of all thetraders before you who are out of business as the convicts who,64
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if they had the chance to do it all over again, would make muchdifferent choices the second time around.We have done studies on over a thousand traders throughdatabase analysis, and I can tell you the correlation of failingtraders to IPOs, sexy tech stocks that are in the news, and fastpaced chaotic dot com companies is amazing! More often than not,stocks that move big are stocks that have experienced their movebefore there was time to react. These moves are often over beforethey start! Chasing the seemingly exciting IPO that opens up 70points over its initial public offering price will tame the sensesquickly when the stock settles in the same opening day 40 pointsoff its debut high. There is no reason to ever expose yourself to thischaos. You will hear all kinds of braggarts tell you what great success they had in these plays because their exuberance causes themto talk, but believe this: They are the most quiet people you willever meet after their luck runs out and the market humbles them(Figure 4.1). Because of their false sense of wisdom created by anyearly luck they may find, they sooner or later fall, and they fall thehardest of all market participants! Don’t be one of them.
FIGURE 4.1 Image created by Stan Yan, active trader and artist
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LIQUIDITYLiquidity is like oxygen to traders; without it, they are dead.Therefore, the first rule to follow for choosing tradable stocks isTrade liquid stocks.The best way to explain liquidity in terms of the market is toconsider it in the context of an auction. The Chicago Board ofTrade (CBOT), the Chicago Board of Options (CBOE), the ChicagoMercantile Exchange (CME), the NYSE, and other regional listedexchanges across the country are all auction markets. To understand liquidity, ask yourself this question: Do you have liquidityin a thin auction market? Obviously, the answer is no. With noparticipants, you have no buyers to “lift offers” nor sellers to “hitbids.” The term lift offers describes buyers’ taking what sellershave for sale at any given price, while hitting bids refers to sellers’offering stock to buyers who bid to own stock.Liquidity, therefore, is found with stocks that attract adequatebuyer and seller activity. Like an auction, in the absence of buyersand sellers, markets become volatile and less efficient. Less efficient stocks increase risk exponentially, putting the trader in jeopardy. In fact, it is at this stage that risk management and disciplinereally begin to be important. Most believe that discipline isdefined as cutting your losses, but I argue that discipline beginslong before that. It begins when choosing stocks by evaluatingtheir risk/reward characteristics, in which liquidity plays a bigpart. While it could be argued that illiquid volatility also createsopportunity through rapid price change, statistics prove thatvolatile issues move the most in the least amount of time. Therefore, most opportunity dissipates while downside risk looms.Below are listed eight attributes of what I consider to be atradable stock for a new trader. The first criterion is that it is beingtraded a minimum of 500,000 shares per day. Experienced tradersoften drop this figure as their skill grows, but before you do, youneed experience in entering and exiting trades in thin markets.The mechanics you must learn, such as how to use limit and leading limit orders, will be a big contribution to your success.Screen Criteria for Stock Selection1. Daily volume of at least 500,000 shares per day. Stockswith daily volume at this level or greater provide you
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with an exit means. No stock is worth trading withoutone.2. Sufficient intraday price volatility. Beta is a measure ofthe sensitivity of a stock. Stocks with high betas such as2.0 will move dramatically up or down on light news ormarket wind (economic forces). I trade stocks with astronger beta but with tight risk tolerance. While thereare no mathematical formulas to track this with a literalnumber, you can measure this by other criteria, such asrelative strength. For example, if while trading AppliedMaterials (AMAT), the market is selling off in thePhiladelphia semiconductor index (SOX) but AMAT isnot participating, I look to go long as soon as the SOXregains footing.3. Correlation with major indices and sector leaders.Stocks that track well against the groups they tradewithin are more readable. I rarely trade stocks that fadethe index or group they trade within. Contrarian stocksusually have a reason they are bucking the trend, andthose reasons are not well known or readable.4. Minimum of five active major market makers. If there arenot at least five active market makers of reasonable cloutmaking the market in a given issue, I don’t trade them.The best market makers trade the best stocks. While somewould argue to stay away from these stocks for that veryreason, I disagree. I want to watch the 900-pound gorillastrade and shadow them. They will leave clues whilemoving big money around, called money flow.5. Reliable technical indicators available. I like “honeststocks.” This simply describes stocks that trade true tothe charts. When a stock establishes a good range ortrend, the stock trades within these patterns predictably.When they break the patterns, I step aside and wait forthe news that caused the pattern to change to dissipatefrom the market, or I day trade the extreme moves for aquick momentum trade.6. Strong book on at least two ECNs. For the same reason Iwant good market maker activity, I want good subscription from ECNs. The www.nasdaqtrader.com Web site
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can show you which ECNs and market makers are activein which stocks.7. Tracked by analysts. Analysts do a lot of research, listen in on earnings reports, attend annual meetings, andhave relationships with the Board of Directors (BODs).By reading research reports they produce, you gaina strong feeling for longer-term sentiment. While Iavoid trading on their immediate news such as ratingschanges, I do want to form a broader view of the stocksand sectors they report on through research reports.8. News easily available. If I can’t read about the companies I trade with current information, I don’t trade them.Many stocks are reported on by only their own companyofficials, and there is little news about them from analysts and researchers. I avoid those companies. If thestock is not gaining the attention of analysts, it is notgaining mine. When stocks are reported on regularly,they set stock in motion since so many amateurs tradethe news. I like to wait for the amateur money to rush inor out of stocks based on news and fade public reaction.What fuels the rate and speed at which stocks trade is againsupply and demand imbalance related. The appetite for stock (orlack of it) market participants have for a given security is whatfuels price movement and liquidity. The speed at which theseinstruments trade is reflected through volume, which is thebyproduct of liquidity and supply and demand. Therefore, volume is at best a coincident indicator of market participants’ passion in any given issue. That passion will reflect itself as bullishwhere demand exceeds supply or as bearish where supplyexceeds demand. As the aggressiveness of bulls and bears grows,volatility can actually fade through balances in supply anddemand, even though volume is strong. As one side actually gainsa strong advantage over the other, such as bulls over bears, it canbecome harder to enter to open a trade or to close or exit a tradebecause the stocks thin out at each price level as imbalances grow.Liquidity, therefore, is found with issues that elicit enoughresponse on both sides of the supply and demand equation toincent buyers (demand) and sellers (supply) to come to market at
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a rate fast enough to provide the trader ample opportunity tomove in and out of trades. Without that “indication of interest”from market participants to trade a given instrument (stock), youare left in the same situation as the auctioneer trying to sellwhere there are no buyers. When absence of liquidity occurs,prices tend to become much more sensitive and volatile. Thisoccurs because extreme measures are taken by one side or theother of the imbalance to create market reaction. One exampleof such measures would include ratings changes by analysts ofsell-side firms (broker-dealers), that in almost all cases cause amarket reaction. Liquidity and volume will measure market participation, but supply and demand imbalances will measurewhere the participation is dominant. For example, if there is anoversaturation of sellers in the absence of buyers at a given pricelevel for a stock, sellers seeking liquidity from buyers tend to