How muchdo you need to day trade or swing trade? Should you open a cashor margin account? Does margin change if positions are heldovernight?Knowing what stocks you will trade and the size of the tradewill help establish your account size. If you selected stocks of$100 per share and you plan to day trade heavily (large sharesize), you would need at the very least $50,000 in a 2:1 marginaccount, and this would still substantially limit your opportunities because you would be confined to just that position while ina trade (assumes 1000 shares at $100 per share).To determine how much capital you need, you should firstdecide whether to open a cash account or a margin account. In acash account, you must pay for whatever stocks you purchasewithin three days. This is known as T+3, or the trading day plusthree more days to settlement day. In a margin account, you payfor half the cost of what you purchase, and you borrow the restfrom your broker. The amount of margin you can borrow is set bythe Federal Reserve in what is known as Regulation T, or Reg T.The fed can adjust the figure up or down to slow down the economy or to heat it up, but at the time of this writing, Reg T is set at50 percent, and it has been at 50 percent for a long time.If you day trade, it makes sense to use a margin account fortwo reasons. One, it doubles your buying power, giving you moreflexibility in higher-priced stocks and the number of shares youcan trade. The other reason is that you generally will not have topay any interest on the amount borrowed for intraday tradesbecause the trades are offset each night at clearing.
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However, if you hold a margined position overnight or fordays, weeks, months, and so on, you must pay interest on thedollar amount borrowed. The interest is based on the broker’scall rate, and it is usually a little above the prime rate.Most brokerage firms have a minimum account size. Generally, it is lower for online trading accounts than for day trading.The reason is that the online accounts tend to be less active andtherefore less risky for the brokerage firm. Some day tradingfirms seek only the most active traders, and their minimums arehigh, as much as $100,000. Other firms seek active traders whopossess discipline and control—therefore, require less capital tobegin, such as $25,000. All margin accounts, by federal regulation, must have at least $2000.There is more than one type of margin and more than onetype of margin call. A margin call is a request from your brokerage firm to add money to your account. A margin call can evenoccur in a cash account. For example, you have $5500 cash inyour cash account. You place a market order to buy 100 shares ofa stock priced a $50. What happens if your market order getsfilled at $60? You owe $6000 plus commission. You get a margincall from your broker for the short fall. If you do not meet thecall, the brokerage firm has the right, via the account papers yousign to open the account, to sell as much of your stock as necessary to satisfy your debit.There are three kinds of margin calls. The first mainlyapplies to day traders, and it is called an intraday margin call.This means that at some time during the trading session youexceeded your buying power. This figure usually appears onyour trading software, and it is calculated by doubling the excessequity in your account. The good news is that most trading software is designed to prevent you from exceeding your daily buying power.The second type of call is the overnight margin call, alsoknown as a Reg T call. This occurs when you exceed the amountof stock that you are allowed to hold overnight. You must haveenough cash or securities in your account to pay for 50 percent ofthe stock you hold overnight. New money is required to meetthis call. If you do not meet the call, your account is immediatelyput on Restriction 2—meaning nothing can be withdrawn andmargin calls must be met the next day.
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The third type of call is a maintenance call. This is the mostcommon call of the new undercapitalized trader because onceyou have been holding a position in a margin account, if it losesvalue, you must maintain enough equity in the account to satisfy25 percent of the current market value for long positions and 30percent for short positions. If your equity drops below this minimum, you will receive a maintenance margin call. During the“.com crash of 2000” (as I believe it will be remembered—March24, 2000, to May 25, 2000), many learned then that their techstocks were not coming back (in time) to alleviate the maintenance calls, which forced sellouts and realized losses that endedmany peoples’ dreams of trading for a living or even as a supplement to their incomes.This topic can be a bit boring, but these rules are expensiveto break, so before opening a margin account it is best to understand the rules placed on your account. A final word on margin:These rules can be made stricter than the Federal Reserve requires, and often are. Each brokerage firm establishes its ownhouse rules. House rules supersede all rules as long as they meetthe minimum Fed criteria. I particularly like firms that havestronger requirements—it shows they are protective and careful,and I would much prefer to have my money in one of those firmsas opposed to a loose cannon firm. Many firms have gone out ofbusiness and have put customers’ capital at risk by having nocoverage greater than the coverage provided by SIPC (SecuritiesInvestors Protection Corporation), which all firms must carry. Iwould suggest you diligently investigate the rules of the firmsyou are considering and not just pay attention to commissionrates alone.The next key area to consider is your financial situation.Much of what will shape your plan will stem from your capitalavailable and the emotional attachment you have to that capital.The rule here is Scared money never wins. Before becoming anactive trader, you should be on sound financial footing; withoutthat, trading will be more associated with excessive fear thanwith reasonable confidence. This rule simply means you must bein a position to lose all your speculative or high-risk capital without the loss materially affecting your lifestyle. Before attemptingany high-risk venture—and online or EDAT day trading shouldcertainly be considered high-risk trading—you need to address
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some fundamental issues. For example, if you plan to trade fulltime, you must consider your cash flow and the money you willlive on. Having a sufficient nest egg to handle unexpected emergencies and funds to cover major impending expenses (college forchildren, retirement, etc.) are all strong considerations, and is notmoney that should be put at risk. “Scared money” already putsthe odds of succeeding against you through conscious or subconscious pressure. Additionally, you need to assess time commitment, support systems, and psychological aspects of trading to“brace yourself for losses,” not winners.Being financially stable takes a considerable amount of pressure off you as a trader. You can enter, exit, and manage tradesmore rationally. A trader, for example, who is in a losing trade andcannot afford to take a loss has the tendency to hold the trade toolong—hoping it will turn in his or her favor. This can result in theviolation of several of the rules that every trading plan shouldinclude whether new or experienced.If this sounds like a lot to learn, you are absolutely right. Butthe knowledge you will acquire through studying will prepare youto decide which trading style will work best to help you meet yourobjectives. You will discover what type of research, markets, andsecurities attract you the most, and that insight will give you anadvantage over the amateur who seeks every gap opening, splitannouncement, or other market event that screams “Trade me!”Headline events in the market are seductive to the aimless marketparticipant, but the disciplined professional who stays focused onhis or her plan and who executes trades that meet the criteria inthe plan is positioned to run the long race. Successful trading is amarathon, not a 100-yard dash.The rules covered this far lead up to one all-encompassing rule:Get the knowledge.I believe a “fork in the road” has developed in terms of market education, instead of what should be more viewed as a scale,with a proper balance between mechanical understanding of themarket and the psychological dynamics that determine how touse such knowledge. In one direction is the road to all cognitive, mechanical knowledge of the market. Because there is somuch to learn and so much of it changes frequently, this road isvery dynamic. In the other direction is the road to the emotional
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influences on the market that are often mysterious, esoteric, andeven elusive. The fact that the two roads exist is not the problem.The problem is that most people choose one road to the exclusion of the other rather than spending time on both.Cognitive learning, or the acquisition of “factual and tangibleinformation,” represents the road that most believe will bring thesuccess they desire. Software programs are perhaps the largest andmost sought after tool that traders focus on in order to look for themagic in trading that really doesn’t exist. This one-sided focusoccludes the psychological or emotional dynamics of trading thatmakes up the other road less traveled. The only true constant in themarkets is the participation of humans who tend to react to similarsituations in predictable ways. If we can understand our true motivations, chances are we can figure out a way to succeed. I believenow, after traveling a fairly long way down both roads, that successful trading does not result from equal devotion to bothapproaches. While both are extremely important, and one couldnot survive without the other, once a solid footing is secured ingaining factual information, it is understanding the psychologicalforces that will yield the greatest gains. Unfortunately, amateurswill continually choose the wrong road, wasting valuable time trying to strengthen their mechanical knowledge through softwaresystems and decision-support tools, while the more importantroad (psychology) is traveled only lightly, if at all.So there it is: The odds for success either fall significantlytoward your favor with knowledge or significantly away withoutit. Ironically, that is the dichotomy of the market itself; brutallyunforgiving of the weak and tremendously rewarding of the competent—a daily representation of Darwin’s survival of the fittest,where success is measured most objectively, in dollars and cents.There isn’t very much in between.
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RULES FOR TRADINGRules of the TradeKnow your strategy.Use Level II as an indicator, not as an allinclusive decision support tool.Read the levels, not the ticks.Know your order routes.Never allow your order flow to be sold.
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his chapter addresses the fork in the road I spoke of inChapter 1, but it focuses first on the mechanical systemsthat we use to trade. While many people know a great dealabout the stock market in terms of research and technical indications, which in today’s marketplace are increasingly important,some of them have abandoned their methodology and tradingtechniques that have worked for them in the past, prior to thedrastic improvements in technology. Many wise traders haveformed strong opinions and strategies of what they should tradeand for what time horizon but have lost their poise to stay withthe opinion because of the rapidly changing action associatedwith “microtools” and real-time information now available withtechnology. The action plan for a given idea or trade can quicklyerode under conditions of what I would call “market schizophrenia,” which is often associated with real-time tick data.Real-time data have changed the course for many usually profitable traders to a new losing course because they have becomeintoxicated with studying stocks too closely under a microscope—a phenomenon that real-time information can provide. Inthis environment, many otherwise intelligent traders lose theirconviction for staying with strategies that have served them wellin the past. They lose the feel of reading the ebb and flow of themarket or a given security when they view its behavior in anelectronic direct-access trading (EDAT) context.While these systems provide incredible power and the freedom to take control of your trading decisions and executions, touse them effectively requires something in addition to a deepunderstanding of their functionality. That addition is your ownthinking. In other words, you must decide whether or not actingon the data will lead you to meet your trading objectives. Let meexplain. I have met many professionals from various fields whohave come to our school equipped with a pretty good tradingexperience. Some have told stories about how much money they24
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were making and how they were going to abandon their successful careers—which have actually afforded them the time andmoney to trade full time. Unfortunately, when this irrational behavior is at its peak, words of caution we offer are no more heardthan the words of a bartender to the drunk who has had one toomany. The effect of the intoxication is the same even though thedrug is different. The proverbial fork in the road is forged whenthis type of individual discovers the power now available throughdirect-access information and execution. Many fail to recognizethat not only has their short-term success in the market been bornof one of the greatest bull markets we have seen but also that thetrading style they unknowingly adopted kept them further backfrom the gyroscopic, micromarket environment.Until real-time information was available, the only marketparticipants that had access to this trading environment wereexchange traders on the floor, who were taught by seasoned professionals whose entire careers were shaped in that very environment. They were taught through the very delivery system andculture that had been built over many years and generations oftraders associated with this environment. There existed, therefore, in this environment, many natural mentors to teach the nextgeneration of traders.This brings us back to our professional that I was speakingabout. Perhaps he or she was a doctor, lawyer, small-businessowner, entrepreneur, engineer, teacher, or any other professionalyou can think of. I think I have met most of them, and they havehad a common experience. They have had some luck provided bythe bull market, and their gain was protected by the natural safebarrier created by the delay in information availability throughmedia such as brokers, the telephone, newspapers, and delayedInternet quotes. Thus many thousands, if not millions, of peoplehave found some “perceived” success in the stock market. Thesepeople of course want more of that success, so they derail themselves completely or partially to travel on a new road with whichthey have absolutely zero experience. They have not been therecipients of training on an exchange floor. They have not had thebenefit of mentoring from seasoned pros. Most have not beenbody slammed and stomped on by the market, and the few whohave been have not stood back up and licked their wounds toreturn to fight another day, unlike the floor traders who are taught
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to do so by their mentors and who wear their battle scars like abadge of honor and beacon of hope for their young protégés.Instead, most online traders are ill prepared and intoxicated witha taste of success, and they have little or no knowledge but arestill trying to day trade a living from the attraction of powerfulreal-time electronic systems. Therefore, the introduction of realtime market data unfortunately produced more money drunksthan true professional market participants.The statistics the industry reports are true: Only 10 percentor so of the people who engage in this sort of trading will be evenmoderately successful. This same 10 percent (if it is that high apercentage) are making fortunes, while the remaining are losing,falling to the sidelines like casualties of war. Is this because daytrading successfully is not possible? Is this because the brokeragefirms that offer day trading services are merely charlatans of themarket, luring the unknowing into the “big top” just to take theirmoney?No. If day trading successfully were impossible, then no percentage of day traders would be successful, and if most brokeragefirms were market charlatans, they would not be surviving either.The market is so pure that it has a powerful self-cleaning mechanism to rid itself of either party. Whether it is the ill-preparedamateur trader or the uncommitted sell-side brokerage firm, themarket eventually punishes and purges both. Therefore, survivalis possible, but to do so requires that the trader know and followthis important rule: Know your strategy.The day traders’ strategy, if defined as microtrading, is totake many small incremental profits (SIPs) from the marketwhile strictly limiting losses. Novice online investors’ strategyhas been, and still is, to buy a stock based on some research, totake a good guess on what the stock is worth based on price association to where it may have been (ebb and flow), and to hold onto it until it returns a profit or the investor is taken out of thetrade through a margin call and excessive losses. The bull marketprior to March 24, 2000 (the beginning of the bear cycle of 2000in my opinion), rewarded this behavior, causing novice onlineinvestors to believe they were “unconscious competents” or even“conscious competents” when in reality many were proven to be“unconscious incompetents” when the bear cycle arrived. A luckyfew missed the carnage.
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The term conscious competent comes from a psychologicalmatrix that was created in the late 1960s and came into popularuse without a real attribution to its originator. The competencymatrix reveals a process whereby an individual progresses fromone level of competence to another. The phases of the matrix asthey apply to trading include the following:• The unconscious incompetence stage, which describes aperson who cannot trade successfully but doesn’t knowit. Too many online investors fit into this category.• The conscious incompetence stage, which describes aperson who cannot trade successfully and knows it. Thisperson knows he or she should seek education andknowledge before proceeding.• The conscious competence stage, which describes theperson who can trade successfully by thinking about itand following a plan. Many have been confused intothinking they are in this phase when in reality they areexperiencing luck in the bull market. While thesetraders seek knowledge, they learn the short side of themarket.• The unconscious competence stage, which describesthe person who can trade successfully and consistentlyon pure instincts. While mechanical knowledge isdynamic, it is likely that these people can reach andremain in this stage because they know themselveswell and they understand the psychological influenceson their thinking. This stage is the goal of every professional trader!Certainly other speculators exist that include money managers, individual traders with a longer-term outlook, and othermarket participants who could be defined as unconscious competents, but in all cases, before you set out in any direction, youshould have a firm strategy in mind and on paper. Before studying the tendencies of successful market participants, we mustfirst explore where most mistakes are made by novices.Many have attempted to leave their respective careers to daytrade full time under the illusion of a forgiving market prior to
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the crash of March 2000. Unfortunately most were humbled oncethe Internet “bubble” burst. Additionally, real-time systems contributed to the amateurs’ failure while continuing to be the professionals’ friend.Many novices become victims of the market not because ofthe powerful tools they are using but because of the way they areapplying those tools. If day trading is the strategy, micro imbalances in supply and demand is the approach for which the toolswe are about to cover will be invaluable. Note that any strategyother than day trading will require an alternative application ofthese tools. However they are used, the new tools available provide tremendous application and utility, but proper use is imperative because improper use is unforgiving. What is to follow arethe rules that should be followed while using the newestmechanical systems in the market. While I consider these rulesto be critical, they are in no way a substitute for the even more critical rules, to be covered later, that relate to psychology. Knowing agreat deal about technology, technical indications, mathematicalformulas, and other tangible applications for the market will neverreplace or supplement the trader’s self-knowledge. Those who donot gain and maintain emotional control once caught in theinevitable maelstrom of the stock market will find it impossible tofind reason and clarity of thought.That said, let’s begin by defining what day trading was andredefine what it has evolved into today. A few short years ago, aday trader’s primary mode of operation was scalping for spreads.Spreads were artificially wide due to market inefficiencies causedby events that are no longer important for the purpose of our discussion but are fully examined in other books such as the Secret ofthe SOES Bandits, written by Harvey Houtkin. Today, trading forspreads is a mistake, and the only profiteer in that equation will bethe brokerage firm with whom the trader attempts this foolishendeavor. Supply and demand (S/D) imbalances have been andwill always be the only enduring strategy for active trading. Ironically, the tools used by the day trading scalper of just two to threeyears ago are the same tools that today are utilized as confirmingindicators for active traders, although they are not the sole literaldecision support tools they once were.Many “SOES bandits” of the past were able to make moneyoff this temporary anomaly in the market, but the enduring
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strategies that have always yielded results are born from supply/demand imbalances.The rules given in this chapter describe the “best-methods”use of these various tools available on an EDAT system. Since somany resources already exist explaining these various tools, Iwill not cover their functions in detail. Instead, I will prescribethe rules that should be followed to use them, making the assumption that you have already or will acquire an understandingof their functionality.
THE LEVEL II SCREENThe Level II screen and the ticker, or tape, as it is called, are twotools that can highlight opportunity for the professional traderthat recognizes trends created by order flow in the market. Thisis important since success leaves clues in most endeavors, and itdoes so in trading as well. These clues are left on real-time electronic systems in the form of S/D imbalances that suggest impending moves for stocks. The rule is Use Level II as an indicator, notas an all-inclusive decision support tool.Level II price quotations are one of the most important toolsfor any short-term trader. I strongly recommend Level II to anyone actively day trading. Understanding Level II price quotationsgives you a tremendous insight into micro imbalances in supplyand demand of any stock, which in turn is your best signal forshort-term direction of stock prices. While learning to accuratelyread the Level II window can take months of practice, withoutthat skill, you put yourself at a distinct disadvantage. These benefits alone more than justify the use of Level II for any tradingstyle, active or passive. However, the problem I see is that manytraders still use it as they did a few years back when spread trading via the Small Order Execution System (SOES) was popular.The utility for this type of trading today is dead in my opinionand should be buried accordingly. Unfortunately, many firmsand novice traders won’t let it die and continue to lose money asa result.Another risk of using Level II and the tape is that, if monitored too closely and too literally, it does become intoxicating, as
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I stated earlier, and it creates a distorted view that does notreflect the true momentum or direction of a given stock. Therefore, Level II is best used in concert with other trend-followingindicators that together shape overall momentum for a trade.Trend-following indicators, defined in many ways, includingtrading price levels, monitoring the futures market, indicestrength, and technical indications, can be found in any goodtechnical analysis book. Another strong attribute of the Level IIscreen is that it can help traders acquire precision executionskills. Level II creates transparency to a stock’s liquidity, whichidentifies the market maker and ECN who is bidding and offeringstock along with the size of their bid or offer. This is of greatvalue because with this level of transparency married to directexecution tools, the need to ever place an order where you losecontrol, such as a market order, is eliminated. I will spend moretime on precision execution methods, market versus limitorders, and trade entry and exit strategies in Chapters 5 and 6.
TIME AND SALES (TAS)The rule regarding this tool is Read the levels, not the ticks.The TAS, or the tape, is one of the oldest tools there is for reading the market’s direction and momentum. First invented in1867, the ticker like the Level II screen can be intoxicating, and,in fact, even more so when it is viewed too closely and literally.I have seen traders work themselves into a state of hysteria onetick at a time trying to interpret what each and every printmeant. Often those who think they know the most actuallyknow the least as is obvious when they claim they can read themarket strictly with this one tool. The better strategy when utilizing this tool is to read the price levels of support and resistance in real time while determining where prices are strongand well supported and where they grow weak and resistant.Think of this as “tape support” and “tape resistance,” whichsimply explains where a stock is well supported from goinglower and where it is resistant to going any higher.Recognizing these levels is important, as is understandingthe strength or weakness of these levels. For example, if CSCO
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trades to $60 on light volume from a support level of $50, thetrader would see that as a strong indication that CSCO is strongwithin this range due to the light volume it traded as it moved10 points. This would suggest that few sellers exist in CSCOwithin this range. If CSCO continued to follow through on heavyvolume another $3 to $63, this would indicate that weaknessmay be setting in within this range due to the heavier sellingvolume. As profit takers come to market, the selling pressurebuilds. Although demand still exceeds the sellers, which is whatallows for the additional $3 move to $63. The increasing, or“thicker,” volume building is an indication that this move isnearing an end. A trader would trust anything within the $50 to$60 range much more than a move from $60 to $63 if the stockshould pull back within this $3 range. For example, supposeCSCO comes in $9 from the high of this range ($63) to $54. Iwould consider the likelihood of CSCO trading from $54 ($63minus $9), which represents a higher low, to $60 much greaterthan its trading from $60 to $63, everything else being equal.The strength or weakness of a stock’s range can be measuredthrough the Time & Sales screen and the volume of shares thattrades through it. This is just one example of the power of thistool, but it is a good example of how to use it to read levels asopposed to every tick.The utility of this tool is far greater than just the examplecited, but the point to draw from it is that, if you attempt to interpret every print or tick with this tool, you force your mind intosuch a microview of the market that you will not see the forestfor the trees. I find this is one of the most common mistakes amateur traders make when they enter the day trading environment.An example of how you can take the data from this tool andincorporate it into indicators that are more macrofocused withinthe day could be the TRIN indicator.TRIN stands for “trader’s index,” and it measures advancingto declining issues against volume. For example, if the number ofadvancing stocks is growing at such a pace that it is disproportionate to advancing volume over declining volume, then the market may be approaching a top, and a reversal or downturn isgetting closer. Without going off on too much of a tangent inexplaining the value and the math of this indicator, the point Iwant to make is that many mathematical formulas such as TRIN
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exist to measure what an active trader is trying to measure throughthe information he or she receives from tools like the tape. Thecore difference is that, when you filter this information throughyour mind, instead of relying completely on filtering the information through a computer, your mind blends your feeling, intuition, and experience while reading these levels, something acomputer cannot do at this time. As TRIN can highlight animproving or deteriorating market condition, the tape can be usedin concert to identify stocks with relative strength or weaknessthat will lead the overall market. While TRIN represents overallmarket condition, it is important to remember that it is the alignment and confirmation of several tools that formulate tradingdecisions. TAS alone loses a great deal of its utility, but whencombined with Level II, technical indicators like TRIN, and otherindicators like sector strength, it is one of the strongest tools atrader can have. The following example also helps to explain.
PRESSURE POINTSThe following is an example of how the Level II and TAS work inconcert with each other and act as a strong short-term indicatorfor trade entry, exit, and decision support. This example is easyto understand when broken down a piece at a time, and veryeffective when implemented by active traders who have the discipline to follow it. I call it pressure points. Pressure points describe areas of support and resistance for a given stock, whichhighlights reversals. Reversals are defined here as a breakdownafter rallies at resistance and a bounce after sell-offs at support.These turning points often show signs of pressure before theyrelease, and make what are often the biggest moves of the day forvolatile issues.Suppose you are reading a Level II screen with a Time &Sales screen, and the bid and offer for the stock in question is 85to 851⁄8. The prints on the TAS screen are showing that the volume of trading at that moment is trading at the bid, indicatingsellers are in the market, hitting the bidding market makers andECNs. As market makers and ECNs are being hit (buying), sellersare providing them with the stock they are buying. The indica-
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tion to look for here is how aggressive are the sellers selling stockto the market participants who are bidding to buy, and howmuch appetite for the stock do the buyers have for the stock atany given price level.Now most ECNs as a rule will not show you as much indication since they generally represent the retail market and the aggregation of many individual traders trading within any given ECN.Therefore, interest to buy or sell a stock at any given price level isdifficult to read since no one person or personality reflects thesentiment in any given ECN. This is not true of a market makerwho is only one or a few people making the market in a givenstock at any given firm. For example, if CS First Boston (FBCO)has one market maker making the market (trading) in VRSN, youcan read the intentions of FBCO as a whole much better than thoseof an ECN, which, as I stated, can represent thousands of traders.Therefore, as the market maker in this example is buying aggressively, evidenced by staying at the bid taking stock, he is showingyou something about his sentiment for the stock (bullish). ECNs,due to the fragmentation within them, are not as strong a signal asan individual market maker. One exception would be Instinet,which is still more reflective of institutional order flow becausethere is less fragmentation in comparison to the public representation within other ECNs such as the Island ECN (ISLD), Archipelago (ARCA), or Speer Leeds Redi ECN (REDI).Back to the example, as sellers aggressively hit these bids(evidenced by a fast-moving tape and high volume with biggersize prints such as 500 to 1000 shares), the indication to look for,in addition to the volume of trades on the tape, is how long andwho is remaining as a buyer of VRSN on the Level II. Additionally, how fast are bidders getting out of the way (fading bids)? Ifbidders are fading fast, while sellers are aggressively hitting theirbids, that spells weakness and indicates that the bid price in themarket will be lowered. On the other hand, if the bidders are taking on a lot of stock while sellers are hitting their bids, marketmakers are revealing their hand by staying at the bid buying,showing their strong appetite for the stock. This will generallybegin to show as the stock has already fallen or come in a bit andhas begun to reflect buying strength to the upside as stock is getting to a support level. Also, this indication can be confirmed asECNs begin